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{
"speaker": "Operator",
"content": "Thank you for standing by. And welcome to the Chubb Limited Third Quarter 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. [Operator Instructions] Thank you. I’d now like to turn the call over to Karen Beyer, Senior Vice President, Investor Relations. You may begin."
},
{
"speaker": "Karen Beyer",
"content": "Thank you and welcome everyone to our September 30, 2024 third quarter earnings conference call. Our report today will contain forward-looking statements including statements relating to company performance, pricing and business mix, growth opportunities and economic market conditions which are subject to risks and uncertainties and actual results may differ materially. Please see our recent SEC filings, earnings release and financial supplement which are available on our [email protected] for more information on factors that could affect these matters. We will also refer today to non-GAAP financial measures, reconciliations of which to the most direct comparable GAAP measures and related details are provided in our earnings Press release and financial supplements. Now I'd like to introduce our speakers. First we have Evan Greenberg, Chairman and Chief Executive Officer, followed by Peter Enns, our Chief Financial Officer, and then we'll take your questions. Also with us to assist with your questions today are several members of our management team and now it's my pleasure to turn the call over to Evan."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning. As you've seen, we had another really great quarter with strong double digit growth in both P&C underwriting and investment income leading to core operating EPS growth of over 15.5%. Global P&C premium revenue, which excludes agriculture, grew 7.6% or 8.5% in constant dollars, which is the clearer way to view intrinsic growth and once again reflected the broad and diversified nature of our company and the opportunities we're capitalizing on around the world with strong contributions from our North America P&C International, P&C and life insurance businesses. Core operating income for the quarter was $2.3 billion, up 14.3%. Earnings for the year are currently at record levels with net and operating income up 16.9% and 13.8% respectively. The three sources of earnings growth, P&C underwriting, investment income and life income each delivered a strong result. Our published combined ratio for the quarter was 87.7% with P&C underwriting income of 1.5 billion up over 11.5% despite an active quarter for the industry globally in terms of natural catastrophes, hurricanes, floods, fires, tornadoes and other severe convective storm activity. On an ex-cat current accident year basis, a secondary measure of underwriting, we produced record underwriting income of $2 billion up 11.5% with a combined ratio of 83.4%. For the year, we have produced record underwriting income on both a published and current accident year basis. As a company in the business of risk, we pride ourselves on being world class underwriters. It's who we are. We're also asset managers with an excellent long-term record of invested asset allocation and risk adjusted returns. Our invested asset now stands at 151 billion and it will continue to grow as a consequence of our basic business of insurance. For the quarter, adjusted net investment income topped 1.6 billion up 15.9%. Our fixed income portfolio yield is 4.9 versus 4.7 a year ago and our current new money rate is averaging 5.5%. In our judgment, given the broad based health of the U.S. economy and the pattern of inflation when one reads past the headlines, the Fed will likely take a reasonably cautious approach to lowering rates. Given the size and continued growth of our federal deficit, which is simply unsustainable, we believe the yield curve will steepen and that too will support our future reinvestment rate. We remain confident in our ability to reinvest our cash flows at rates that will continue to accrete to the overall portfolio yield. Life insurance segment income of $284 million was ahead of plan and while you know it's our policy to generally refrain from guidance, we are well on pace to exceed our life division income target of a billion for the year. Our annualized core operating ROE for the quarter was 13.9% with a return on tangible equity of 21.7. Peter will have more to say about financial items. Turning to growth, pricing and the rate environment, Global P&C net premiums, which excludes agriculture increased 7.6 in the quarter were again 8.5 in constant dollar with commercial premiums up 8.1% and consumer up 9.4%. Again, growth was global and broad based geographically by product and customer segment. North America, Europe, Asia and Latin America all contributed favorably. Life premiums grew 10.6% in constant dollar with growth of 10 in international life and 15 in combined North America. In terms of the commercial P&C rate environment, market trends were consistent with those of the previous quarter. Overall conditions are favorable in both property which is incrementally more competitive in certain areas and casualty which is incrementally firmer. Loss cost inflation remains steady and within what we have contemplated in our pricing and reserving pricing for both remains ahead of loss costs. Property has become more competitive in the large account and EMS segments while middle market property pricing was in fact up over prior quarter are large in all three segments of the market. Our property book is well priced and terms and conditions remain steady. As with prior quarter casualty is firming in the areas that need rate and we see this trend in casualty enduring. Overall, our casualty rate and price were up over prior quarter. Let me give you a little more color by division. Beginning with North America premiums excluding agriculture were up 7.8% and consisted of 10% growth in personal insurance and 7.2 in commercial with P&C lines up nearly 10% and financial lines down about 5%. We wrote more than $1.2 billion of new business up over 18% versus prior year and our renewal retention rate on a policy count basis is 89.6%. Again, both speak to the reasonably disciplined tone of the market, the power of Chubb and our excellent operating performance. Premiums in our major accounts and specialty division increased 7.2 with P&C up 9.5% and financial lines down over 6%. Within major and specialty, our E&S business grew 11% with strong contributions for both property and casualty related lines. Premium in our middle market division increased just under 7% with P&C up 10.7% and financial lines down 5.7. Again, the underwriting environment in North America is generally favorable and rational. Financial lines aside, pricing for property and casualty excluding financial lines and workers comp was up 9.9% with rates up 8% and exposure change of 1.8 again with both rates and pricing up from second quarter. Financial alliance pricing was down 3.2% with rates down about 3.4%. In workers comp which includes both primary and large account risk management pricing was up 4.2% with rates up 1.4 and exposure up 2.8. Breaking down P&C pricing further, property pricing was up 6.7% with rate of 3.7% and exposure change of 2.9%. Casualty pricing in North America was up 12.7% well in excess of loss costs with rates up 11.9% and exposure 0.7%. Our loss cost in North America again remains stable, no change and in line with what we contemplate in our loss events. In agriculture, where we are the market leader, we gained increased market share and wrote more policies insuring more farmers and fields. Though premiums were down from prior year primarily due to lower commodity prices than last year. Commodity prices are used to price the premiums we charge farmers. Far more importantly, our crop underwriting results this quarter were excellent and from everything we know now, 24 is shaping up to be a very good underwriting year. On the consumer side of North America, our high net worth personal lines business had another outstanding quarter with premium growth of 10% including new business growth exceeding 25%. Premium growth for our true high net worth segments, the group that seeks our brand for the differentiated coverage and service we're known for was 16.8%. Our homeowners pricing was up 13.7% in the quarter and ahead of loss cost trend which remained steady. Turning to our international general insurance operations, it was a decent quarter. Net Premiums were up 4.9% or 7.5% in constant dollars. Our international commercial business grew 6.7% while consumer was up 8.5%. Asia Pacific led the way with premiums up 9.2%. Latin America grew over 7.5% while Europe grew over 7% with the continent of Europe up 8.7%. Premiums in our international retail commercial P&C business were 6.5% in constant dollar. P&C lines were up almost 11% and financial lines were down 10%. It is worth noting adjusting for a one time premium benefit we received in the third quarter of last year underlying growth was over 14% in P&C lines internationally with financial lines down 3.8%. We continue to achieve positive rate to exposure across our international retail commercial portfolio with P&C lines pricing up 6.3% and financial lines pricing down 3.5%. Premiums in our international wholesale business grew about 8% in constant dollar. As is typical, the London wholesale market is growing more competitive and frankly for me is exhibiting classic London underwriter and broker behavior. Generally speaking, underwriting prosperity likely won't endure over time and London will underperform in due course. Except for those few real underwriters who know how to manage what is simply a trade. I have seen this movie many times. Our international personal lines business had an excellent quarter with growth of 12.7% led by Asia Pacific and Latin America. And our global reinsurance business had a strong quarter. Premiums were up about 35%. We had a combined ratio of 94.4% which included a more active cat loss quarter. Again, in our international life insurance business which is fundamentally Asia, premiums and deposits were up about 21% in constant dollar. International life earnings grew over 9% in the quarter in constant dollar. So that's a lot of news and in summary we had another excellent quarter and having a record earnings year. While we're in the risk business and volatility is a natural feature, we are very confident in our ability to continue growing our operating earnings and EPS at a superior rate. P&C revenue growth and underwriting margins, investment income and life income. I'm going to turn the call over to Peter and then we're going to come back and take your question."
},
{
"speaker": "Peter Enns",
"content": "Good morning. As you have just heard from Evan, despite an elevated level of industry wide cats, we had another strong quarter that generated adjusted operating cash flow for the quarter and through nine months of $4.6 billion and a record $11.7 billion respectively. Our results further strengthened our overall financial position, ending the quarter with all-time highs in book value of nearly $66 billion and invested assets of $151 billion. On July 31st we issued $700 million of 5 year debt and $600 million of 10 year debt at an attractive weighted average cost of under 5%. The proceeds will be used for general corporate purposes including a repayment of 700 million of euro denominated debt due in December. We returned $782 million of capital to capital shareholders this quarter including $413 million in share repurchases and $369 million in dividends and $2.4 billion in total. Through nine months, book and tangible book value per share excluding AOCI increased 2.7% and 4.3% respectively for the quarter and 7.7% and 10.6% respectively year-to-date benefiting from core operating income partially offset by the capital returned to shareholders. Core operating ROE and return on tangible equity were 13.6% and a record 21.5% respectively year-to-date. Turning to investments, our A rated portfolio produced adjusted net investment income of $1.64 billion which included approximately $40 million of higher than normal income from private equity. Regarding underwriting results, the quarter included pretax catastrophe losses of $765 million of which $250 million was related to Hurricane Helene and the balance principally from weather related events split 70% in the U.S. and 30% internationally. Prior period development in the quarter interactive companies was a favorable $299 million pretax with favorable development of $358 million in short tail lines primarily from property and $59 million of unfavorable development in long tail lines which was primarily from general casualty. Our corporate runoff portfolio had adverse development of $55 million primarily environmental liability related. Our paid to incurred ratio for the quarter and the year was 77%. Our core effective tax rate was 17.7% for the quarter which is below our previously guided range due to shifts in the mix of income as well as certain discrete tax benefits recorded in the quarter. We expect our fourth quarter core effective tax rate to now be between 19% and 19.25% [ph] with the full year between 18% and 18.25% [ph]. We expect to provide guidance on the 2025 tax rate as part of our fourth quarter earnings at the end of January. I'll now turn the call back over to Karen."
},
{
"speaker": "Karen Beyer",
"content": "Thank you. And at this point we're happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Bob Huang from Morgan Stanley. Your line is open."
},
{
"speaker": "Bob Huang",
"content": "Good morning. So first question is on the North America commercial. I think if we like you said before, right. Pricing, Ex Financial Alliance, Ex Workers comp continue to be very strong over the last few quarters and you had really incredible margins in this business. Just given the pricing and the growth, should we expect growth to accelerate from here or how should we think about growth in this business? Ex Financial Alliance, Ex Workers comp going forward?"
},
{
"speaker": "Evan Greenberg",
"content": "Yes. First of all, we don't give forward guidance, as you know. So I'm not going to answer that in a specific way. You see the amount of new business we run, you see our retention rate. You see we're in a healthy market and we're in an underwriter's market. Risk selection, structure of risk, how you structure it and pricing matter. All underwriters aren't created equal. So we compete for business. And some areas of business have become more competitive, naturally. Speaking to property, I'm confident when I look forward at Chubb's ability to continue to grow above trend, when I look at longer term trend and as I look forward over a period of time, and I'll leave it at that."
},
{
"speaker": "Bob Huang",
"content": "Great, thank you. Second question is on the international business. Apology in advance if I misinterpreted your commentary, but it sounded like what you're saying is that in London there could be more competition. Does that imply that a lot of the international growth going forward will be driven by Asia and elsewhere? If that is the case, does the upcoming election potentially have an impact on the growth in that area?"
},
{
"speaker": "Evan Greenberg",
"content": "Wow. First of all, our London wholesale business is proportionately is not the overwhelming part of our international business. It's about 10%. And so put that in perspective, 90% is our global retail international Europe grew eight and a half. Latin America grew seven and a half. Asia grew in the nines. So it's that vast territory. And then the U.K. itself rose well, and then which is U.K. retail, which is a big business. And then you have the London wholesale market, where business comes to London to get placed. And that's what my comment was referring to. The classic London market competition that I just thought I would call out because you start to see the behavior that is classic of London. The election, I'm not sure how you linked it to the election and the election outcome. You'd have to enlighten me, but does that help you?"
},
{
"speaker": "Bob Huang",
"content": "Okay. No, no, I think it does. Really appreciate the U.K. comments there. Thank you."
},
{
"speaker": "Evan Greenberg",
"content": "You got it. I feel good about our international growth capabilities."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Brian Meredith from UBS Financial. Your line is open."
},
{
"speaker": "Brian Meredith",
"content": "Yes, thank you. Evan I'm just curious, given the hurricane activity we've seen in the elevated call it cat losses, what are you seeing in the property lines, right now? What's your expectations if we go into 1:1 renewals both on the primary and reinsured side?"
},
{
"speaker": "Evan Greenberg",
"content": "Yes, on the primary side in the middle market, small commercial, which is really the vast majority of business in insurance in North America. Overall when you look at the industry, pricing remains firm and prices continue to go up and it's both hurricane and active SCS activity, modeled, non-modeled loss and the market needs the price and it continues to move in that direction. Would you get to shared and layered particularly whether it's large account or it's E&S related. That's where there is more -- the business is well priced but there is rate pressure. Rates are coming down though they remain at good levels and because there's more capital that's entered the market, more competition and again in particular I call out London behavior that is almost aberrant relative to everybody else. But it remains a robust market."
},
{
"speaker": "Brian Meredith",
"content": "Great, thank you. And my second question Peter, you mentioned there was 59 million of call it general casualty adverse development in North America. What accident years was that coming from? And maybe break it down a little more. Was it GL commercial auto? What's driving some of that development?"
},
{
"speaker": "Peter Enns",
"content": "Yes, it was 19 to 22 years and it was in the general casualty areas, the negative and look, we do a lot of studies in the third quarter of casualty in the U.S. and it was. There were puts and calls so that you really have a clearer view of it. There were a number of long tail classes in the quarter that had positive results and then there was in particular excess casualty that produced a negative result. So it's a, it's a kind of a mixed bag. It's not all in one direction and that is what all added up to the North America casualty reserve charge which was..."
},
{
"speaker": "Brian Meredith",
"content": "Thanks, I appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question comes from a line of David Motemaden from Evercore ISI. Your line is open."
},
{
"speaker": "David Motemaden",
"content": "Thanks. Good morning Evan. I think you know over the last several quarters you guys had called out some troubled classes in North America commercial that you guys were reworking. I think it was a $50 million drag last quarter. I know there was also some of that in 4Q23. Is that largely behind you at this point? Aside from just sort of the normal course managing the book where we should see continued acceleration in some of those commercial casualty lines."
},
{
"speaker": "Evan Greenberg",
"content": "We have another quarter or two to go before we finish. We began fourth quarter last year in most of it. We have a part of it that we began really in first quarter. So we have, we had about another 50 or so million this quarter, and it'll continue into fourth and a little bit into first. But, in the grand scheme of the total premiums we write, it's just not that significant. And remember, it's not. It's a combination of, whether some business moves to others who just don't get it. But a lot of it is due to how we change terms and attempts. This is large account related comments. And then of course the excess areas are getting a lot of rate that help to ameliorate. So maybe that helps you with it."
},
{
"speaker": "David Motemaden",
"content": "Yes, thanks. That's, that's helpful."
},
{
"speaker": "Evan Greenberg",
"content": "When you look at the broad nature of our business, I mean, let's just keep a perspective. We write 20 some odd billion of net premiums in North America. Personal lines is about 7 of that. So all the rest is commercial. Massive number two middle market player, a large E&S player, major agricultural writer, large major account writer. And so when you start hearing numbers like, that we're talking about this area in large account casualty, well, it's not unimportant relative to the business keep perspective. It's small."
},
{
"speaker": "David Motemaden",
"content": "Right. No, that's fair. And I see the rate is also accelerating there in casualty, so that's good to see as well. Maybe just moving on the property side. The catastrophe losses over the last several years and in the third quarter, this third quarter, were definitely surprisingly low just given the mix shift to property that you guys have had over the last several years. I guess I'm wondering if just from your perspective, is this third quarter sort of in line with sort of a normal third quarter that you would expect? And I guess as you think about the mix of property and casualty business, is this sort of -- are you still comfortable shifting more to property? Or is that something where, just given the market dynamics, it should stabilize at this point?"
},
{
"speaker": "Evan Greenberg",
"content": "Yes, the cat losses were a bit lower in the quarter than we would have modeled than our modeling that we contemplated pricing would have produced. So in our annual expected, that to me is just lost volatility. We're in a business that in a risk business there's volatility and there's two sides to the volatility. There's a favorable side and an unfavorable side. Because your average expected loss that you divide into four quarters is just an average. It's just that. And it contemplates all return periods in the loss and in the pricing. So you know, that makes sense to me that I'd see volatility. You're not going to hit the number. You're either up or down from it. And number one, number two, we have, we have a lot of capital flexibility. I think we're good underwriters of the business. So our risk selection and portfolio construction and ensuring we have good pricing I think contributes to Chubb's overall results in a major way versus the industry. And we're going to write the business whether it is property or casualty. We have an appetite for the volatility. We are going to write the business wherever it is. If we understand it, we can price it, structure it and assume. And so we're continuing to lean into property, we're continuing to lean into cash and personal lines and all other areas where we see there is growth potential. And frankly, the most frustrating thing inside our own organization, we can't get after opportunity fast enough and execute efficiently enough for our own appetite and expectations."
},
{
"speaker": "David Motemaden",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Yaron Kinar from Jefferies. Your line is open."
},
{
"speaker": "Yaron Kinar",
"content": "Thank you. Good morning. And maybe just continuing on the previous questions. So when we look at North America casualty, it is where you're getting the most rate, I think based on the data I quickly charted jot down and definitely exceeding loss trend. But that's also where the exposure growth has been less pronounced. I'm guessing that's because of the work you're doing on fixing the trouble classes that you referenced. So without asking for guidance here, but just based on the data, is it fair to think of a growing appetite for casualty coming through in results as the troubled lines are fixed?"
},
{
"speaker": "Evan Greenberg",
"content": "I don't know where you're getting that picture, but I can tell you that our casualty lines are actually growing quickly. And I'm not going to give you a breakdown, but our casualty lines are actually growing quickly. And in North America, in the areas where we see decent pricing and I don't see much of an overhang of $50 billion, hardly much of an overhang. So I can't agree with you. Your line of logic and I have to leave you to think your own thoughts."
},
{
"speaker": "Yaron Kinar",
"content": "I'm just referencing the exposure growth of 70 basis points you called out in casualty pricing in North America."
},
{
"speaker": "Evan Greenberg",
"content": "No, you're missing it. That's not growth in premium. That's okay. I have a store, My store sold more goods this year than last year. It sold 1% more in goods. My theater sold 1% more tickets than last year. That's exposure growth and we rate off of that. That's how you get to price. You're confusing price and rate with growth in premium. Two different things. My unit growth of number of customers I wrote is totally different. Yaron, you got to go. Just learn those basics. Sorry."
},
{
"speaker": "Yaron Kinar",
"content": "Okay. All right. And then in the London behavior that you have referenced, is that the competitive nature true in both casualty and property?"
},
{
"speaker": "Evan Greenberg",
"content": "Yes, across the board."
},
{
"speaker": "Yaron Kinar",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gregory Peters from Raymond James. Your line is open."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. Evan, for my first question, I want to go back to your comments around the life insurance business. As you pointed out, you rarely give forward guidance, so this is somewhat of a departure. Looking some of the statistics with the growth and constant dollars and the growth in deposit assets, just curious why we're not seeing that translate to more income growth. Is there something going on inside there other than currency or just some clarification on that would be helpful."
},
{
"speaker": "Peter Enns",
"content": "Hey, it's Peter, Greg. The top line growth on total Life and on international as you know and as I said was around 10% the income growth in international was just over 9% so pretty much tracking. The combined insurance business in the last half of last year, I called out in the fourth quarterly earnings call had a bit of a non-recurring or oversized item, so if you back that out the growth rate would be relatively consistent for all of life with International."
},
{
"speaker": "Gregory Peters",
"content": "Great thanks for the reminder on that. Appreciate that. The second question I had was on capital. Noted your comments around dividends and share repurchase in the third quarter. The results of your company are outstanding. The free cash flow is really strong. Curious if you have any changed view on share repurchase versus shared special dividends as the stock price appreciates or given the results if there's any change on your views on capital management."
},
{
"speaker": "Evan Greenberg",
"content": "No it's steady as she does. We're returning a healthy amount of capital to shareholders and the balance of capital that we hold, we can put to work at good risk adjusted returns that well exceed our cost of capital. And we're -- that's the balance."
},
{
"speaker": "Gregory Peters",
"content": "Fair enough. Thanks for your time."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ryan Tunis from Autonomous Research. Your line is open."
},
{
"speaker": "Ryan Tunis",
"content": "Hey, thanks. Good morning, Evan. I guess on your comments about competition in London wholesale, typical behavior there. I guess my concern, maybe you can talk me off the ledge on this a bit, but to me that market is London wholesale is pretty intertwined. When I hear commentary like that, I start wondering a little bit about like what might be coming next. I mean, is that a fair concern or when you say that, are you really just honing in on just strictly London?"
},
{
"speaker": "Evan Greenberg",
"content": "No, I think it's, I'm saying it particularly about London. And look, the business in London, overall the market is profitable. But my real point was the kind of behavior I'm seeing them exhibit, the way they're trying to attract more capital to a finite amount of business. The behavior of the capital as I look at it and the guises that it's in it just sets the table for the same movie I've watched that will occur over a number of years many times. And they just can't ultimately stand prosperity. And so I'm just calling it out because I'm seeing it or I'm seeing it begin and it is peculiar in particular to the London."
},
{
"speaker": "Ryan Tunis",
"content": "Got it. And then I guess just a follow up thinking about international life. So it took more than a decade to get to a billion dollars of premium. Any, any, any suggestion you want to give us on how long it's going to take to get the next billion of operating earnings there?"
},
{
"speaker": "Evan Greenberg",
"content": "In Life International? In International, I think it's Life. Did you say international Life, Ryan?"
},
{
"speaker": "Ryan Tunis",
"content": "I did, yes."
},
{
"speaker": "Evan Greenberg",
"content": "Yes, stay tuned, buddy. It ain't going to take a decade."
},
{
"speaker": "Ryan Tunis",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Alex Scott from Barclays. Your line is open."
},
{
"speaker": "Alex Scott",
"content": "Hi, good morning. Thanks for taking the question. First one I had for you is just on the casualty pricing dynamics we're seeing in the market. I mean, on one hand we're seeing some unfavorable here or there in some of these specific product lines like excess liability and so forth. But overall profitability seems pretty good when we look at overall ROEs across many of these businesses. And I just wanted to get your thoughts on price adequacy in general across some of those casualty lines and how much need is there for the industry in your view to keep pushing price and casualty."
},
{
"speaker": "Evan Greenberg",
"content": "Yes, there is no general statement. It varies by area of casualty by customer, cohort by geography. There is no simple and that's why it's always an underwriter's market and you got to have the data, you got to have the experience and then you got to have the command and control to actually put them to work, and you got to have the analytics and actuarial to back it up. So there is no general statement that could put casualty which is a massive class of insurance in a neat box and on a bumper sticker."
},
{
"speaker": "Alex Scott",
"content": "Understood. And sorry for the more broad based question it's just something I grapple with. Looking at the specific products versus like the overall profitability of companies. I honestly, I give it I'd help you out and give it to you. Understood. Next one I have is just on the asset base I guess is we're seeing I guess lower paid claims relative to incurred sort of an elongation of the claim cycle and casualty we're seeing asset bases kind of grow more than they otherwise would, which the good part about that is you get more net investment income potentially. I mean how should we think about the growth in the asset base?"
},
{
"speaker": "Evan Greenberg",
"content": "I think you just said something that you're going to have to think about how you connected those dots. You just said elongated payout pattern. And I don't relate to an elongated payout pattern. I do relate to strength of reserves that all things being equal paid to incurred can point to. And I do understand growth in business and in longer tail areas and mix in that regard. But I don't relate to a notion of elongated payout pattern generally speaking. And I don't know, I got the data, at least when it comes to Chubb."
},
{
"speaker": "Alex Scott",
"content": "Can I. I mean the invested asset base growing at a pretty strong clip. I mean what's the underlying driver?"
},
{
"speaker": "Evan Greenberg",
"content": "Our business has been growing. And our margins have been good, and so our invested asset base, yes, continues to grow and our capital has been growing and that invested asset is a source of income and at superior returns on a risk adjusted well in excess of cost of capital. So that is a source of strength for the company. And we will continue to grow the invested asset on purpose and we will continue to focus on returns within that portfolio as a good asset allocator would, which is my earlier comments about us as an asset manager. We're a manager of capital and claim reserves. That's third party and that will continue to grow."
},
{
"speaker": "Alex Scott",
"content": "Thanks very much."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Andrew Kligerman from TD Cowen. Your line is open."
},
{
"speaker": "Andrew Kligerman",
"content": "Hey, good morning. Just thinking about the financial lines where premium was down 6.2% and I think you highlighted rate off low single digit but you still generated about a billion and a quarter of premium. So I'm wondering how much of that was D&O? Can you still make money in D&O and just how are you thinking about the outlook there?"
},
{
"speaker": "Evan Greenberg",
"content": "I'm not going to give you a breakdown of how much was D&O, that's proprietary. But I am, what I will tell you is we're not writing the business if we can't make money, and we have a very large installed customer base. We have a long storied reputation in G&O and financial lines. We're a major brand in it. And when they're looking for someone to write their primary that is manage their risk, more often than not they want Chubb on that and the competition then is more in the excess layers. And yes, we're writing D&O because where we are, we're making."
},
{
"speaker": "Andrew Kligerman",
"content": "That makes a lot of sense. And then just maybe to kind of follow on that London movie commentary that you gave. You're doing such exceptional underlying combined 80.8 in North America, 84.8. And overseas, Evan, could you see an environment where, it just gets more competitive globally and these excellent, these exceptional combines maybe erode a little bit. You still do great. But it's five years into the hard market already. Didn't we see?"
},
{
"speaker": "Evan Greenberg",
"content": "Here's what you're missing. You're looking at it on an ex-cat basis. When everyone is cat levered, look at published bind ratios. That's what tells you you can't chuck out the losses and leave the premium in the denominator. I reject that discussion because that's just not, that's just not understanding risk. And so what those ex cat look like and then ask yourself in and you have to do the work. But when you look at various companies, you look at various markets, you got to understand how much is cat levered, how much is not cat levered to get a real the health. And then that's why I continue to say published combined ratio is your most important indicator. And then after that a secondary indicator, all things being equal, is ex-cat. It tells you some things. But don't over read it."
},
{
"speaker": "Andrew Kligerman",
"content": "So what I'm right, so what I should just simply read in is that the combines on an absolute basis are still very high for the industry and the outlook is good for Chubb."
},
{
"speaker": "Evan Greenberg",
"content": "They're good. They're delivering good returns for the industry overall. And it varies by company. Some companies it's delivering good returns, some it's not. They're decent. There's not a lot of room to move. If you're thinking about pricing adequacy, it's not like industry ROEs are off the charts. They're decent, they're good on a risk adjusted basis. And then loss trend is relentless. Every year you have loss trend. See, you can't just stand still just to stay where you are. You got to get rate or price."
},
{
"speaker": "Andrew Kligerman",
"content": "Makes a lot of sense."
},
{
"speaker": "Evan Greenberg",
"content": "You got it, buddy."
},
{
"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, you guys said right there was 59 million of I guess strengthening on long tail reserves. I know in response to an earlier question there were some pushes and polls. Can you guys give us a sense of, what was released in workers comp versus what was added to excess casualty in the quarter?"
},
{
"speaker": "Evan Greenberg",
"content": "No, we've given. I gave as much color around that there was in long tail, there was both positive and negative and negative was more excess related. And beyond that we're not giving detail."
},
{
"speaker": "Elyse Greenspan",
"content": "Okay, thanks. And then you guys typically provide an investment income guide. I don't think that was given this quarter. Any color you can provide there just relative to, fourth quarter and forward."
},
{
"speaker": "Evan Greenberg",
"content": "Yes, Elyse, and last quarter I gave last six months guidance. So what I would say for the fourth quarter is we will be at the high end of that guidance for the fourth quarter on a recurring basis. Obviously there's things that are harder to predict. Like I spiked out the 40 million in the third quarter that was higher than normal on PE. But I'd say the high end of the guidance rate guidance level on a recurring basis for the fourth quarter."
},
{
"speaker": "Elyse Greenspan",
"content": "And then on tax you said you would give us right next year with Q4, but given, just Bermuda tax changes going into effect, just directionally, would that imply you guys would think the tax rate would be higher next year relative to this year's guide?"
},
{
"speaker": "Evan Greenberg",
"content": "We typically give the full year guidance in the fourth quarter. That's as far as we go. There is uncertainty, so we're not giving any more specific."
},
{
"speaker": "Elyse Greenspan",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from a line of Meyer Shields from KBW. Your line is open."
},
{
"speaker": "Meyer Shields",
"content": "Great, thanks. If I can go back to the division of pricing to rate and exposure unit, to the extent that more of pricing is coming from rate rather than exposed units, does that have implications for loss ratio progress?"
},
{
"speaker": "Evan Greenberg",
"content": "Does it, what?"
},
{
"speaker": "Meyer Shields",
"content": "Does that have? Well, if more of pricing comes from rate than exposure units, does that imply a difference in terms of how when these premiums are earned, the loss ratio will move."
},
{
"speaker": "Evan Greenberg",
"content": "No, no, not at all. Look, be careful. I didn't say exposure. Maybe we're using different terms. An exposure unit to me would be that I wrote more policies, I took more insureds. That doesn't go into price. We're only talking rate and price times exposure. And so we have rate and then we have a certain kind of exposure that equals price. And you apply it against units of exposure which is insured. And so the exposure part of price is just like rate. It acts like rate. The portion of it that we count, and that has nothing to do with it all earns exactly the same way."
},
{
"speaker": "Meyer Shields",
"content": "Okay."
},
{
"speaker": "Evan Greenberg",
"content": "Because driving both premium. And if it's an annual policy, it's earned 1/12 a month. One, three."
},
{
"speaker": "Meyer Shields",
"content": "No, I think I understand that. Yes. I apologize for the terminology issue. Second question, though to the extent that that component of pricing is slowing down, to the extent that that reflects maybe slowing economic growth, does that itself have implications for underwriting profitability?"
},
{
"speaker": "Evan Greenberg",
"content": "Not that we. No, not as we see it, no, not all things. And that's a whole different theoretical discussion that depends on the line of business, what we're talking about, so, Oh my God, no. If you want to sit in and have a gestalt [ph] discussion about that sometime, Meyer, I'll do."
},
{
"speaker": "Meyer Shields",
"content": "All right, I'll bring the herring."
},
{
"speaker": "Evan Greenberg",
"content": "No, no, only in sour cream sauce."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Zaremski from BMO. Your line is open."
},
{
"speaker": "Michael Zaremski",
"content": "Hey, good morning. So just kind of back to the casualty competitive marketplace. So casualty pricing has accelerated in recent quarters to approximately 12%. And as you state too, that's well above what most companies publicly stated their loss cost assumption. I guess I'm just trying to understand why pricing would be accelerating all the way up to 12, especially in today's higher interest rate environment, which is good for long tail lines. If loss costs are indeed below, then well below that number."
},
{
"speaker": "Evan Greenberg",
"content": "Yes, so. Yes. So what I've been clear about, and that you're trying to be too simplistic, there are many cohorts of casualty, the majority significant. The vast majority of our portfolio is adequately priced. There are areas where price has had to accelerate to achieve an adequate risk adjusted return. It's those everyone's book of casualty is different. And our portfolio of casualty has produced these kinds of rate increases which were made up of just to keep pace with loss costs where we are adequately priced and greater levels of rate increase where we're pushing to achieve price adequacy and it all mixes together. And by the way, what's producing outstanding combined ratios. And that's as far as I can take it."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. Okay, that's understood. Maybe just switching gears. Lastly, since you were willing to offer some color on your guidance on life insurance. So if the target this year was I guess a billion or so."
},
{
"speaker": "Evan Greenberg",
"content": "No, Mike, it's not going to happen. I'm not giving you forward guidance. The only thing I was doing is because it was a year where it's the first year and I was just doing it for all of you because this was our first year where you didn't have noise of acquisitions and that in it. And you're trying to get it. Where are we relative to where we think we should be? That was why I gave a comment about the 2024 full year where our own target was, I just said in excess of $1 billion for operating income and that we are well on track to achieve that or exceed that. And that it was just to give you guys a sort of a landing place and then from there we don't get forward."
},
{
"speaker": "Michael Zaremski",
"content": "Okay, got it because last year was over a billion. But yes, there was definitely some noise and obviously earnings there have been great. So, okay. Thank you for taking my questions."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome. But by the way, it's a growth area."
},
{
"speaker": "Michael Zaremski",
"content": "Thanks."
},
{
"speaker": "Karen Beyer",
"content": "Thank you everyone for joining us today. If you have any follow up questions, we'll be around to take your call. Enjoy the day. Thanks."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
cb | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. My name is Eric, and I will be your conference operator today. At this time, I would like to welcome everyone to the Chubb Limited 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] Thank you. I would now like to turn the call over to Karen Beyer, Senior Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "Karen Beyer",
"content": "Thank you, and good morning, everyone. Welcome to our June 30, 2024, second quarter earnings conference call. Our report today will contain forward-looking statements, including statements relating to company performance, pricing and business mix, growth opportunities and economic and market conditions, which are subject to risks and uncertainties and actual results may differ materially. Please see our recent SEC filings, earnings release and financial supplement, which are available on our website at investors.chubb.com for more information on factors that could affect these matters. We will also refer today to non-GAAP financial measures. Reconciliations of which to the most direct comparable GAAP measures and related details are provided in our earnings press release and financial supplement. Now, I'd like to introduce our speakers. First, we have Evan Greenberg, Chairman and Chief Executive Officer, followed by Peter Enns, our Chief Financial Officer. Then, we'll take your questions. Also with us to assist with your questions are several members of our management team. And now, it's my pleasure to turn the call over to Evan."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning. As you saw from the numbers, we had another great quarter. We produced core operating EPS of $5.38, up 9.3%. Premium revenue growth reflects strong results in our businesses around the world. North America P&C, International P&C and Life Insurance demonstrates the broad-based diversified strength of our company. Our underwriting results were simply excellent. We published a combined ratio of 86.8%. We grew investment income more than 25%. Life segment income was up 8.7%, with International Life up double-digit. Core operating income for the quarter was $2.2 billion, bringing year-to-date operating earnings to $4.4 billion, up 13.5% and a record six-month result. P&C underwriting income in quarter of $1.4 billion was essentially flat as a result of higher cat losses globally. As you know, it was an active quarter for the industry. Our losses of $580 million compared with $400 million prior year, and they were in line with our modeled expectations, while last year's second quarter losses were light. On an ex-cat current accident year basis, underwriting income of $1.8 billion was up over 11% with a combined ratio of 83.2%, both were record underwriting results. Investment income topped $1.5 billion, up nearly 26% and a record as well. At June 30, our reinvestment rate is averaging 5.9% and our fixed income portfolio yield is 4.9% versus 4.5% a year ago. Our liquidity is very strong, and investment income will continue to grow as we reinvest cash flows at higher rates. Our invested asset now stands at $141 billion and we expect it to continue growing. Life segment income of $276 million was right in line with our plan. Our annualized core operating ROE for the quarter was 13.3%, with a return on tangible equity of over 21%. Peter will have more to say about financial items. Turning to other matters, growth, pricing and the rate environment. Consolidated net premiums for the company increased 11.8% in the quarter or 12.3% in constant dollars. We are a large diversified global insurer and our growth this quarter is again a reflection of who we are. Growth was broad-based geographically by product and customer segment, both commercial and consumer, from North America commercial to North America consumer, international commercial, Asia, Europe and Latin America to international consumer, particularly Asia and Latin America. In terms of the commercial P&C rate environment, overall conditions remain favorable in both property, which is naturally more competitive, and casualty, which is firming in those classes that require rate. Loss-cost inflation remains steady within what we have contemplated in our pricing and our reserving. Property has become more competitive as more capital is entered. Our book is well priced, and terms and conditions remain steady. Casualty is firming in the areas that need rate, and we see this trend in casualty enduring, and I'm going to give you some more color by division. So, let's start with North America. Premiums, excluding agriculture, were up 8% and consisted of 12.3% growth in personal lines and 6.7% growth in commercial, with all P&C lines, including comp, up 8.7%, and financial lines down about 3%. We wrote over $1.3 billion of new business, which is a record, and our renewal retention on a policy count basis was 90%, both speak to the reasonably disciplined tone of the market and our excellent operating performance. Premiums in our major accounts and specialty division increased 6.5%, with P&C up about 8% and financial lines down 2.5%. Our E&S business grew about 8.5%. Premiums in our middle market division increased about 7.5%, with P&C lines up almost 11% and financial lines down 4.5%. Again, the underwriting environment in North America is generally favorable and rational, financial lines aside. P&C pricing, excluding financial lines and comp, was up 8.3%, with rates up 5.5% and exposure change of 2.7%. Financial lines pricing was down 3.2%, with rates down about 3.5% and exposure up 0.3%. In workers' comp, which includes both primary and large account risk management comp, pricing was up 4.2%, with rates up 1.6% and exposure up 2.6%. And breaking down P&C pricing further, property pricing was up 5.3%, with rates up about 1.1% and exposure change of 4.2%. Large accounts shared and layered in E&S property pricing was flat to down, while in the middle market, rates continue to rise, about 7%. We are big in all three, and again all three are priced adequately. Casualty pricing in North America was up 11.7%, with rates up 9.9% and exposure up 1.6%. Loss-costs in North America remain stable, in line -- and in line with what we contemplate in our loss picks. Loss-costs for P&C, excluding financial lines and comp, are trending at 7.3%, with short-tail classes up 5.3%, and casualty, excluding comp, at 8.6%. We are trending our first dollar work comp book at 4.6%. As I said, when it comes to financial lines, the underwriting environment in a number of classes is simply not smart. We are trading growth for a reasonable underwriting margin. We are trending financial lines loss-costs at just over 5%. On the consumer side of North America, our high net-worth personal lines business had another outstanding quarter, with premium growth of over 12%, including new business growth of 30%. Premium growth for our true high net-worth segments, the group that seeks our brand for the differentiated coverage and service we are known, for grew 17%. These numbers are really impressive. When you consider our high net-worth personal lines division, it's almost a $7 billion business. Our homeowners pricing was up 14.6% in the quarter, while the loss-cost trend remains steady at 10.5%. Turning to our International General Insurance operations, net premiums were up over 16.5% in constant dollar. Our International commercial business grew nearly 14%, while consumer was up almost 21%. Asia Pacific led the way with premiums up 36%, and excluding China's contribution, premiums were up over 9%. Latin America had a strong quarter, with premiums up about 12%, and Europe retail grew over 9%, with the continent up 11%. 41% of our Overseas General division's premium is consumer, both A&H and personal lines, and it's growing at a good clip. In the quarter, premiums in our International A&H business were up over 10.5%, led by Asia Pacific and Europe. Our International personal lines business had another excellent quarter, with growth of 32%, led by Asia Pac and Latin America. We continue to achieve positive rate to exposure across our International commercial portfolio, with retail, property and casualty lines pricing up 6.1% and financial lines pricing down 4.1%. Loss-cost inflation across our International retail commercial portfolio is trending at 5.8% with P&C lines trending 6.1% and financial lines trending 4.8%. In our International Life Insurance business, which is fundamentally Asia, premiums were up 31.7% in constant dollar. Excluding China, life premiums were up almost 10%. Depending on the country, growth was driven by tied agency, brokerage, bank assurance and direct marketing distribution channels. International Life earnings grew over 15% in the quarter in constant dollar. Lastly, Global Re had a strong quarter with premium growth exceeding 40% and a combined ratio of 72.7%. Growth was property-driven, both risk and cat. And in the quarter, we wrote more one-off structured transactions, which contributed to our growth. In summary, as you could see, we had a great quarter, and again, our results reflect the strength, the breadth and the depth globally of the company. We are confident in our ability to continue growing our operating earnings at a superior rate through P&C revenue growth and underwriting margins, investment income and life income. I'm going to turn the call over to Peter and we're going to come back and take your questions."
},
{
"speaker": "Peter Enns",
"content": "Good morning. As you know, our balance sheet and overall financial position are very strong and just got stronger, benefiting from our first half results. Our underwriting and investment results continue to generate substantial capital and significant positive cash flow. Our book value reached over $61 billion or $151 per share, and adjusted operating cash flow for the quarter and through six months were $3.6 billion and a record $7.2 billion, respectively. We returned $939 million of capital to shareholders this quarter, including $570 million in share repurchases and $369 million in dividends, and $1.6 billion in total through six months. [indiscernible] tangible book value per share excluding AOCI increased 2.6% and 3.1%, respectively, for the quarter, and 4.9% and 6.1%, respectively, year-to-date, benefiting from core operating income partially offset by capital return to shareholders noted earlier. In addition, we closed on two small acquisitions this quarter Healthy Paws, a pet insurance business, and Catalyst Aviation, which together diluted tangible book value by about $300 million. Core operating ROE and return on tangible equity were 13.3% and 21.1%, respectively, for the quarter, and 13.6% and a record 21.6%, respectively, year-to-date. Turning to investments, our A-rated portfolio produced adjusted net investment income of $1.56 billion, which included approximately $30 million of higher-than-normal income from private equity and other areas. We expect our quarterly adjusted net investment income to average approximately $1.57 billion to $1.63 billion for the remainder of the year. Regarding underwriting results, the quarter included pre-tax catastrophe losses of $580 million, which were principally from weather-related events, with 75% in the US and 25% internationally. Prior-period development in the quarter in our active companies was a positive $285 million pre-tax, with $144 million in North America Commercial, $64 million in North America Personal, $61 million in Overseas General and $16 million in Global Retail. The $285 million was split 35% long-tail lines predominantly in North America Commercial and 65% in short-tail lines. Our corporate run-off portfolio had adverse development of $93 million, mostly coming from molestations-related claims development. Our paid-to-incurred ratio for the quarter was 71% and 77% year-to-date. Our core effective tax rate was 18.8% for the quarter, which is within our guided range. We continue to expect our core effective tax rate to be within 18.75% to 19.25% for the remainder of this year. I'll now turn the call back over to Karen."
},
{
"speaker": "Karen Beyer",
"content": "Thank you. We'll be happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Michael Zaremski with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Michael Zaremski",
"content": "Hey, guys. Good morning. Most of the focus, as you know, and you guys -- you gave good commentary, Evan, as you usually do on loss-cost trends. I'm trying my best to use the live transcript to true up some of the quarter-over-quarters, but I believe you made commentary about loss-cost trend in North America, specifically being stable and kind of in-line with your expectations, but I think you said there was a -- it was, excluding comp, in the 8%s, and I believe last quarter was in the 7%s. So just curious, is loss-cost trend changing a bit in terms of the trend line?"
},
{
"speaker": "Evan Greenberg",
"content": "No, there wasn't a change of loss-cost, and frankly, it was 7.3%, is what I said for P&C lines, which excludes financial lines and comp. I think that's the way to look at it. And the 8% was pricing, was up 8.3%. Pricing exceeded loss-costs P&C lines. As we..."
},
{
"speaker": "Michael Zaremski",
"content": "Would you say -- got it. Okay. Thanks for the clarification. So, just sticking with that and I guess this will just be my follow-up, there's a number of indices out there which kind of show that pricing in certain parts of the marketplace, even ex-financial lines are sub-6%, sub-5%. Would you say that -- I know you've talked about not accepting all business, that's not priced adequately. Would you say that Chubb's kind of in a doing that more so today in terms of kind of saying no to more business than it usually does in order to kind of make sure you're keeping pricing above loss-cost trend, whereas maybe others don't appear to be doing that when we see their trend lines on their loss ratios?"
},
{
"speaker": "Evan Greenberg",
"content": "Well, I think I understood what you just said. Let me answer this. We wrote $1.3 billion of new business. That's a record. We grew in our P&C business 8% or so, and we gave comps separately, gave financial lines separate. The market overall, those numbers, as I said, I'm repeating myself, speak to the tone of the market, which is overall quite good. We published a combined ratio of 86.8% with higher cats and 83.2% current accident year combined ratio. I'm hardly wringing my hands. Our results are outstanding underwriting results. The pricing in the market is reasonably rational, financial lines aside to me. Good areas -- and we're only writing business where we can earn an underwriting profit, and in all classes, we strive to earn an underwriting profit that reflects a good return on capital that we're deploying against that line of business. In some classes, they're well priced and getting rate that equals loss-cost, brilliant. In some classes, there is pricing below loss-cost, because the margins are so decent. And in other classes and they're casualty-related, we're writing the business because we're getting rate while in excess of loss-cost as those lines approach their adequacy. I hope that answers your question."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. It does. Appreciate it."
},
{
"speaker": "Evan Greenberg",
"content": "Then, if you look at something like financial lines, there is a glaring example hiding in plain sight that demonstrates we are shrinking when we can't earn an adequate return, which is what we have done consistently for 20 years."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Paul Newsome with Piper Sandler. Please go ahead."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning, Paul."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Meredith with UBS. Please go ahead."
},
{
"speaker": "Brian Meredith",
"content": "Thank you. Evan, I'm just curious..."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning, Brian."
},
{
"speaker": "Brian Meredith",
"content": "Hey, good morning. Given the good pricing you're still seeing in [casualty] (ph) lines right now, I'm just a little surprised that we aren't seeing more growth in that area from y'all. And, actually, if you just look at your pricing versus where the kind of premium growth was, it almost looks like you're shrinking a little bit on a absolute unit basis. Maybe correct me if there's something else going on that I'm just not seeing in the numbers."
},
{
"speaker": "Evan Greenberg",
"content": "No. We're growing property, and the unit count grew well. So, I don't -- and I don't know what -- we don't have any that reflects unit count."
},
{
"speaker": "Brian Meredith",
"content": "That was in casualty."
},
{
"speaker": "Evan Greenberg",
"content": "You can't see number of policies. And you're talking property, right?"
},
{
"speaker": "Brian Meredith",
"content": "No. My apologies, I said casualty. I'm just looking at your commercial casualty numbers that you gave us. Apologies."
},
{
"speaker": "Evan Greenberg",
"content": "No, casualty is growing, and it's growing in the areas that we think we should be growing. And then, we have some areas, remember, in large account where we have been restructuring, in troubled classes and increasing retentions and we have accounts we've gotten off of or who have left us because of change of terms and all of that, it was worth about $50 million in the quarter. And that will run its string. It's particularly auto liability related. And -- but other than that, certain classes grew, some stayed flat, but overall casualty was up."
},
{
"speaker": "Brian Meredith",
"content": "Makes sense. Thank you. And then, Evan, just second question, and I appreciate all the color on loss trend and stuff, but given some of the uncertainty that others in the industry are talking about on what's going on in the social inflation environment, are you all kind of thinking about maybe or are adding some additional IBNR to perhaps loss picks and stuff, or are we not at that point of this right now?"
},
{
"speaker": "Evan Greenberg",
"content": "That's a strange way of framing for me. You're either raising your loss pick, which is IBNR, it's IBNR in casualty, generally you're -- if it's on a more recent year, it's all IBNR. If it's case -- if it's due to case reserve on recent years, then hang on to your hat. And if you're -- whereas on older, older years, you could be raising your loss pick based on the actual incurred claim. So, to me, it's just simply another way of saying are you raising your loss picks on more recent years. We already have raised our loss picks. It's already been baked into our business as we've gone along, and we've raised our loss-cost trends and we take rate against loss-cost and on a written basis and then to earn through, we pick -- we've been picking higher loss ratios over the last few years. And that's just steady. We haven't adjusted our loss picks this year for what we see in loss-cost trends. The loss-cost trends, as I said, remain steady with what we have contemplated. Now, as you do reserve studies, there are individual classes where if you're taking reserve charge, you're taking reserve charge because that, by its nature, means you're raising the loss picks, which includes IBNR on a cohort of years. It may be that you're raising it just because of development you see on older years, it may be that you see that flowing through to more -- to change your view in more recent years and in which case you raise them, but that's study by study. I hope that answers your question."
},
{
"speaker": "Brian Meredith",
"content": "Yeah. It was very helpful. Thank you."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Bob Huang with Morgan Stanley. Please go ahead."
},
{
"speaker": "Bob Huang",
"content": "Hi, good morning."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning."
},
{
"speaker": "Bob Huang",
"content": "Yeah. Good morning. Just want to shift gears a little bit to personal line. You grew in pretty incredible 42% premium year-to-date. Can you maybe talk about the driver of this growth in North America personal? And also, how should we think about just the growth trajectory of this line going forward? I understand, obviously, homeowner and auto is going to be very different, but just curious your thoughts going forward."
},
{
"speaker": "Evan Greenberg",
"content": "Did you -- we did not grow North America personal lines 42% year-to-date, but we've grown it double-digit year-to-date. And so just -- so we level set between each other, the line is growing at a very healthy rate. And look, it's for -- there's a combination of reasons. It's broad-based growth. We're not growing simply in -- okay, cat-exposed stressed areas. We're growing where high net-worth customers have homes. And so that would of course have a strong cat-exposed element to it, but we're growing at a broad variety of geographies across the United States. We're getting improved rate to exposure. Our pricing -- and we've worked on it for years now, our ability to price the business is far more sophisticated and our by-peril pricing is very sophisticated. The services we provide and the richness of the coverage, if you are a customer whose profile meets our product, we're who you want, because the richness of the coverage and the way we administer it, that's what our brand is well known about. And there is a real increase in demand for Chubb. We are not the cheap guys on the street. And in fact, there are many who I personally will tell them, if you're looking for a cheaper price, let me give you the name of three other insurance companies. But no, they want Chubb and the renewal retention rate and the growth in new business, it's very gratifying that way. And we're improving our services and constantly improving our services and in the way we communicate with our customer. And that is in front of us. We can continue improving this and improve the -- which is the competitive profile of the product area. So -- and then, yes, in cat-exposed areas, we're getting well paid for the business we're writing. I don't mind saying we're reshaping and have been shaping in cat-exposed areas to a healthier portfolio in terms of the quality of risk and whether they're just given us cat business or they're giving us a broad base of business beyond cat exposure. And we're shaping that portfolio and getting priced reasonably for it and we're purchasing enough protection to protect the balance sheet as we grow accumulations. So, all in all, our personal lines business is in a very healthy place."
},
{
"speaker": "Bob Huang",
"content": "Great. Thank you. Yeah, the 42%, personal auto, I misspoke there. Yeah. So, the second question is, in the press release, you talked about, you're seeing a broad set of opportunities in accident and health and personal lines across the globe, right? Can you maybe expand on where you think that opportunity resides? It feels like your European business is doing well. Your Asia business is doing well. Is this globe -- are you referring to more broadly speaking, or is it more Southeast Asia, South Asia? Can you maybe give us a little bit more details there? Is it more organic, inorganic, things of that nature?"
},
{
"speaker": "Evan Greenberg",
"content": "Love the question. Thank you. Okay. So, let's take accident and health. The combined insurance company in North America, which I'm going to start talking about more soon, but we've been a little quieter about it. It is growing at double-digits. It is a worksite voluntary benefits business and it is growing at a very healthy double-digit clip, and that is traditional -- our traditional accident and health. We're growing it for small-account companies and middle- and large-account companies, one through brokerage, one through agency. Our accident and health business in Asia Pacific has grown because we're the largest direct marketers of insurance in Asia for sure and maybe the world. It's over a $4.5 billion portfolio. And our direct marketed A&H business growing in Korea, growing through Southeast Asia is an excellent contributor. Our digital distributed consumer lines business, A&H and personal lines with over 200 digital platforms from the grabs of Southeast Asia to the new banks of Latin America for -- in what we call embedded or in path selling for accident and health and simple consumer products, think householders, think term life insurance, think device coverage for protecting devices, is growing at a -- that's our digital business, growing at a very healthy double-digit clip. Travel insurance in Asia growing well. In Europe, employer, employee and direct marketed A&H growing very well. I could go on and on, but that's a flavor of how it's -- maybe giving you a sense granularly of how it is across the globe."
},
{
"speaker": "Bob Huang",
"content": "Really appreciate that. So, I think we'll look forward to more commentary down the road about this. Thank you."
},
{
"speaker": "Evan Greenberg",
"content": "You got it. Thanks for the questions."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Motemaden with Evercore ISI. Please go ahead."
},
{
"speaker": "Evan Greenberg",
"content": "Good morning, David."
},
{
"speaker": "David Motemaden",
"content": "Good morning, Evan. I had a follow-up just on the North America P&C long-tail ex-comp..."
},
{
"speaker": "Evan Greenberg",
"content": "Of course."
},
{
"speaker": "David Motemaden",
"content": "...loss trend. It sounds like that increased about 1 point sequentially. Just wondering what you saw in the quarter."
},
{
"speaker": "Evan Greenberg",
"content": "No. It did not -- no. I'm going to cut you. It did not. It -- didn't it go ahead, Paul?"
},
{
"speaker": "Paul O'Connell",
"content": "I think last quarter, we had given casualty number, which was 8.6% in comparison, that's standalone casualty number. The number you just cited was P&C ex-financial lines and ex-workers' comp, it didn't change that quarter."
},
{
"speaker": "Evan Greenberg",
"content": "Did you hear that explanation? Did it help you? David?"
},
{
"speaker": "David Motemaden",
"content": "Yeah. I did. It was a little faint, but I think I got most of it. So, it just sounds..."
},
{
"speaker": "Evan Greenberg",
"content": "No, you want to -- let's repeat it. Paul, go ahead."
},
{
"speaker": "Paul O'Connell",
"content": "The numbers didn't change sequentially. It might have been a different mix or different combination of product lines. So, the 7.3% that we cited was total ex-financial lines and ex-workers' compensation."
},
{
"speaker": "Evan Greenberg",
"content": "Which is -- which we think is the purest way for you to hear casualty."
},
{
"speaker": "Paul O'Connell",
"content": "Property and casualty."
},
{
"speaker": "Evan Greenberg",
"content": "Yeah, property and casualty. And then, we gave casualty separately, right? And the casualty separately hasn't changed."
},
{
"speaker": "Paul O'Connell",
"content": "No."
},
{
"speaker": "Evan Greenberg",
"content": "I mean, I'm looking at my Chief Actuary, so I'm scratching my head. We haven't changed it."
},
{
"speaker": "David Motemaden",
"content": "Got it. Okay. That's helpful clarification on that front. I guess, we've obviously heard a lot of noise this quarter from just across the industry on more recent accident year casualty reserves. Doesn't sound like there's been any big shifts in the claims environment just based on what you guys have done, but I'm wondering if you might just give some of your observations in terms of how we should be thinking about just the loss environment as the claims environment sort of normalizes following COVID."
},
{
"speaker": "Evan Greenberg",
"content": "Yeah. Look, let me observe this way to you. On the loss side of it, we have been talking for many quarters for years now about the inflation in the casualty loss-cost environment. I won't go into all the reasons, but the litigation. We have talked about the reasons and we have talked about some of the areas, whether it is excess casualty related, auto liability related. And that's just not new noise or new facts. That's been for a long time we've been talking. We've talked about how inflation in that area has accelerated over a period of time. We talked about how the court system was closed down and how you had to be careful in not taking the head fake and continuing to trend up. We've talked about how companies have managed this and some have been quicker, some have been slower to recognize development. Though everyone is in the boat of struggling to stay on top of it, some have reacted more quickly and their recognition in reserves and loss picks than others. So again, everyone struggles to stay on top. We've talked about how reinsurers are late -- are the latest to the party. And those who may not have as good a data set or be as activist and intrusive in how they use data and interpret it for management information, all of that rolls together to make the soup everyone is obsessed about at this moment about casualty, and I understand it. I say it that way, because when it comes to Chubb, we have almost $65 billion of loss reserves, very broad-based. We study them all on an annual basis, and we watch them all on a monthly and quarterly basis. There's always something developing well and something not developing as well as you imagine. It's never a precise science. On balance, our reserves are as strong. And frankly, we said this at December and I can tell you as of June 30, our loss reserves are stronger than they were in December in aggregate when we look at them today. And that is with staying on top of the positive development in casualty, i.e. comp and other areas and the negative development that is occurring in auto liability and access and umbrella, et cetera. David, I hope that's as much as I can say on the subject."
},
{
"speaker": "David Motemaden",
"content": "I really appreciate it. Thanks, Evan."
},
{
"speaker": "Evan Greenberg",
"content": "You got it."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Yaron Kinar with Jefferies. Please go ahead."
},
{
"speaker": "Yaron Kinar",
"content": "Thank you. Good morning. I want to maybe take a broader view here, specifically on North America commercial. So, I think you've been running at a low 80%s underlying, combined mid-80%s reported in recent years, including year-to-date. That's a whopping improvement relative to where it's been historically, right, 5 points to 10 points better I think. So, how do you think about the balance of protecting these margins and risk-adjusted returns on the one hand and pursuing growth on the other in the context of maybe elevated market uncertainty, but these terrific margins?"
},
{
"speaker": "Evan Greenberg",
"content": "Well, let's see. I think it speaks for itself. We grew at a pretty healthy clip when you look at it. Our middle market P&C business grew at 11%. Our E&S business grew at 8.7%. Our large-account business grew a little slower clip. Our financial line shrank, while P&C grew. I've gone through that where rates achieve a risk-adjusted return from everything we can tell, that we contemplate achieving, we're growing that business as fast as we can. Where it's not achieving it, we're striving to achieve it. Where we can't earn an underwriting profit, we're shrinking. Where it's adequate, we're growing as fast as we can. And we have the capital, the depth of balance sheet and an appetite and knowledge and geographic reach and the distribution brand, the underwriting capability to grow in those areas where we want to grow. And there are times we'll trade rate for growth and we'll -- there are times we'll trade growth for rate. We're doing both. And when it comes to the current accident year combined ratio, I've said before and I've written this, it's very interesting about the industry's current accident year combined ratio ex-cat. Property is a much larger part and a growing -- everybody is more cat-levered because of the changes in the [reinsurance] (ph) market, the rates and terms. And we take the cat loss out of the numerator, but in the denominator, we leave all the premium, that naturally drives down our current accident year combined ratio in mix of business all else being equal. So, it's -- I look -- that's a part and parcel of the published combined ratio, which is the primary number that everyone should look at. And the current accident year to look through volatility is a secondary indicator. And that's how I think of about. And I think what we published of an 86.8%, which has higher cat losses than prior quarter -- prior year's quarter because volatility in property is simply an outstanding number. I hope that answers your question. This is a company with big appetite and -- but a big appetite and an ambition to grow when we can earn a reasonable return."
},
{
"speaker": "Yaron Kinar",
"content": "Got it. And maybe to follow -- sorry, go ahead."
},
{
"speaker": "Evan Greenberg",
"content": "No, I'm done."
},
{
"speaker": "Yaron Kinar",
"content": "So, maybe to follow-up on that. So, in lines where you are getting rate in excess of trend, is it reasonable to think of an acceleration of growth in those -- premium growth in those lines? So essentially policies in-force increasing or accelerating at a faster pace?"
},
{
"speaker": "Evan Greenberg",
"content": "There is. We've met -- you can't see it, and we're not going to disclose anything like that. But it is apparent to us, again, we wrote $1.3 billion of new business, a record. And we had a renewal retention rate policy cap of 90%. I rest my case."
},
{
"speaker": "Yaron Kinar",
"content": "Thank you."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Ward with Citi. Please go ahead."
},
{
"speaker": "Mike Ward",
"content": "Thank you. Good morning. I just -- I was wondering on the prior-period development, I don't think this has been asked, but I was hoping you could maybe break down the -- I think it was $144 million in North America commercial. Just sort of curious, if there were any notable movements within that, including long-tail casualty versus workers' comp?"
},
{
"speaker": "Evan Greenberg",
"content": "Yeah, sure. We studied large-account comp this quarter, and we studied auto liability across the organization, large, medium, small, all added together. Among other casualty lines, that we studied a variety of GL, general liability-related ones, comp produced about $287 million release and the auto liability studies produced about $116 million of charge and not concentrated in any one year spread out. And that was the major piece."
},
{
"speaker": "Mike Ward",
"content": "Okay. That's really helpful. Thank you, Evan. And then maybe kind of on a similar theme, but I saw some media sort of reporting on, an executive that you hired specifically to handle inflated jury verdicts. Just wondering if you could expand on that role and how you expect the industry to actually..."
},
{
"speaker": "Evan Greenberg",
"content": "Yeah. He's not going to handle inflated jury verdicts. That sounds like I hired somebody out of the mafia, because I don't know any other way except with a mask and a gun. But what he's -- what we're focused on is the litigation environment and what we can do to help galvanize and lead in that lead efforts among corporate America to pool our influence and our resources to impact the litigation environment, which is going to be impacted through the political arena and the regulatory arena. You going to get some laws changed, and it's a state by state when you get down to the critical issues, whether you're talking mass tort or you're talking individual large awards or you're talking litigation funding, any of that. And so, we're going to double down on focusing on that to work with corporate America that is waking up and becoming more energized about this. And I will in the future, I'm sure have more to say about it. And right now, we'll just go to work on it."
},
{
"speaker": "Mike Ward",
"content": "Thank you."
},
{
"speaker": "Evan Greenberg",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gregory Peters with Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. So, you started to touch upon this in the last question, but I wanted to step back. In the last 90 days, it seems like there's been a flurry of announcements from the company on management changes and promotions. And I'm curious, Evan, if you could just step back, give us a snapshot of what's going on behind the curtain."
},
{
"speaker": "Evan Greenberg",
"content": "Sure. Behind the curtain? No curtain. What an energizing thing for this organization. These -- we have a very well-oiled and effective succession management and key employee process. We've been engaged in for over 18 years. And at my level, it involves keeping our eye on about 500 people across the company. The people who were promoted and the change of responsibilities is a reflection of that succession management process. This was -- these changes were planned over 18 months ago. The individuals, [John Keogh] (ph), and we had planned it. John Lupica, and we had planned for it. It's very orderly. It was individuals who've had long history with the company. They're of our culture. They have the talent, the capability to do more. The company, to state the obvious, look at the size and scale of it, it's growing. And therefore, the structure has to adapt and the talent that you put in place has to reflect the opportunity set and all of the dynamics around management of the organization that you need to address all at once. We have bigger strategic issues that have to do with opportunities and we just talked about litigation. These massive structural things in front of us that Chubb is a leader, as it has a responsibility and an opportunity, participate in, and we need leadership that can address that. All the day to day of our business and managing the day to day of our business grows more complicated and is more diverse. And so, part of my job is to reflect on all of that and to use the succession process we have that produces a deep, well-diversified bench of talent to match up against all of that. And that's what it reflects. And what's so great is everyone who was on that -- those announcements know each other well, have been together well for a long time, and it just -- it means the team just gets stronger."
},
{
"speaker": "Gregory Peters",
"content": "Great. I'm going to, for my follow-up question, get out of the North American commercial liability reserve sandbox and jump into the agricultural business. I was watching -- I think I checked..."
},
{
"speaker": "Evan Greenberg",
"content": "I think we dug all for the sand out of that box. So, I'm like, I'm done, but go ahead."
},
{
"speaker": "Gregory Peters",
"content": "I figured. It's exhausting."
},
{
"speaker": "Evan Greenberg",
"content": "I'm so known for my patients."
},
{
"speaker": "Gregory Peters",
"content": "You handled yourself very well, so congratulations on that. For -- I checked the spot rate of a bushel of corn, looks like it's down, what, some 30% year-over-year. So, not that that's an arbiter of the outlook for your agricultural business, but maybe if you could give us an update on how this year looks to be shaping up? Obviously, I know the harvest season is still emerging, but any color there would be helpful."
},
{
"speaker": "Evan Greenberg",
"content": "Yeah. I'm going to be very careful because I'm not going to jinx myself in the middle of the game. But where we have concentration of exposure, it is a very good growing season so far, particularly for corn and soybean. We have a well-diversified book. We're heavier, and we've always been west of the Mississippi, but in a very broad swath of geography, Midwest, upper Midwest, in particular. And the growing conditions are very good. When you see spot markets at this moment and it just -- it's not something to obsess about or look at really because it reflects what people were imagining. It's a speculative class and they're imagining what the -- what's the government going to say about growing and they're all out there looking at the years of corn on -- counting the years on stocks right now. And that's what's driving price at the moment. We'll see how it pans out, but right now, it's shaping up well."
},
{
"speaker": "Gregory Peters",
"content": "Got it. Thanks for the answers."
},
{
"speaker": "Evan Greenberg",
"content": "John, you wanted to say something about base price?"
},
{
"speaker": "Unidentified Company Representative",
"content": "Yeah. Just you noted a spot price below last year, but I think the more important number is what the base price was and it's only off 10% from base price, which is a good spot for us right now."
},
{
"speaker": "Evan Greenberg",
"content": "Yeah, which was in within a lot of the deductible. Frankly, if you -- and is a little outside deductible averages, but, look, who knows, we'll see."
},
{
"speaker": "Gregory Peters",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "I'll now turn the call back over to Karen Beyer for closing remarks. Please go ahead."
},
{
"speaker": "Karen Beyer",
"content": "Thanks, everyone, for joining us today. If you have any follow-up questions, we'll be around to take your calls. Enjoy the day. Thank you."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes today's call. Thank you all for joining, and you may now disconnect."
}
] |
cb | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. My name is Eric, and I will be your conference operator today. At this time, I would like to welcome everyone to the Chubb Limited First Quarter 2024 Earnings Call. [Operator Instructions] I would now like to turn the call over to Karen Beyer, Senior Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "Karen Beyer",
"content": "Good morning, everyone, and welcome to our March 31, 2024, First Quarter Earnings Conference Call. Our report today will contain forward-looking statements, including statements relating to company performance, pricing and business mix, growth opportunities and economic and market conditions, which are subject to risks and uncertainties and actual results may differ materially. Please see our recent SEC filings, earnings release and financial supplement, which are available on our website at investors.chubb.com, for more information on factors that could affect these matters."
},
{
"speaker": "",
"content": "We will also refer today to non-GAAP financial measures, reconciliations of which to the most direct comparable GAAP measures and related details are provided in our earnings press release and financial supplement. I'd like to introduce our speakers this morning. First, we have Evan Greenberg, Chairman and Chief Executive Officer; followed by Peter Enns, our Chief Financial Officer. We'll then take your questions. Also with us to assist with your questions are several members of our management team. And now it's my pleasure to turn the call over to Evan."
},
{
"speaker": "Evan G. Greenberg",
"content": "Good morning. We had an excellent start to the year. Core operating income was up double digit, driven by all 3 sources of income. P&C underwriting income was up over 15% with a published combined ratio of 86%. Investment income was up more than 23% and life insurance income was up almost 10%. We produced double-digit premium revenue growth from across the globe with strong results in our commercial and consumer P&C and international life businesses. Core operating income was up over 20% to $2.2 billion and operating EPS was up nearly 23%, $5.41. As you saw, our earnings and EPS benefited modestly from 2 onetime items that partially offset each other. Adjusting for these, they were up 18.6% and nearly 21%, $5.33."
},
{
"speaker": "",
"content": "Again, our P&C underwriting income was up over 15% to $1.4 billion, driven by strong earned premium growth and great underwriting margins. The ex-CAT current accident year combined ratio was 83.7%. On the investment side, adjusted net investment income of nearly $1.5 billion was up 23.5%. We now have more than $140 billion in invested assets, up over 19% in the last 2 years. And our fixed income portfolio yield is 4.9% versus 4.4% a year ago. Our reinvestment rate is currently averaging 6.1%. Our liquidity is very strong, and investment income will continue to grow well as we reinvest cash flows at higher rates. Life segment income of $268 million was up 9.8%. Our annualized core operating ROE was 13.7%, with a return on tangible equity of nearly 22%. Peter will have some more to say about financial items."
},
{
"speaker": "",
"content": "Turning to growth, pricing and the rate environment. Consolidated net premiums for the company increased over 14%. For Global P&C, which excludes agriculture, net premiums increased 13.3% in the quarter with commercial up over 11% and consumer up over 19%. P&C premium growth in the quarter again was balanced broad-based globally between areas of the globe and commercial versus consumer, reflecting favorable underwriting and market conditions overall. Life insurance premiums and deposits were up over 39%, driven by our business in Asia and came from a number of countries and distribution channels."
},
{
"speaker": "",
"content": "Huatai contributed 2.9% and 20.6 percentage points, respectively, to the global P&C and life growth results. In terms of the commercial P&C rate environment, overall conditions were quite favorable in both property and casualty, and price increases exceeded loss cost while rate decreases in financial lines slowed. So starting with North America, premiums, excluding agriculture, were up over 10%, and consisted of 12.3% growth in personal insurance and about 9.5% growth in commercial. P&C lines up 13% and financial lines down about 7.5%. If we adjust the P&C growth to the net impact from 2 items in the major accounts division, P&C lines normalized growth was a very strong 11.6%."
},
{
"speaker": "",
"content": "The 2 items were an unusually large structured transaction we wrote partially offset by the previously discussed corrective underwriting actions in primary and excess casualty that are continuing to wind down over the next few quarters. By the way, that large structured transaction negatively impacted North America commercial's combined ratio by over 0.5 point, the loss ratio impacted by over 1 point. Excluding this impact, unmasks the current accident year combined ratio run rate."
},
{
"speaker": "",
"content": "Supporting North America P&C growth was record new business of over $1.2 billion at a very strong renewal retention on a policy count basis of 84.7%. Both speak to the tone of the market and our excellent operating performance. Premiums in our major accounts and specialty division increased 12% with our large account retail business up 12% and our E&S business up about 10.5%. Premiums in our middle market division increased about 7% with P&C lines up 10.6% and financial lines down 6.5%. Again, the P&C market environment in North America overall is quite favorable and rational, financial lines aside. Pricing increased 12.8% including rate of 9.4%, an exposure change that acts like rate of 3.1%."
},
{
"speaker": "",
"content": "From our very large middle market business to small commercial to personal lines, and driven by both property and casualty, we saw the best rates in pricing overall that we've seen in the last 4 to 5 quarters. It was one of the best quarters for large casualty pricing. In our North America business, rate increases for property and casualty exceeded loss cost trends, let alone pricing, which was even stronger. So let me provide a bit more color around rates and pricing. Property pricing was up 13%, with rates up 7.8% and exposure change of 4.8%. Casualty pricing in North America was up 13.1% with rates up 10.9% and exposure up 2%. And in workers' comp, which includes both primary comp and large account risk management, pricing was up 4.8% with rates up 0.2% and exposure up 4.6%. Loss costs in North America are relatively stable and in line with what we contemplate in our loss specs."
},
{
"speaker": "",
"content": "We are trending loss costs at 6.8%, short-tail classes at 5.3% and long tail, excluding comp at 7.6%, trending our first dollar workers' comp book at 4.6%. For financial lines, the underwriting environment and a number of classes in a word is simply dumb. Rates continue to decline, albeit at a slower pace. We are, of course, trading growth for underwriting margin and income where we need to. In the quarter, rates and pricing for North America financial lines in aggregate were down 3% and 2.7%, respectively. We are trending financial lines loss costs at just over 5%."
},
{
"speaker": "",
"content": "On the consumer side of North America, our high net worth personal lines business had another outstanding quarter. This is a powerhouse business, over $5.5 billion in premium last year and it grew over 12% in the quarter with new business growth of nearly 35%. It speaks to a franchise and a class of its own in terms of service and capability. Premium growth for our true high net worth Premier and Signature segments, the group that demands the most underwriting and servicing, grew 16.5%. In our homeowners business, we achieved pricing of 17% in the quarter, while our selected loss cost trend remained steady at 10.5%. While a small quarter, our agriculture business had a very good underwriting result as the '23 crop year turned out a bit better than we projected."
},
{
"speaker": "",
"content": "Turning to our international general insurance operations. Net premiums were up 17.5% or 16.7% in constant dollars. Our international commercial business grew 11.4%, while our consumer was up over 26%. Growth this quarter was geographically diverse with all major regions contributing, which again illustrates the true global nature of the company. Asia led the way with premiums up 40%. Excluding Huatai's contribution, premiums were up 7.7%. Latin America had a strong quarter, with premiums up about 13%, while the continent of Europe grew 10.3%. We continue to achieve positive breakthrough exposure across our international commercial portfolio. Retail property and casualty lines pricing, up 5.5% and financial lines pricing, down 2.3% million."
},
{
"speaker": "",
"content": "Loss cost inflation across our international retail commercial portfolio is trending at 5.8%, with P&C lines trending 6.1% and financial lines trending 4.8%. Within our international consumer P&C business, our Personal Lines division had an exceptional quarter with constant dollar growth of 47%, led by Asia and Latin America. By the way, the modest increase in Overseas General's ex-CAT current accident year combined ratio this quarter was primarily due to the consolidation of our China business."
},
{
"speaker": "",
"content": "In our international life insurance business, which is overwhelmingly Asia, premium and deposits were up over 50% in constant dollar, with strong contributions from Taiwan, Hong Kong, China and Korea. Excluding Huatai Life, premiums and deposits were up over 10%. Depending on the country, growth was driven by tied agency, brokerage and direct marketing distribution channels. Lastly, Global Re had a strong quarter with premium growth of almost 30% and a combined ratio of 76.9%. We allocate incrementally more CAT capacity to our reinsurance business and grew both our CAT excess and risk property portfolios, in particular, this quarter."
},
{
"speaker": "",
"content": "In summary, we had an excellent quarter and start to the year. We remain well positioned to continue producing outstanding results through the balance of the year and beyond. We remain confident in our ability to continue growing operating earnings at a rapid pace through P&C revenue growth and underwriting margins, investment income and lifing."
},
{
"speaker": "",
"content": "Now I'm going to turn it over to Peter and then we're going to come back, and we're going to take your questions."
},
{
"speaker": "Peter Enns",
"content": "Thank you, Evan. As you all just heard, we continue to build on the momentum of our record 2023 year with strong growth in top line and earnings per share this quarter. We continue to effectively manage our balance sheet and ended the quarter in a strong financial position, including book value that exceeded $60 billion in cash and invested assets of $143 billion, each topping last quarter's all-time highs. Adjusted operating cash flow was $3.6 billion. There were 2 onetime earnings items this quarter that I would like to touch on. First, we recognized an incremental $55 million deferred tax benefit related to the new 2023 Bermuda corporate income tax law. This resulted from finalizing our review of 2 smaller subsidiaries since last quarter. We don't expect additional deferred tax gains related to this law going forward."
},
{
"speaker": "",
"content": "Second, there was a contribution made to the Chubb Foundation, charitable foundation of $30 million pretax or $24 million after tax. These items provided a net benefit of $0.08 per share. Additionally, there were 2 other noteworthy items in the quarter. In March, we issued $1 billion of 10-year debt to retire existing debt due to retire -- mature in May 2024. Lastly, we closed on an additional 9% of shares of Huatai that brought our ownership interest of 85.5%. This leaves the last tranche of less than 1% of outstanding Huatai shares remaining to close. During the quarter, book and tangible book value per share, excluding AOCI, increased 2.2% and 2.9%, respectively, from December 31, driven by strong operating results partially offset by $350 million in dividends and $316 million in share repurchases in the quarter."
},
{
"speaker": "",
"content": "Turning to investments. Our A-rated portfolio produced adjusted net investment income of $1.48 billion, slightly beating our guidance of $1.45 billion. We expect our adjusted net investment income to have a run rate of approximately $1.5 billion to $1.52 billion next quarter and to go up from there."
},
{
"speaker": "",
"content": "Turning to underwriting results. The quarter included pretax catastrophe losses of $435 million, which is modestly lower relative to prior year and is principally from winter storms and other weather-related events in the U.S. Prior period development in the quarter in our active companies was a positive $216 million pretax with favorable development of $311 million in short tail lines, primarily from property and credit-related lines, and $95 million of unfavorable development in long tail lines, which was primarily from excess casualty and was within our range of expectations."
},
{
"speaker": "",
"content": "Our corporate runoff portfolio had unfavorable development of $9 million pretax. Our paid-to-incurred ratio for the quarter was 84%. Our reported core effective tax rate was 15.2% or 17.3% for the quarter, excluding the update to our Bermuda tax benefit. As I've said before, our first quarter tax rate also tends to be the lowest of the year, due to certain tax benefits associated with equity award vesting and stock option exercises. We continue to expect our annual core operating effective tax rate for the full year to be in the range of 18.75% to 19.25%."
},
{
"speaker": "",
"content": "I'll now turn the call back over to Karen."
},
{
"speaker": "Karen Beyer",
"content": "Thank you. At this point, we're happy to take the questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]"
},
{
"speaker": "",
"content": "Your first question comes from the line of David Motemaden with Evercore ISI."
},
{
"speaker": "David Motemaden",
"content": "First question. Evan, I just wanted to maybe get a little bit more detail on the $95 million of unfavorable reserve development on the long tail lines that you guys took this quarter? And maybe just unpack that a little bit more would be helpful."
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes. Look, we recognized over $200 million of reserve releases, so to give perspective. And that included adverse development of $95 million in North America commercial lines long tail. It was not concentrated in any one period, it was spread out from '16 forward. It was predominantly large account excess casualty, auto related in areas we've discussed. Trucking, logistics companies, companies with large commercial fleets and it's the business we've been addressing in terms of rate and underwriting actions and in that case, think retentions."
},
{
"speaker": "",
"content": "And our loss picks that reflect our action. The -- in fact, when we talk about that we gave you color around that we had this large LPT that was larger than usual. And then we offset to a degree by the underwriting actions that we've been taking. You heard it all last quarter. It will run 2 or more -- maybe 2 more quarters. That's all related back to the same business as you know. So there's the mental model. The development was not a surprise because we continually track actual versus expected activity for all product lines. And we had continued to observe higher-than-expected loss activity for this business. So we study it more deeply this quarter. And we took as we always will. We took the bad news and we are slow to recognize good news, no different than I said last quarter, our reserves are really strong."
},
{
"speaker": "David Motemaden",
"content": "Got it. That's helpful. And then I did notice that the commercial casualty net premium written growth accelerated during the quarter and you mentioned -- you also mentioned the rate increases accelerated a little bit in the quarter as well in commercial casualty. Could you just talk about how you're thinking about balancing all the elevated uncertainty in the environment with leaning into growth, which it seems like you guys are doing a little bit?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Well, the growth is coming. It wasn't a little bit. It was a step change in the rate we got exceeded loss costs, let alone pricing, which includes exposure change. And that is what contributed substantially to the growth. We grew exposure as well, particularly in our middle market long-tail business."
},
{
"speaker": "",
"content": "Though there was some growth in particular lines in large accounts as well where the pricing -- the vast majority of our book is adequately priced in casualty, and we're getting rate that recognizes loss cost trend, and so we maintain the adequacy. And then the stress classes, which need rate to hit our target combined ratios. That's where rate has accelerated in the market, and we -- because the market is also reacting, we're able to achieve and grow the business to a degree. Otherwise, we get the rate, like the business. And there were 1 or 2 classes where that's occurring."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Zaremski with BMO Capital Markets."
},
{
"speaker": "Michael Zaremski",
"content": "On the topic of social inflation, I think, I'm assuming when we think about the social inflation that the main way to tackle it is risk selection and pricing, et cetera. But I recall in your shareholder letter, Evan, you talked about working or maybe you can elaborate, you and others have talked about kind of -- it sounds like a more concerted effort to lobby efforts or to maybe state by state see if there could be some reforms. And so just curious if you could elaborate if there's anything changing there in terms of what Chubb or the industry is doing to maybe tackle it from the back end or..."
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes. First of all, our loss picks reflect the reality of the environment, the inflation we observe. And that includes any actions as we know them to be that might ameliorate it around tort reform. Tort reform is going to be a long-term never-ending process. As you say, it's not going to be federal. State by state, it could be county by county, depending. And it depends on the class of business as to the kind of reform that's required to bend that curve and loss cost. The insurance industry can support tort reform and does. The insurance industry can't particularly lead it. We don't have the printing press. This is ultimately paid for by corporate America, and it's paid for by consumers, by the products and the services from corporate America, it's a tax on everybody."
},
{
"speaker": "",
"content": "If you look at it in a clear eye way, we reflect the inflation that we see, whether it comes from social inflation, so-called social inflation, or other causes in the prices and the rates we ultimately charge corporate America to the business. Tort reform comes and there's litigation finance where disclosure laws have to change around that and I mentioned that better. And some states require it, most don't. And it's very simple because it puts in context how sympathetic is the plaintiff. And what are the motives? There's laws around who bears liability, the responsibility, what they call joint and several laws around it. You could be 1% liable, but you're the only one with any money, so they make you 100% responsible financially."
},
{
"speaker": "",
"content": "There are reasons that, that occurs, but that is also being gamed by the trial bar in how they target cases and how they target companies. It's those sorts of things. The insurance industry is hardly sympathetic. Corporate America needs to do more in this case, and we are all active. A number of companies are active in advocating for reforms, but it's not a magic, it's no silver magic bullet. It's going to take many years and it's going to require more effort than is currently being expended."
},
{
"speaker": "Michael Zaremski",
"content": "Great. Switching gears, maybe a quicker question on Personal Lines. If I look at kind of what Chubb has said about kind of loss cost inflation in personal lines and appreciating you have a different book than I guess the average of your peers. But you got -- you all have been talking about kind of close to double digit or double-digit loss cost inflation for many years now. It feels like that's been -- some of your peers have caught up to you in terms of, I think, they were underestimating it. But just curious if you can provide any context. Is the loss cost inflation more so coming from weather inflation? Or is it just as much coming from wage inflation? Or just any context unpacking that kind of 10%, 10.5% loss inflation?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes, it comes from 3 sources -- or a couple of sources. It comes from frequency of loss and from various perils. It comes from -- and so there you could think weather-related. You can also think water-related. And so the infrastructure impact to housing stock itself. It comes from wage inflation, and it comes from materials, which -- remember, we ensure not the average homeowner, we're ensuring those who are more affluent. And our product is a richer product in terms of how it responds to loss and the position it places you back in following loss. We try to duplicate exactly what you had before the loss, not sort of like it, but we duplicate it."
},
{
"speaker": "",
"content": "That has an inherent inflation to it as well. And we ensure more complex properties, and we ensure more complex and expensive content. So that may contribute to a degree to a greater amount of inflation than you might see generally across. But we stay on top of it. And we have and we've stayed on top of it in terms of both pricing and the amount of coverage we give to our clients. So they don't fall behind, which for all our homeowners, in shorts, that shows up, yes, in your bill that you get once a year from us, be included."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Gregory Peters with Raymond James."
},
{
"speaker": "Charles Peters",
"content": "When I was looking through your results, I was particularly struck by the growth in the reinsurance lines, seems to have accelerated. And I'm just curious if there is a change in your perspective regarding leading into those market conditions."
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes. Greg, keep in mind, percentages are a funny thing. It's not a big business. It's not a big book of business. We're not a large reinsurer. So the percentage growth, which is very good to see, is off of a relatively small base. So in dollar terms, it's nice. Thank you very much to all our Global Re colleagues, but it's not a large amount. We allocated given the pricing environment and given structure and given underlying pricing and structure of cedent's portfolios. We allocated more -- incrementally, as I said in the opening, more CAT capacity with 2 Global Re, which means they're writing a bit more CAT excess and a bit more property proportional and excess per risk. And it's across the globe where they see favorable conditions. That's predominantly with the CAT results."
},
{
"speaker": "Charles Peters",
"content": "Okay. Fair enough. I know -- I got to preview this question knowing that I'm probably not going to get a great answer, but I feel like it's appropriate to ask..."
},
{
"speaker": "Evan G. Greenberg",
"content": "You can ask anyway, and you'll get a lousy answer, go ahead."
},
{
"speaker": "Charles Peters",
"content": "Well, the topic is M&A. I mean, you featured it. You talked about the 1 to 2 points of drag you get on holding excess capital. You mentioned that in your shareholder letter. You're generating great results. I feel like this is a time where we could see you get more active in the market. But maybe you can just talk to us broadly about what you're seeing in the market? Is there a pipeline out there? Or is it -- is there a lot of opportunities? Or give us some perspective if possible."
},
{
"speaker": "Evan G. Greenberg",
"content": "Greg, I'm at rest. And the results are terrific. We have excess capital for both risk and opportunity. It's earning -- putting money to work at over 6% right now. If you put the capital against our invested asset, it requires certainly a damn good ROE. The cash that we hold is accretive to shareholder returns. And look, we're a global company with a lot of global opportunity and our eyes are always open. But as I said, I'm at rest. Don't hold your breath."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ryan Tunis with Autonomous."
},
{
"speaker": "Ryan Tunis",
"content": "I guess first question, just on financial lines. I think you said that it's quite frankly, dumb. Now that's obviously like a pretty broad set of various lines within financials. I think I heard you say that you're shrinking in mid-market, too. And my perception is that, it was a little bit more disciplined than some of the major accounts. So just curious if you could just take us within financial lines, whether it's account size or D&O excess whatever, like where are folks acting more or less irrationally?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes, look, the way to think about this -- don't just think, it behaves differently to a degree in major account than it does in middle market in the cohorts that show up where market competition is irrational. I'm not going to unpack each one of those. But what I'll break down for you is this. You have publicly traded D&O. And whether it's in middle market or it's in large account, there is dumb behavior depending on the cohort. I'm not going to unpack which one of them it is that much transparency, but you see it in large accounts and you see it in publicly traded deal. There is not-for-profit D&O. We write it in both major accounts and we write it in middle market."
},
{
"speaker": "",
"content": "And by the way, we write it in E&S. And there are cohorts where market, we know because we're the largest writers of this business. We know what the experience is, what the real exposures are, where losses are coming from, market and pockets of that important buckets irrational, dumb. Employment practices liability. Again, I'm going to say which cohorts, but market is -- many are very naive and don't understand the trends and the exposures that are driving EPLI and where it's being driven, what states, where law has changed. Is it around? It's not simply wage an hour, now technology impacts it. There are those who have no idea what's catching up to them."
},
{
"speaker": "",
"content": "And then you have legal changes that are occurring at the federal level that are impacting financial lines. You can see it and it's coming. So the good news about the business is, claims made reveals its secrets pretty quickly that will occur and it is a big company. We got a lot of opportunity in a lot of places. And in some of those areas, we're just not going to follow people off the cliff. It doesn't matter."
},
{
"speaker": "Ryan Tunis",
"content": "Got you. And a follow-up, just shifting gears. Just curious about priorities in U.S. personal lines. It kind of felt like you had the stuff in California a few years ago that in the past few years, it's sort of been more of a business where you've been focused more on risk selection and growth for good reason. But I mean it looks like it's more than $1 billion of underwriting earnings today. It looks a little underwritten. Just maybe if you could update us on -- yes, like what are the key sets of priorities in terms of managing that business right now?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Well, key sense of priorities, good question. On one hand, we can continue pushing the envelope and we're impatient about it. On the -- how we define the services and coverage is that a customer in our space are to expect from a great carrier. The kind of resiliency services and engineering services, the kinds of technology that we can use to interface with our customers, give them a better experience. How we can use technology and claims and manage a better and more seamless outcome for them. All of that is wrapped up in how we think about that part of the business."
},
{
"speaker": "",
"content": "Our clients are CAT exposed. They were in a world where they choose to live where they live and know and make the choice to live where they're more CAT exposed. They will share more risk with us, but we can help them manage that risk on the portion that they share and as well reduce the exposure to loss on the portion we take. It also is allowing us, as we're doing that both through admitted and non-admitted to, in a sense, manufacture, more CAT capacity, which is really part of the ability or fuel to take on more exposure. We have a finite balance sheet. We can't take infinite risk. So we think about it in that regard."
},
{
"speaker": "",
"content": "Our pricing and the rate against exposure from perils continues to improve. We can keep pushing the envelope on how granular we become in terms of risk rating, more cohorts of risk to apply rate and price against. And we're continuing to do that, but we're restless about that. We can be even better at it. That allows us to provide more coverage in areas, think about it, like flood, where we have areas where we're actually leaning in to offer more protection to clients, but be able to manage the portfolio. Maybe that gives you a few."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"content": "Evan, just curious, and I'm sure there's some moving parts here, but can you help me kind of square in North America commercial. I'm looking at gross written premiums up a little below 2% and then nets up 9.5%. And have seen your ceded premiums kind of continue to drop the last couple of quarters, is there something going on there? Is it technical? Are you buying less reinsurance? What's going on?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Yes. I'm going to let John Lupica give this -- it's really coming -- it came this quarter from 2 things. And that LPT, I forget had on an impact on and it distorted the gross in that."
},
{
"speaker": "John Lupica",
"content": "Yes, Brian, as Evan had noted, we had in that large structured transaction this quarter that produced net written premium with no gross written premium. In addition, we had exited 2 large MGAs or fronted programs that historically pursed a lot of gross with very little net. When you adjust for those 3 items, the gross and net are virtually identical."
},
{
"speaker": "Evan G. Greenberg",
"content": "That's really..."
},
{
"speaker": "John Lupica",
"content": "That's the same answer on the net to gross ratio."
},
{
"speaker": "Evan G. Greenberg",
"content": "It's really transactional, not fundamental."
},
{
"speaker": "Brian Meredith",
"content": "Got you. No change in reinsurance by now, that makes sense."
},
{
"speaker": "Evan G. Greenberg",
"content": "I just see..."
},
{
"speaker": "Brian Meredith",
"content": "Okay. Excellent. And then, Evan, I may have missed this, but you provided a lot of great kind of pricing rate and trend exposure commentary. But did you give us what the kind of total North America commercial pricing, call it, rate and trend was? And if not, could we get that, you typically provided it?"
},
{
"speaker": "Evan G. Greenberg",
"content": "I did give it to you. Are you asking me to go back and do it again? Do you actually want me to look -- I'll give it to you if you want me to take my notes and do it [indiscernible]. Listen, North America, I said pricing increased 12.8% including in P&C, including rate of 9.4% and exposure change of 3.1%."
},
{
"speaker": "Brian Meredith",
"content": "Got you. And trend?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Loss cost. So we're trending short tail at 6.8% and long tail -- short -- sorry, overall loss cost 6.8%; short-tail, 5.3%; long tail, 7.6%. Yes, this is full service call."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Bob Huang with Morgan Stanley."
},
{
"speaker": "Jian Huang",
"content": "Hopefully, I'm not asking anyone to repeat anything. But just a quick question on the -- on your annual shareholder letter, right? You talked about the willingness to pull back on unprofitable lines a demonstration of underwriting discipline, which is kind of really curious as to how to square away that line of thinking with your first quarter results because it seems like the first quarter results continue to demonstrate a lot of strength, a lot of growth. Is the financial line somewhere you're looking at as a..."
},
{
"speaker": "Evan G. Greenberg",
"content": "Hey, you're not listening. Not listening. Did you see that -- so I'm going to interrupt you. Are you really -- financial line, [ frank, ] number one. Number two, I said right upfront in major accounts in certain areas of casualty, where we're taking action. And we saw it last quarter, saw it this quarter and it impacts growth. And then there are other areas growing. Those are 2 that are visible."
},
{
"speaker": "Jian Huang",
"content": "No, that's..."
},
{
"speaker": "Evan G. Greenberg",
"content": "By the way, look at our 20-year track record over any period of time, where we have shrunk our business, cut businesses in half over periods of time when we couldn't earn an underwriting profit and then triple the math to that. Do you have another question for me?"
},
{
"speaker": "Jian Huang",
"content": "No, I think that's very helpful. Yes, it helps me contextualize things."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Robert Cox with Goldman Sachs."
},
{
"speaker": "Robert Cox",
"content": "A high-level question. So Chubb produced an 86% combined ratio, which has continued to improve and net investment income contributions to ROEs have gone up. I know there's more bifurcation than ever with respect to pricing adequacy by line of business. But I'm curious when do you think the market will sort of dictate the matching of rate and loss trend versus the excess margin you're generating now?"
},
{
"speaker": "Evan G. Greenberg",
"content": "I'm not sure I understand your question. Sorry."
},
{
"speaker": "Robert Cox",
"content": "So I'm curious -- yes, I'm just curious when you think basically rate and loss trend will be at similar levels versus rate exceeding loss trend."
},
{
"speaker": "Evan G. Greenberg",
"content": "I have no idea. It depends on when the market -- and it will never really happen. But I'm seeing you're asking in a very theoretical way. There's something neat in what is a market, so it's always inherently messy. But when typically, when rate and price are adequate or in excess of what's required to earn a reasonable return then the market in time notices and responds and becomes more competitive. And at that time, rate and price stay steady with loss cost. And then the market begins to go soft. And when that part of the cycle happens, it means the rate on price are less than loss cost. And that is not terrible until rate and price versus loss cost is not enough to achieve a reasonable return on capital."
},
{
"speaker": "Robert Cox",
"content": "And maybe just a follow up on that. Curious if you think that with data and analytics, these cycles are becoming less volatile over time."
},
{
"speaker": "Evan G. Greenberg",
"content": "In some areas, yes. Some areas, absolutely not. Because the loss cost environment, which data and analytics cannot [Technical Difficulty] is not less volatile. When the loss cost environment is more specific i.e., loss cost inflation, then with data and analytics in steady periods like that, then the amplitude of cycles is different."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"content": "I had a question on just your comments on dumb behavior and financial lines. I was wondering if you could talk about who it is that you're seeing being undisciplined. Is it companies that are established, that are large peers in the market? Or smaller competitors, new money that's come in, just some color on who's driving because it's been going on for a while, so."
},
{
"speaker": "Evan G. Greenberg",
"content": "Next question, Jimmy."
},
{
"speaker": "Jamminder Bhullar",
"content": "Not going to comment? All right."
},
{
"speaker": "Evan G. Greenberg",
"content": "No."
},
{
"speaker": "Jamminder Bhullar",
"content": "So -- and then on cash, there's been a lot of talk about post -- or pre-COVID, you're starting to emerge negatively and a few companies have seen post-COVID adverse development as well. So any comments you can make on your view of casualty reserves overall for the industry and for your own book?"
},
{
"speaker": "Evan G. Greenberg",
"content": "We did expect a change of loss cost pattern frequency in particular. And we have talked about it during COVID that we didn't take the head fakes that loss costs during shutdown, obviously, courts are closed, frequency plummets and as does severity. And at that time, we maintained our view. We saw right through it and said, trends aren't changing, so we continue to trend. It's just a question of reporting on what period does it get reported in? So we expected that the trend doesn't change, but the reporting pattern changes. So therefore, if you really want to look at it in a correct way, you'd say, it went down during COVID to reaccelerate after COVID and then the expected cohorts of claims in aggregate still appear, and that's what we've seen. The pattern post COVID is not out of line with our expectations in our pricing and loss picks."
},
{
"speaker": "Jamminder Bhullar",
"content": "Okay. And just for Peter, what do you expect your tax -- do you expect a change in your tax rate next year given what's the changes in Bermuda? And to the extent you can quantify the expected tax rate."
},
{
"speaker": "Peter Enns",
"content": "For next year and after, it's just too early to say. There's too many moving parts in terms of how the different countries are going to adopt and we're looking at it closely, but it's just too early to say."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Cave Montazeri with Deutsche Bank."
},
{
"speaker": "Cave Montazeri",
"content": "There was nothing called out this quarter with regards to the Baltimore bridge losses? I appreciate it's early days, but is there any color worth sharing with us on this topic?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Our policy is, we do not report on individual claims, but I've noticed a lot of commentary on this. Look, it's a tragedy that an accident like this occurs, and it's done a lot of damage. However, when it comes to Chubb, it's another large loss. There is nothing -- yes, of course, we have exposure, but the exposure is within what we would contemplate and there's nothing outsize to us. And so another large unfortunate claim, that's all there is to it."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"content": "My first question, Evan, I was hoping you could just provide some more color on what drove the sequential acceleration in exposure growth that you pointed to within Property Casualty as well as within workers' comp?"
},
{
"speaker": "Evan G. Greenberg",
"content": "Well, what I said, Elyse, thank you, is the premium growth because we don't really disclose exposure, but the premium growth came from, a substantial portion of it came from rate and price, which were very healthy across the portfolio. Property grew nicely. Property was our biggest growth area. Casualty grew, particularly in our middle market area and E&S. And rate and price had a substantial contribution to the growth, though we also grew new business where pricing versus loss cost is healthy to us."
},
{
"speaker": "Elyse Greenspan",
"content": "And then my follow-up, you highlighted some planned reunderwriting within North America commercial. I believe you had also told us about that last quarter, and it sounds like we'll have that work through for the next couple of quarters. So is it right way to think about, I guess, the growth in North America commercial ex the LPT and just the reunderwriting as kind of the baseline of growth for the year. I know you don't like to guide, but you seem pretty positive about just casualty pricing and things like that, just trying to pull it all together."
},
{
"speaker": "Evan G. Greenberg",
"content": "I'm not going to help you with your worksheet, I'm sorry, Elyse. I don't guide. We don't guide growth for the year. What we did tell you is excluding the LPT, excluding the unusual size of the LPT because we have LPTs virtually every quarter. But excluding the unusual size of it, and what we view as the unusual, the onetime underwriting action in large account that I described, the net of that, we gave you a growth rate, and we said that's the underlying growth rate for that quarter. That is not -- we didn't say that's a run rate for the year. This is a diversified commercial and personal property casualty book of business. And you're hardly -- we don't give guidance on growth for the year."
},
{
"speaker": "Operator",
"content": "I will now turn the call back over to Karen Beyer for closing remarks. Please go ahead."
},
{
"speaker": "Karen Beyer",
"content": "Thanks, everyone, for joining us today. If you have any follow-up questions, we'll be around to take your call. Enjoy the day. Thank you."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that concludes today's call. Thank you all for joining, and you may now disconnect your lines."
}
] |
cboe | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. At this time, I would like to welcome everyone to the Cboe Global Markets Fourth Quarter Earnings 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] Thank you. I would now like to turn the call over to Ken Hill, Head of Investor Relations and Treasurer. Ken, please go ahead."
},
{
"speaker": "Ken Hill",
"content": "Good morning, and thank you for joining us for our fourth quarter earnings conference call. On the call today, Fred Tomczyk, our CEO; and Dave Howson, our Global President will discuss our performance for the quarter and provide an update on our strategic initiatives. Then, Jill Griebenow, our Chief Financial Officer will provide an overview of our financial results for the quarter, as well as discuss our 2025 financial outlook. Following their comments, we will open the call to Q&A. Also joining us for Q&A will be Chris Isaacson, our Chief Operating Officer. I'd like to point out that this presentation will include the use of slides. We'll be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the Investor Relations portion of our website. During our remarks, we'll make some forward-looking statements, which represent our current judgment on what the future may hold. And while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks, and uncertainties. Actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. Please refer to our filings with the SEC for a full discussion of these factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise after this conference call. During the call this morning, we will be referring to non-GAAP measures as defined and reconciled in our earnings material. Now, I'd like to turn the call over to Fred."
},
{
"speaker": "Fred Tomczyk",
"content": "Good morning, and thank you for joining us today. I hope the year is off to a great start for everyone. I'm pleased to report on strong fourth quarter and full year results for Cboe Global Markets. During the quarter, we grew net revenue 5% year-over-year to $524.5 million and adjusted diluted earnings per share by 2% to $2.10 over a strong fourth quarter in 2023. These results capped another record year, which saw us grow net revenue 8% to a record $2.1 billion and adjusted diluted earnings per share 10% to a record $8.61. Our results for the year were driven by solid volumes across our Derivatives business, strong volumes across our cash and spot markets, growth of our Data Vantage business, formerly known as Data and Access Solutions, and more disciplined expense management. I'm incredibly pleased with the strong 8% net revenue growth in 2024, coming against a modest 6% increase in adjusted expenses, stabilizing our margins and driving a 10% improvement in adjusted diluted earnings per share for the year. While the robust option volumes were a standout for 2024, the results were notable in that each category, derivatives markets, Data Vantage, and cash and spot markets contributed to the fourth quarter and full year growth. Record setting trends drove broad-based growth across business lines as every major segment and category produced year-over-year net revenue growth in 2024. Our Derivatives business delivered a solid year with organic net revenue increasing 8%, wrapping up another record year of option volume growth. Total volume across Cboe's four options exchanges was 3.8 billion contracts traded in 2024 with an ADV of nearly 15 million contracts traded, a fifth consecutive record breaking year. For 2024, we saw record volume in SPX and VIX options as investors turn to our S&P 500 volatility toolkit to help navigate markets. ADV and SPX options was a record 3.1 million contracts traded, while ADV and VIX options was a record 830,000 contracts traded. Our Data Vantage business finished the year strong, driving a 7% increase in organic net revenue in 2024. The technology investments we made to further optimize access, data, and insights for our Data Vantage business drove positive results for Cboe and our customers. We continue to see durability in this business as we leverage our global footprint and technology enhancements to drive growth. Our cash and spot markets performed well during the year as organic net revenue increased 10%, driven by healthy trading volumes and growth across all of our regional equities markets. Overall, it was an excellent year for both transaction and non-transaction growth, capped by a strong fourth quarter for Cboe. As we entered 2025 with our sharpened strategic focus and framework, we outlined last quarter, we believe that we're well-positioned for the secular trends that we expect to continue shaping the markets globally. The rising popularity and adoption of options trading, the continued rise of the retail investor, the globalization of markets, and the rapidly evolving area of technology and data management, including newer technologies like artificial intelligence. 2024 was another record breaking year for the options market as more investors embraced the utility and versatility of options. Our derivatives business remains resilient, supported by a growing customer base, demand for access to the U.S. market, and an increasing demand for options. The combination of these trends means that we're well-positioned as we enter 2025 to further expand and enhance our derivatives ecosystem. With our diverse suite of products, we are well situated to help market participants navigate the elevated uncertainty we're witnessing across the market and geopolitical environment. We believe the new administration in Washington has a markedly different tone signaling a pro-business environment with regards to deregulation and tax cuts, fostering a bullish settlement. However, significant uncertainty remains around the strange geopolitical environment, combined with the record number of executive orders and the more recent tariffs coming out of the new administration, all of which injected volatility in the market. As markets evolve in response to these events, our SPX and VIX products provide an unparalleled toolkit for investors to help seize opportunities and hedge their portfolios around the clock. We believe that the strong performance in the U.S. market with the S&P 500 Index launching a return of more than 20% for two consecutive years will continue to attract new investors, both domestically and internationally. Through our SPX options complex, the ability to facilitate risk management and import foreign investment back into the U.S. market is expected to be a significant and growing opportunity that will be a top focus for us in 2025. On the retail front, we continue to work with key retail broker partners across the globe to expand access to our products and education, so more investors can leverage the numerous benefits of index options. I'm pleased to report that Cboe's index options are now available to all customers at Robinhood, one of the largest options trading platforms for retail investors. We believe that retail adoption of index options still has room to run and Cboe is well positioned to meet this growing demand through education, access, and product innovation. One of the core components of innovation is technology. And over the last year, we have reallocated capital and resources towards investment in our exchange technology platform. Last month, we unveiled a new brand identity for this platform, Cboe Titanium, signaling an exciting new chapter in our ongoing evolution and commitment to delivering best-in-class trading technology for our market participants around the globe. Cboe Titanium enables innovation across our markets, products, data, and insights, all on a unified and scalable global technology platform. In every new market we have entered, our market share has improved following our migration to Cboe technology. As we enter 2025, I'm excited about how Cboe is positioned. Our strategic framework is well aligned to the secular trends we see in the capital markets we compete in and leverages our strengths. Our balance sheet is in a strong position and enables us to follow a disciplined and long-term approach to capital allocation, and we're well suited to invest in strategic organic growth opportunities that drive growth not just in 2025 but beyond. I'll now pass it over to Dave to discuss the business line results in more detail."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Fred. Starting with our Derivatives business, on a full year basis, net revenues were up 8%, led by another year of strong index options growth. We remain excited about the secular trends in place for our Options business as SPX options volumes increased 7% year-over-year to a record ADV of $3.1 million in 2024, while VIX options ADV hit a record high of 830,000 contracts, up 12% from 2023's record. The fourth quarter showcased the utility of our S&P volatility toolkit in helping investors quickly and effectively navigate changing market conditions. While we saw a pickup in hedging demand going into the U.S. election, we saw a risk-on rally that caught many investors by surprise following the results. SPX core options volumes jumped post-election as investors used options to quickly adjust their portfolio. Meanwhile, VIX put volumes surged higher as traders positioned for a normalization in volatility. While volatility conditions and market outlooks changed, VIX stayed constant with a sustained growth in our 0DTE options in both SPX and RUT. In the fourth quarter, SPX 0DTE Options ADV gained 8% quarter-over-quarter to nearly 1.6 million contracts, now making up over half of all SPX Options ADV for the first time. Since we launched daily expirations on options on the Russell 2000 Index last January, RUTs option volumes have grown 11% year-over-year with the share of 0DTE options trading doubling from 11% in January 2024 to 23% in January 2025. As we look ahead to this year, we see a sustained need for investors to stay nimble in the face of changing monetary and fiscal policies in the U.S., as well as rising trade tensions globally. We believe options are a great tool in these environments as they allow investors to quickly reposition and hedge their portfolios as market conditions change. Against this macro backdrop, we're excited to work towards broadening access to our products, increasing education efforts for all investors, and showcasing the advantages of our expanding S&P volatility toolkit to help manage risk. On the access front, we are well aligned with the secular drivers of our business, including the rise of the retail investor. We are pleased with the early traction following the Robinhood launch in the fourth quarter and anticipate the increased volume from the platform will be additive to our proprietary product volumes as we expand access to more retail traders. With the expanded access on the Robinhood platform, customers are able to leverage the full advantages of index options from the simplicity of cash settlement and the certainty of European style exercise to the potential 60-40 tax treatment. Turning to our international endeavors. We are excited by the import and export potential of our derivatives products. We anticipate that making investments in our sales and educational efforts around the globe will translate to greater volumes being imported back to the U.S. In the Asia-Pacific region, specifically, we remain focused on expanding our presence in our six priority markets, Japan, Australia, South Korea, Singapore, Taiwan, and Hong Kong, by building a local salesforce and educational tools tailored for local customers. During the fourth quarter, we saw two new brokers turn on access in our priority markets, making Cboe products available for trading during global and regular trading hours. Outside our initial priority markets, we now have two brokers providing Malaysian investors with listed options. On the export side, CEDX continues to add capabilities with over 320 single stock company options available to trade from 14 countries and record levels of open interest to finish 2024. And on the innovation front, the fourth quarter was a busy one for our product development team as we introduced two new ways to trade S&P Index Volatility through various futures and VIX options on futures. Given the introduction of these products, education will be a key focus in 2025 as we continue to grow the toolkit. To maximize the impact of these initiatives across our global derivatives platform, we must have the right talent in place to drive success at Cboe. This week, I was incredibly excited to welcome Meaghan Dugan, who is joining the company as Head of U.S. Options. In addition, we recently outlined several new hires and key promotions to further strengthen our business development, market intelligence, and sales capabilities across the U.S., Europe, and Asia-Pacific. We expect 2025 to be a transformational year as we leverage a strong bench of talent to provide customers with improved access, enhanced education, and continued innovation around our volatility toolkits. Moving to cash and spot markets. The fourth quarter produced robust results with net revenues increasing 14% on a year-over-year basis. This capped a strong year where net revenues increased 10% given solid contributions from all regions. 2024 was notable not only for the healthy results, but also the innovation across markets that helped drive improved market share in regions like Europe and Asia Pacific. As we near the end of our integration efforts in Canada later this quarter, we are excited to leverage the full power of our global and cohesive trading infrastructure. In North America, a 28% increase in net transaction and clearing fees during the fourth quarter helped improve net revenue for the segment by 10% on a year-over-year basis. Industry volumes were a tailwind, with 22% growth in the U.S. on-exchange ADV, 5% growth in off-exchange ADV, and 11% growth in Canadian ADV on a year-over-year basis. Capture in U.S. on exchange equities improved 42% as compared to the fourth quarter of 2023, as we continue to strike the right balance between market share and capture to optimize revenues. In Canada, we are excited to build on the solid 2024 trends as we anticipate completing the migration of our Canadian market to Cboe Technology on March 3. Our Europe and Asia-Pacific segment delivered impressive 17% year-over-year net revenue growth in the fourth quarter and 16% growth for the full year. The increases were driven by higher net transaction and clearing fees, up 23% in the fourth quarter and 17% for the full year. For Europe, specifically, Cboe was the largest European stock exchange for the fourth quarter, with our share of continuous trading volume hitting 33%, up nearly 90 basis points versus the third quarter's record level. The results were again helped by strength in periodic auctions with a market share of 87% with periodic auctions accounting for a record 9.6% of continuous trading during the fourth quarter. In Asia-Pacific, we saw sustained progress in both Australia and Japan market share and industry volumes, driving year-over-year net revenue growth in the region. Turning to Data Vantage, net revenue grew 8% for the fourth quarter and 7% for the full year. Results in the fourth quarter were driven by increases in all three components of our Data Vantage business, real time market data, analytics, and indices with notable strength in our dedicated course offering and proprietary market data. More broadly, on a full-year basis, the record results were underpinned by two hallmarks of Cboe Data Vantage that we expect to carry through 2025 and beyond, new product development and the ability to sell products across our global network. The uptick from our U.S. dedicated cores launch in 2024 exceeded our expectations. We have built on that success by rolling the product out across Europe and Australia in the first quarter of 2025, highlighting our ability to take a product working well in one region and replicate that success across our global network. With our technology team shifting from migration work to revenue generating activities, we look forward to further product development that leverages our scaled infrastructure. Looking at our sales trends for Data Vantage more broadly, in 2024, we saw net new annual contract value hit record levels, increasing 33% year-over-year. International growth was healthy with 40% of new sales coming from outside the U.S. I'm excited to build on that global growth with a larger sales and educational resources footprint across the globe. This investment should help amplify the benefits of our global network. The fourth quarter again highlighted the power of the entire ecosystem at Cboe with derivatives, cash and spot markets, and Cboe Data Vantage all delivering durable results. 2025 will be a year of focused execution for Cboe by providing more uniform access, greater education, and leveraging our differentiated set of products for investors. January is off to a great start with index options ADV running at record levels, trends we look forward to building on in the year ahead. With that, I will turn the call over to Jill."
},
{
"speaker": "Jill Griebenow",
"content": "Thanks, Dave. Cboe posted a solid fourth quarter with adjusted diluted earnings per share up 2% on a year-over-year basis to $2.10. The fourth quarter results continue to illustrate the strength across our segments that was on display during 2024. I will provide some high level takeaways from this quarter's operating results before going through segment results. Our fourth quarter net revenue increased 5% versus the fourth quarter of 2023 to finish at $524.5 million, the growth was driven by strength in our cash and spot Markets and Data Vantage categories, as well as solid results from the derivatives business. Specifically, cash and spot markets organic net revenues grew 14% on a year-over-year basis, with all geographies contributing to the growth. Data Vantage net revenues increased 8% on an organic basis during the quarter and derivatives markets produced 1% net revenue growth versus a robust fourth quarter of 2023. Adjusted operating expenses increased 7% to $205 million for the quarter with the year-over-year growth driven by higher travel and promotional expenses as well as technology support services expenses. Adjusted EBITDA of $332 million grew 3% versus the fourth quarter of 2023. Turning to the key drivers by segment. Our press release and the appendix of our slide deck include information detailing the key metrics for our business segments. So, I'll provide some highlights for each. The options segment produced another quarter of record net revenue with 3% year-over-year growth led by higher multi-listed options transaction fees, total options ADV was up 5%, driven by an 8% increase in multi-listed options volume. Revenue per contract decreased 5% as index options represented a lower percentage of total options volume during the quarter. North American equities net revenue increased 10% on a year-over-year basis. Net transaction and clearing fees grew 28%, reflecting higher industry volumes and an improved net capture rate in on-exchange U.S. equities. On the non-transaction side, access and capacity fees increased 14% as compared to the fourth quarter of 2023. The Europe and APAC segment delivered a 17% year-over-year increase in net revenue, a result of strong growth across both transaction and non-transaction revenues. Transaction revenues across each region benefited from market share gains as well as increased volumes versus the fourth quarter of 2023. Futures net revenue decreased 7% from the fourth quarter of 2023 with lower net transaction and clearing fees reflecting a 12% decrease in ADV. And finally, the FX segment recorded 3% year-over-year net revenue growth as a product of higher net transaction and clearing fees. Turning now to Cboe's Data Vantage business. Net revenues were up 8% on an organic basis in the fourth quarter. International sales enhanced growth with 40% of new sales coming from outside the U.S. over the quarter. We believe Data Vantage is positioned to perform well in 2025. More specifically, we expect increased capabilities around our data, access, and insights as we reallocate technology resources from integration efforts to organic revenue generating enhancements. We anticipate growth will be aided by greater demand for access across our global markets, particularly, as we increase our sales presence in new geographies and leverage the distribution capabilities of Cboe Global Cloud. Turning to expenses. Total adjusted operating expenses were approximately $205 million for the quarter, up 7% compared to the fourth quarter of 2023. The increase primarily resulted from higher travel and promotional expenses as well as technology support services expenses. I would note that the fourth quarter is a seasonally high quarter for travel and promotional expenses, given our annual risk management conference. This year, we also saw an increase in our marketing spend, coinciding with the launch of index options on Robinhood's platform. While we plan to continue investing behind marketing efforts as we see opportunities for returns for our business, we expect to see travel and promotional expenses move lower sequentially from fourth quarter levels. As we look ahead on Slide 16 to our 2025 guidance, we anticipate our Data Vantage organic net revenue growth to be in the mid to high-single digit range, and we expect our full year total organic net revenue growth to be in the mid-single digit range. I would note that while we tweaked our guidance framework for 2025, both our Data Vantage organic net revenue guidance and our total organic net revenue guidance are in line with the ranges we provided under our previous guidance framework at this time last year. We are also introducing our full year 2025 adjusted expense guidance range of $837 million to $852 million, representing 4.8% growth on the lower end and 6.7% growth on the higher end. The 2025 guidance accounts for modest growth in our core expense lines, while allowing for investment to help drive incremental revenue expansion across Cboe's businesses. A few examples of the types of investments we plan to make include incremental sales hires in the APAC region, our securities financing transaction offering in Europe, and continuing marketing efforts to improve investor education and monetize the expanding access to our index options products. Taking a step back, in 2024, Cboe produced 8% net revenue growth against 6% adjusted expense growth, stabilizing our adjusted EBITDA margin and expanding it by 30 basis points for the full year. We believe that 2025 revenue and expense guidance outlined today strikes the right balance between investment for long-term growth and disciplined expense management as we look to drive long-term margin stability. Rounding out the remaining pieces of our 2025 guidance our full year guidance range for CapEx is $75 million to $85 million and depreciation and amortization is expected to be in the $55 million to $59 million range. The year-over-year increase in CapEx and depreciation and amortization reflect our efforts to sustainably invest in the business where we see long-term growth potential. A portion of the CapEx budget is also earmarked for our Kansas City office move, which is planned for this summer. We maintain a sizable presence with many of our technology and operations, finance, and regulatory associates in the area, and we remain committed to investing in our people and culture. We expect the effective tax rate on adjusted earnings under the current tax laws to come in at 28.5% to 30.5% for the full year. And while we don't provide formal guidance on interest income or interest expense, I wanted to highlight that fourth quarter interest income outperformed our expectations given some additional accounts that started to earn interest income and higher cash balances. We expect that interest expense, net of interest income will be in the $5 million to $6 million range for the first quarter of 2025. The last element I wanted to touch on as it relates to our 2025 guidance is the below the line items, earnings on investments, and other income. In past years, we have provided detailed guidance on these items, but today, we believe that we have reached a more mature phase in our investment cycle and anticipate a more modest impact on our earnings and investments line in 2025. We anticipate other income will continue to grow gradually, in line with cash dividends received. Turning to our balance sheet, the effective allocation of capital has been a cornerstone of our strategic review process. We take a long term view in allocating capital to areas where we see the greatest returns, whether it be organic investments or in the form of share repurchases, dividends, or inorganic investments. In the fourth quarter, we returned a total of $66 million to shareholders in the form of a $0.63 dividend, bringing the total amount of dividends paid to $249 million for 2024. Factoring in both share repurchases and dividends for 2024, Cboe returned a total of $454 million to shareholders, representing 50% of adjusted earnings for the year. We enter 2025 on a strong financial footing with $880 million of adjusted cash on our balance sheet, an attractive debt profile with low medium term fixed rates averaging below 3%, and an average leverage ratio of 1.1 times. As we move forward, we anticipate leveraging our flexible balance sheet and healthy free cash flow profile to produce durable returns for shareholders. Now, I'd like to turn it back over to Fred for some closing comments before we open it up for Q&A."
},
{
"speaker": "Fred Tomczyk",
"content": "I'd like to thank the entire Cboe team for their incredible work in 2024 that led to record results. When I moved from the Board to CEO in September of 2023, my priorities were to stabilize the organization after the sudden departure of the previous CEO, sharpen our strategic focus, bring a more disciplined approach to capital allocation and leadership development and succession. On my first priority, unexpected succession require an experienced CEO to lead the organization through that challenging time. The management team has been stable since. Our current management team is a strong team that is more unified than ever and focused on executing our refocused strategy. Over the past 18 months, we've made significant progress sharpening our strategic focus and framework, leveraging the core strength of our equity derivatives franchise. We're well-positioned to benefit from the secular trends as we start the year. We have also changed our capital allocation strategy to focus less on M&A and more on investing in organic growth opportunities and allocating resources to line up behind our strategic focus. Following the completion of the two technology migrations this year, this will be the first time in 10 years that our technology resources will be fully focused on the business and driving out our strategy as opposed to focusing on migrations. Redeploying our technology resources enables us to leverage one of our greatest strengths to focus on strategic organic growth opportunities. The company now has a clear organic growth strategy, moderated expense growth and stabilized margins, and attractive return of capital strategy and a strong balance sheet. As we enter 2025 on solid footing with a refined strategic focus and the financial flexibility to execute that strategy while being well positioned to take advantage of opportunities as they arise, which brings me back to my last priority, leadership development and succession. Cboe has been through a lot of change in the executive ranks over the last 18 months. But not only did we get through all that change, I believe we've come out stronger and more unified as a team. This is a credit to the strong management team I have around me. While the Board and I have devoted considerable time to leadership development and succession throughout 2024, in the latter part of last year, the Board engaged a search firm to more formally assist with the process. We have reviewed internal candidates and are also considering external candidates with the search firm's help. While the Board and I are putting greater focus on my succession, I will continue to serve as CEO until a successor is appointed and will help ensure a smooth transition. Upon transitioning out of the CEO role, I plan to remain a Director on the Board. I will continue to work closely with the management team to execute our strategy and drive continued success for Cboe. We have many exciting initiatives underway and I remain steadfastly committed to ensuring we stay focused on our long term goals. With that, I'll turn the call back over to Ken for Q&A."
},
{
"speaker": "Ken Hill",
"content": "At this point, we'll be happy to take questions. We ask that you please limit your questions to one per person to allow time to get to everyone. Feel free to get back in the queue, and as time permits, we'll take a second question."
},
{
"speaker": "Operator",
"content": "Thanks, Ken. [Operator Instructions] Looks like our first question today comes from the line of Patrick Moley with Piper Sandler. Patrick, please go ahead."
},
{
"speaker": "Patrick Moley",
"content": "Yeah. Good morning. Thanks for taking the question. So I just had one on the D&A revenue guide or Data Vantage that you're calling it now. Jill, you mentioned it -- you touched on it a little bit in the prepared remarks, but it does seem like the mid to high-single digit revenue growth range is a little weaker than the 7% to 10% that you guided to the last few years. So could you just maybe talk about some of the drivers that went into the decision to adjust the parameters there, and is it incorrect for us to think that the growth outlook there has softened a little bit? Thanks."
},
{
"speaker": "Jill Griebenow",
"content": "Yeah. You bet. Thanks for the question, Patrick. So just to clarify, historically, we provided a great deal of more granularity in our guidance and we've just -- we want to be helpful, but we believe that what we've moved to today in the refreshed guidance language reflects more of the market standards, but remains consistent with our prior ranges. So as I alluded to in my prepared remarks, again, very consistent with the guidance ranges that we provided a year ago at this time, so think that 5% to 7% for net revenue and then 7% to 10% for the Data Vantage."
},
{
"speaker": "Operator",
"content": "Okay. Thank you, Patrick. And our next question comes from the line of Ben Budish with Barclays. Ben, please go ahead."
},
{
"speaker": "Unidentified Participant",
"content": "Hi. This is Chris, (ph) I'm on for Ben. Thanks for taking the question. I actually wanted to dig into Robinhood a little bit. It sounds like it's been a healthy start for Index Options over there. And I know it's early days, but what is the uptake among SPX and the smaller XSP contract look like, and kind of what the mix looks like of the product adoption for this customer? And can you maybe dive into some of the initiatives that might help increase the education and drive further adoption as I think it's going? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Absolutely. It's Dave here. Thank you for the question there. We'll talk a little bit about how we think about attacking the retail space and we've mentioned it before, it's really across three pillars, that's access, education, and product. When we look specifically at the Robinhood rollout, from the access point of view, it's exceeded our expectations in two ways. First, it has been quicker than we expected, and second, that the uptake has been greater than we had expected. So we stand today with the mobile device rolled out index options and we had -- we saw Robinhood roll out index options to the Legend platform in recent weeks, which was ahead of our expectations. And the volumes that we see coming through are in our estimation, largely additive. Then when we go to the second pillar of education, what's been encouraging to see through time is the increased use of more complex strategies or spread trades in particular as the rollout has progressed, which means the toolkit, the index options are being used in a manner that we would expect them to be used. Thirdly, then coming to product, what's been really encouraging is that customers have used the core of our volatility toolkit. So what do I mean by that? That means that we've seen them use SPX options, VIX options and the smaller XSP options throughout that rollout. And to the profile that you asked about there, we've seen most of that flow coming through SPX, but what also is being really positive is actually all three of those products have grown in usage as the rollout has progressed. So that tells us that the customers are really accessing that simplicity of cash settlement, certainty of European exercise, and accessing the potential benefits of that 60-40 potential tax treatment there. And our expectation has been met that these products are resonating with Robinhood's target audience of the active trader universe. And so then as we think forward, what are we going to do more of, we're going to do more joint marketing, more joint education as we continue to roll out here. And we do that with all of the key retail brokers that we have on the platform. And so as we think about international growth there as well, that's where we spend our time as well on education, joint marketing, and increased sales force boots on the ground to help tell the story. So the outlook for 2025 as we continue here is a really constructive setup. And just think about those nearly 25 million funded accounts with what we understand to be 4% penetration for options there, that's a really solid runway for us to continue to access throughout 2025."
},
{
"speaker": "Operator",
"content": "Thanks, Chris for the question. And our next question comes from the line of Jeff Schmitt with William Blair. Jeff, please go ahead."
},
{
"speaker": "Jeff Schmitt",
"content": "Hi. Good morning. Could you discuss some of the initiatives you have on the AI front that could help customers generate more revenue? Thanks."
},
{
"speaker": "Chris Isaacson",
"content": "Yeah. Sure. Good morning, Jeff. Thanks for the question. As I mentioned, last year, we created an AI center of excellence internally last year and we've been adopting AI quite a bit internally to improve productivity and AI center of excellence will create an internal platform that we think is going to help us develop new products, as well as grow productivity amongst our engineering staff and across all the functions and associates we have. Don't have any immediate revenue opportunities to talk about with the use of AI, but we are working with the platform now to work with our sales teams and our product teams to see what insights we can get out of all the conversations we're having with our customers as well as our unified data platform internally we've been using. So nothing immediate to report, but we're investing a lot internally in AI to then hopefully bring new products to market that can serve customers."
},
{
"speaker": "Operator",
"content": "Great. Thank you, Jeff. And our next question comes from the line of Alex Kramm with UBS. Alex, please go ahead."
},
{
"speaker": "Alex Kramm",
"content": "Yeah. Hey. Just maybe since the beginning of the year, capital allocation is a topic we should talk about. Noticed you didn't buy back any stock in the quarter, but then Fred, you also talked about obviously thinking about M&A a little bit differently over the last year or so since you've taken over. So maybe you could just give us your latest update why; A, why you didn't buy back stock and then where are you still interested in enhancing the products with M&A?"
},
{
"speaker": "Jill Griebenow",
"content": "I can start with the share repurchases. And then maybe turn it back over to Fred to comment on the M&A piece. But as it relates to share repurchases, I think we messaged before that obviously it would be an important part of our capital allocation strategy. You see the strong balance sheet that we have. But as Fred mentioned in his closing remarks, given where we were in the succession planning process in the later part of the year and the fact that it wasn't public, we just decided that it wasn't appropriate for us to be out in the market repurchasing our shares. Again, that doesn't mean that it won't be part of our strategy in the future, it absolutely is. Like I mentioned, very, very strong balance sheet. We will continue to be opportunistic. And again, share repurchases will remain an important part of our capital allocation framework as we head into 2025 here."
},
{
"speaker": "Fred Tomczyk",
"content": "Great. Thanks, Jill, With respect to M&A, I think I'll be consistent with what I've said in the past, which is any M&A that we do, it has to make strategic sense and financial sense and moves the needle. Or if it's a little smaller, it has to fit within an area that we prioritize strategically. And we look at any M&A to leverage the scale and technology that we have and also make sure it lines up with the secular trends since that will deliver long-term value and it has the growth profile of Cboe. But back to Jill's point note, return of capital remains an important part of our capital allocation strategy here."
},
{
"speaker": "Operator",
"content": "Great. Thanks, Alex. And our next question comes from the line of Michael Cyprys with Morgan Stanley. Michael, please go ahead."
},
{
"speaker": "Michael Cyprys",
"content": "Great. Thank you. Good morning. Just a question on U.S. equities trading and your announcement to move 24/5. Just hoping you could elaborate a bit on the opportunity set that you see here, if successful, what might we see in terms of contribution to volumes? Maybe you can remind us what you see across extended day? And just more broadly, what are some of the hurdles here that you might see to implement time frame? Why not go to 24/7 all the way and why you chose to run this on EDGX versus other exchanges that you have? Thank you."
},
{
"speaker": "Dave Howson",
"content": "Great. Thanks for the question. I'll tag team this answer with Chris as we go through here. So 24/5 is something that we already do at Cboe. If you look at our proprietary index complex, we operate 24/5 over our scaled infrastructure and scaled operations teams. And when we look at the demand with our global footprint, we get to have those high level on the level discussions with customers around the world and in particular in Asia-Pacific, we're seeing increased demand over time for accessing the U.S. equities market during the daylight hours of those investors, of those market participants. And we see good differentiation available to Cboe when we look at EDGX, when you see the 4 a.m. to 7:00 am. market share on EDGX being in excess of 35%. Also on that platform, we have some differentiated functionality, which appeals to retail investors. So really that venue very much primed to be set up for extending hours there. In terms of readiness and timing, the key piece will be regulatory approvals from the SEC, which is yet to be forthcoming and the SIP, the consolidated tape there for publishing trades performed in those securities. We expect that with the SIP needing to implement those final rule and filings that came out of the SEC. But this is likely to be end of this year, early next year in our estimation when the infrastructure will be ready for us to go there. And we've -- as we stated, we'll be ready to go at that time. Because in return for that, we also see demand for our global equities data and we do -- we're accessing that day to day as we go through and putting boots on the ground to sell our US equity data internationally. So really that's a great feeder for us to be able to step into this. But without -- pass over to Chris for some more comments and potentially on 24/7."
},
{
"speaker": "Chris Isaacson",
"content": "Yeah, Michael. Thanks for the question. Dave covered it pretty well. As you said, this is really customer-driven given our 27 markets around the world and our global footprint, global infrastructure, we're hearing a lot of demand from customers. They want to trade 24x5, as Dave has mentioned. And we think our global data opportunities, usually the sale of data free is a precursor to them wanting to trade and we see a lot of demand for US equities data outside of the U.S., in fact, driving a lot of demand there. Dave mentioned why we're covering EDGX, that's been a more retail heavy equity exchange and already has long trading hours starting at 4:00 a.m. going all the way to 8:00 p.m. And so extending those hours to 24 hours a day or nearly 24 hours a day would be relatively easy for us. We'll be ready when the infrastructure of the industry is ready with the consolidated tapes and the clearing facility as well. You asked about 24/7. Again, I think that's really a market infrastructure readiness question, just the industry getting to 24/5 is the first big step, being able to clear and then have a consolidated tape on the weekends in U.S. equities would require, I think, some substantial plumbing changes within the industry, which given enough customer demand, we would work with the industry to figure out if we can meet that demand. But right now, we first need to get to 24/5 or nearly 24/5 to meet the customer demands. I will mention, as Dave also said, we already trade 24/5 or nearly 24/5 across many of our markets, and even in January, given the geopolitical events and what went on, we saw a tremendous amount of global trading hours trading in our derivatives markets to good effect there. So just looking forward to serving customers as we deliver client-driven solutions."
},
{
"speaker": "Operator",
"content": "Thanks, Michael. And our next question comes from Ashish Sabadra -- excuse me, Ashish is with RBC Capital Markets. Ashish, please go ahead."
},
{
"speaker": "Ashish Sabadra",
"content": "Thanks for taking my question. I was just wondering if you could comment on the price increases for options in 2025. And then just as we think about adoption of greater -- retail adoption of options, how should we think about that influencing RPC going forward? Thanks."
},
{
"speaker": "Chris Isaacson",
"content": "Thanks for the question. As we look at our options complex, I would divide that for you into two broad categories. One would be the multi-list options complex and one would be the proprietary index complex. In the form of that, the multi-list options pricing changes on a regular basis often each month to really retune and tune, and calibrate the venues according to the latest market conditions and customer flows where our objective is to balance market share with capture to optimize our revenue. So those changes are quite dynamic. When you look over to the index side of the street there, the pricing changes are much less frequent and much more targeted to very specific things such as trying to open up the doors to allow a more diverse range of participants to get an edge and begin to participate in the platform. So I think that's the landscape and options for pricing on those two broad categories. And then retail, retail is one of our large strategic focuses. If you look at the last five years and the incredible rise of retail adoption of options going from single stock options to index and ETF options and moving to that shorter end of the curve, and what we've seen interestingly, I would say, driven by a range of market participants is that we've seen an increase in the proportion and the total percentages of 0DTE trading in the SPX complex in particular. If you look at January '25 to January '24, there was nearly an 11% growth in 0DTE trading, which has been particularly attractive to retail. And then more generally in retail, as we spoke just earlier on this call, it's about focusing on education. It's fundamental tenet of gaining access and building out that retail capability. It's about global distribution. It's about those brokers and retail brokers in the Asia Pacific region where customers want to interact with the largest equity pool, liquidity pool in the world being the SPX. So we'll continue to do that as we make hires in region. I was really pleased to announce the broadening out of our team in the option space with Meaghan Dugan, but also the addition of Market Intelligence hires coming in the Asia Pacific region. So really broadening and deepening our bench of derivatives expertise to serve that customer base more acutely as we go into 2025."
},
{
"speaker": "Operator",
"content": "Thanks for the question, Ashish. And our next question comes from the line of Craig Siegenthaler with Bank of America. Craig, please go ahead."
},
{
"speaker": "Unidentified Participant",
"content": "Good morning. This is [indiscernible] from Craig's team. Thanks for taking the question. Can you elaborate on the recent decision to rebrand Cboe's technology platform as Titanium? What's the materiality of that change? And I know some of your exchange peers have been successful white labeling their technology to third-party trading venues, should we read this as a step in that direction? How do you think about that opportunity as well?"
},
{
"speaker": "Chris Isaacson",
"content": "Yeah. Thanks for the questions, Chris here. Yeah. We decided to re -- to name Cboe Titanium, our technology that runs all of our equities options in futures markets around the world, as Fred mentioned in others, the technology is a core strength of us here at Cboe and we think it needs to have a brand in order to accentuate that strength. Now to your question about whether or not we plan to monetize and sell the platform itself as software as a service as other exchanges, there's no current plans for that. Our plans are just to continue to invest in Cboe Titanium as it drives our Derivatives business, our Data Vantage business, and all the markets we operate around the world. So no plans to commercialize it specifically today. Just plans to continue to invest very heavily in it as it drives and powers our business around the world."
},
{
"speaker": "Operator",
"content": "All right. Thank you for the question, [indiscernible]. And our next question comes from the line of Owen Lau with Oppenheimer. Owen, please go ahead."
},
{
"speaker": "Owen Lau",
"content": "Good morning, and thank you for taking my question. So for the succession plan or search, could you please talk about the characteristic of the new CEO, why now, the timing of the search, and how will the search impact the strategy you have put out so far? Thanks."
},
{
"speaker": "Fred Tomczyk",
"content": "Okay. Well, let me start with a why now. When I stepped into the job, I had the three or four objectives that I mentioned earlier to stabilize the organization, to sharpen the strategic focus and then work on leadership development and succession. If you look back at what I've done since I've taken over as a CEO, the situation has been stabilized. The strategy has been sharp. The strategic focus has been sharpened. The management team, which is a strong team is now focused on executing that strategy and the balance sheet is in great shape. So with all that completed, the last part was obviously our leadership development and succession, and the Board and I felt this was the right time for a whole variety of reasons to move on that and get the organization on more stability for a longer period of time. With respect to what we're looking for in the CEO, I mean, the Board does have a list of qualities and characteristics looking for. I'm not going to get into each one of those. But they're very clear on what they're looking for and why. And I would repeat, we have a very strong team here. So that's really the logic and the reasoning. And basically, from my point of view, I've completed what I set out to do when I stepped into the role in an unusual situation and it's now time for me to go back to the Board."
},
{
"speaker": "Operator",
"content": "All right. Thanks for the question, Owen. And our next question comes from the line of Alex Blostein with Goldman Sachs, excuse me. Alex, please go ahead."
},
{
"speaker": "Anthony Corbin",
"content": "Hey, everybody. This is Anthony on for Alex. Maybe just one on the SPX franchise. What are you seeing in terms of customer trends that can maybe reaccelerate growth from here? And maybe I missed it from earlier on the call, but what would you expect the volume contribution from Hood to be throughout the year given early traction? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks very much. I think it's probably worth referring you to the earlier answer on Robinhood, which was reasonably detailed, but the just briefly there to say that the rollout was quicker than expected, had better results than expected and we estimate that the volume is largely additive and it's a great setup for the rest of the year as we continue to partner around education and marketing there. It's a really positive setup. Think about those almost 25 million funded accounts with only -- as we understand it, around about 4% of them trading options. So great runway there, really excited about the setup and frame there. More broadly on the SPX complex, it's been a great start to the year when you look at the volatility toolkit at large coming into its own. You see resetting Fed expectations, inflation risk, fiscal outlook, uncertainty, markets whipsawed by headlines coming through on tariffs rolled out, and then walked back. So what we saw in January is a lot of what we would likely expect to see throughout the rest of the year with that continued uncertainty was gravitation towards SPX options as the demand for hedges increased and we saw the second-highest month on record for SPX options higher than the record average for 2024 there. Also, Global training analyst for SPX hit a record in January. So really encouraged by that as customers manage risk and take the opportunity to be dynamic and nimble using options 24/5, and Chris spoke eloquently about having capabilities to support flow there. Then the volatility toolkit moves into VIX options and we need to think about the toolkit together, not just one product or the other, and fixed options also provide a great utility for that. The hedge potential for the tail risk that exist in the market and we saw 925,000 contracts on a daily basis -- on average daily basis in January, which is 12% higher than the record in 2024. So when you take that together, the volatility toolkit coming into its own, when we take into account the growth, that nearly 11% growth actually of 0DTE trading in SPX between January '24 and January '25 into account, we see a really great setup with cyclical trends combining with a long-term secular trend. So really excited about international flows coming in and us leaning into that with hiring, marketing, education, really excited about the retail setup, increasing sophistication, the broadening of access to products is really encouraging. Then you've got the direct and indirect access to options coming through options-based funds and ETFs where customers maybe not quite confident yet to trade options directly can access that through derivative income fund. So also pulling volumes there. And then the product torque just to bring it home is really neatly coming together, as I said, that volatility toolkit really providing great utilities for a very wide spectrum of customer types as we see a really encouraging setup for '25."
},
{
"speaker": "Operator",
"content": "Thanks for the question, Anthony. And our final question today comes from the line of Dan Fannon with Jefferies. Dan, please go ahead."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. Just to clarify a couple of the guidance comments. So for the new segment Data Vantage, just to clarify, you're saying the old way that you used to -- you guided to or talked about 2024 is still consistent and in that range. And then on the below-the-line items, can you tell us what the actual dividends and interest was in '24 to understand if that's the go-forward versus some of the one, I guess other things that markups that you were expecting or you booked this year, just so we understand kind of the run rate?"
},
{
"speaker": "Jill Griebenow",
"content": "Sure. I'll start with the Data Vantage question. So to answer your question there, correct, again, just we have been very, very granular from a numerical perspective in the past with our former guidance approach. So again, just looking at kind of market standards move to this mid to high-single digits, think of it though exactly where we were at this time a year ago in that 7% to 10% range. And then for the below the line items, I think we'll provide more clarity on that. Our Form 10-K will be issued on February 21, somewhere later there in February, and we'll see more granularity there. I will say though there -- the components that comprise the below the line items. We do have minority investments, make up one portion of it and then dividends from investments are another portion of it. So you do see the income from the minority investments drop a bit compared to what it had been previously. So, much of that relates to our minority investments in Trading Technologies via 7RIDGE fund. So that minority investment under equity-method accounting three years ago when we made that investment in 2021, it's typical. You take quarterly marks based upon P&L pickups, a variety of market factors. But over time, that investment cycle starts to mature and that's where we are three years later, which is why you're starting to see that taper off a bit. The dividend income though from other investments, that continues to pick up. So again, more granularity will be provided later in February in the form of that 10-K."
},
{
"speaker": "Operator",
"content": "All right. Thank you, Dan, for the question. And that appears to be all the questions we have. So I will now turn the call back over to management for closing remarks."
},
{
"speaker": "Ken Hill",
"content": "So, thank you for joining us today. And I wish everyone a great 2025. We'll see you in April."
},
{
"speaker": "Operator",
"content": "Thank you. And ladies and gentlemen, that concludes today's call. Again, thank you for joining and you may now disconnect. Have a great day, everyone."
}
] |
cboe | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. My name is (Jenny), and I will be your conference operator today. At this time, I would like to welcome everyone to the Cboe Global Markets Third Quarter Earnings Call. [Operator Instructions] I would now like to turn the conference over to Ken Hill, Treasurer and Head of Investor Relations. You may begin."
},
{
"speaker": "Ken Hill",
"content": "Good morning, and thank you for joining us for our third quarter earnings conference call. On the call today, Fred Tomczyk, our CEO, and Dave Howson, our Global President, will discuss our performance for the quarter and provide an update on our strategic initiatives. Then, Jill Griebenow, our Chief Financial Officer, will provide an overview of our financial results for the quarter, as well as discuss our 2024 financial outlook. Following their comments, we will open the call for Q&A. Also joining us for Q&A will be Chris Isaacson, our Chief Operating Officer. I’d like to point out that this presentation will include the use of slides. We will be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the Investor Relations portion of our website. During our remarks, we’ll make some forward-looking statements, which represent our current judgment on what the future may hold. And while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks, and uncertainties. Actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. Please refer to our filings with the SEC for a full discussion of the factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise after this conference call. During the call this morning, we will be referring to non-GAAP measures as defined and reconciled in our earnings materials. Now, I'd like to turn the call over to Fred."
},
{
"speaker": "Fred Tomczyk",
"content": "Good morning, and thank you for joining us today. I'm pleased to report on another record quarter of results for Cboe Global Markets. During the quarter, we grew net revenue 11% year-over-year to a record $532 million and adjusted diluted earnings per share rose by 8% to a record $2.22 These results were driven by strong volumes in our Derivatives franchise, specifically our proprietary index options and futures products, solid volumes across our Cash and Spot Markets, continued expansion of our Data and Access Solutions business, and steady expense management. Our Derivatives business delivered another record quarter as organic net revenue increased 13% year-over-year. We saw solid volumes across our suite of S&P 500 index option products, with third quarter ADV and the SPX contract increasing 7% year-over-year to 3.1 million contracts. We also saw strong year-over-year growth in our volatility product suite during the third quarter, as ADV increased 33% in VIX options, and 20% in VIX futures. Given the secular and cyclical tailwinds in place, we believe we're well positioned as investors continue to utilize options in their portfolios and trading strategies. Our Cash and Spot Markets category delivered another strong quarter, with revenue increasing 12% on a year-over-year basis. The contribution was broad-based, with each of our global regions posting solid growth as compared to the third quarter of 2023. Our Data and Access Solutions business continued to drive solid results, with organic net revenue increasing 6% year-over-year for the third quarter. Given the acceleration we see in the trends during the month of September, we remain optimistic in the outlook for this business as we look to further leverage our global network and ecosystem to drive growth. Overall, it was another solid quarter for both transaction and non-transaction revenues and we are well positioned as we head into the final quarter of the year. Over the past year as CEO, I have concentrated on sharpening our strategic focus and making important and deliberate decisions on how to best allocate our capital and resources to support our growth strategy. Over the course of the strategic review process, we have made fundamental adjustments, including dialing back at our M&A activities, lowering expense growth, and stabilizing margins, changing our capital allocation strategy to increase investments in organic initiatives, and returning capital to our shareholders. And lastly, reallocating resources to align with our core strengths, specifically our Derivatives and Data and Access Solutions business, and leading-edge technology. As we move forward, we have set forth a strategic framework that we believe will ensure we are well positioned to drive growth and capitalize on opportunities we see in the market, and we are well aligned to the secular trends occurring in the market today. This strategic framework includes investing in the continued growth of our core business, Global Derivatives, increasing recurring revenue opportunities through our D&A business, harnessing the power of our global network and client base to expand product reach and access, capitalizing on the dominance of the US capital markets, leveraging our superior technology to drive innovation and product development, and disciplined allocation of resources and capital towards long-term secular growth trends. Our Derivatives business remains very resilient, supported by a growing customer base, demand for access to the US market, and an increasing demand for options. Given that options by their very nature expire, investors must repurchase new options to reposition themselves in the market, which in turn creates a quasi-recurring revenue stream that continues to increase Cboe as investors shift to shorter duration expirations and more frequent repositioning in response to market events. Our Derivatives ecosystem continued to flourish in the third quarter, as traders and investors utilize our flagship VIX and S&P 500 index option products across an ever-changing market environment, responding to geopolitical events, market volatility, and uncertainty ahead of the US election. As a pioneer of listed options, Cboe has led the way in making options more accessible, transforming them from a small asset class into a key component of the global trading ecosystem. We remain optimistic about the growing retail participation in the options market. Last month, we were excited to announce that Robinhood, one of the largest options trading platforms for retail investors, will begin offering Cboe’s index options to their clients. We believe retail adoption of index options is just beginning, and Cboe is well positioned to cater to this growing demand. Index options come with numerous benefits and retail traders deserve access to those benefits as much as any institution, professional, or wealthy investor. We are focused on three key pillars for supporting the growth of this important customer segment. First, education. Cboe’s Options Institute is equipping retail traders with the knowledge and empowering them through education. Second, access. We continue to broaden access to our products by working with retail brokers and meeting demand where it exists. And third, product. We continue to evolve our suite of index option products to provide opportunities for customers of all dimensions to trade a contract that is right-sized for them and on a timeframe that suits their unique needs. Additionally, we continue to focus on product innovation across our ecosystem and unlocking access to US markets for international investors. Whether it be through increased accessibility, new products, or education, we’ll continue to help people access this liquidity, efficiency, and stability of the US markets, while also providing trusted markets in local regions worldwide. Turning to our Data and Access Solutions business, our global footprint continued to help drive the momentum during the third quarter. Approximately 40% of the new sales in our D&A business came internationally through the first three quarters of the year. Additionally, as we reallocated capitals towards investment in our technology platform over the past year, we have seen these organic investments begin to bear fruit within our D&A business. The D&A technology investments have been focused on optimizing efficiencies across three core areas, access, data, and insights. While we execute our organic growth strategy, we will continue to explore non-organic opportunities to provide scale and broaden distribution inside key geographic markets. To that end, during October, we acquired a 14.8% ownership stake in Japanx, a leading proprietary trading system in Japan. Japan is one of the largest and most important capital marketplaces in the world and is undergoing a lot of change. As the regulatory landscape evolves and the market opens to more competition, we see tremendous opportunity for Cboe to compete. This investment reaffirms Cboe’s strong commitment to Japan, and will help us strengthen our relationships within the industry and expand our presence in the region. With our global network largely built and our final technology migration wrapping up early next year, we now have the keys to unlock our future success, a strategic framework aligned with the secular trends, great technology and a common platform, our global footprint and strong free cash flow. We remain committed to maintaining a flexible balance sheet while investing in organic growth initiatives, our technology, and operating efficiencies, in turn driving future revenue growth, enhanced margins, and earnings growth for Cboe. I'll now pass it over to Dave to discuss business line results."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Fred. The third quarter was a strong one for our Derivatives franchise, with Cboe producing a 13% increase in net revenue on a year-over-year basis. The increase was led by strength in our proprietary products, with year-over-year volume growth of 7% in SPX options, 18% in XSP options, 20% in VIX futures, and 33% in VIX options. The Q3 results build on our strong first half trends, translating to an 11% increase in year-to-date Derivatives net revenue as compared to 2023 levels. During the quarter, investors relied on the full range of the Cboe volatility toolkit as they navigated a rising geopolitical uncertainty, varying economic data points, and election uncertainty. Perhaps the most notable event last quarter was the August the 5th yen carry trade unwind that produced one of the largest short-term volatility events since COVID and the global financial crisis. Investors rushed for downside protection in the form of VIX options. VIX options ADV of 1.2 million contracts in August was the second highest on record, trailing only February 2018. The higher volatile regime continued into September, extending demand for VIX options as VIX ADV totaled 945,000 contracts for the month, the second highest level of demand for VIX options in over two years. Similar to past election cycles, the VIX term structure is pricing in increased uncertainty as we move through next week's elections, as evidenced by the term structures backwardation. And while investors have gravitated towards the higher convexity profile that VIX options offered during bouts of volatility, SPX volumes have remained healthy. Interestingly, we have seen a variety of trading styles used based on duration, with a more balanced put to call ratio for short duration trades versus longer duration trades that favor more put protection. Zero DTE volumes registered a six-month high in October, and as the trading environment continues to evolve, we have seen our user base continue to expand, the use cases grow, and our customer base season, all pointing to an increasingly durable use case for the product. Building on our strong index product trends, we were pleased to launch Cboe S&P 500 variance futures in September, the latest tool in the volatility toolkit provides an exchange-listed alternative to over the counter variant swaps, and has an additive impact to activity across the SBX ecosystem. On October the 14th, we launched VIX Options on Futures. These options physically settle into the underlying front month VIX future and provide a few key benefits. First, it allows us to provide access to our VIX Options product for a wider set of market participants in the US and abroad that may not have access to our securities options exchange. Second, it allows us to offer more tenants, in particular those with a shorter duration, to meet customer demand. As we look to avenues of future growth, we are incredibly excited by the opportunity, both in the US and abroad, for our volatility toolkit. Looking at the options asset class more holistically, we believe that potential to bring options to a greater portion of the US customer base remains a meaningful opportunity for Cboe. The use of options in exchange-traded products provides an innovative way for broker-dealer clients to access a variety of options strategies in a traditional ETF wrapper, US listed options-based ETFs have grown to an estimated $120 billion in AUM, with assets increasing over 600% over the past three years. As for more direct access to options trading, we estimate that less than 10% of customers at major retail broker dealers are enabled to trade options today, with some of our largest key customer platforms at a fraction of that amount. The ability to introduce and educate broker dealer customers as to the benefits of this fast-growing asset class is a secular tailwind we believe we can leverage for years to come. Later this quarter, Robinhood will begin providing customers access to index options, enhancing their trading capabilities. Cboe’s proprietary suite of index options provides broad US market exposure, hedging capabilities against US large cap and US small cap equity market volatility, and can allow customers to generate income and capitalize on market movement. We anticipate that the simplicity of cash settlement, the certainty of European style exercise, and the potential 60/40 tax treatment, may resonate with Robinhood’s active trade community. Fred and I had the opportunity to take part in the Hood summit 2024, two weeks ago, and I was inspired by the customer excitement around the new features and capabilities being rolled out, as well as the hunger for greater education around how to most effectively use these tools in their portfolio. Turning to Cash and Spot Markets, third quarter results continued the strong trends we saw in the second quarter, with third quarter net revenues increasing 12% year-over-year, pushing growth in our Cash and Spot Markets and 9% on a year-to-date basis. In the third quarter, we saw year-over-year growth in every region as Cboe continue to leverage its scaled infrastructure to monetize our supportive market backdrop. In North America, US on-exchange net capture trends were again solid, and industry volumes were up 10% year-over-year. Our off-exchange business saw an improvement in volumes and capture on a year-over-year basis in the third quarter. And rounding out our North American equity segment, stronger industry volumes and net capture helped drive another quarter of year-over-year growth for our Canadian equities business. We remain particularly excited about the outlook for our Canadian business, and we remain on track with the migration of our Canadian market to Cboe technology in early 2025, subject to regulatory approval. Our Europe and Asia Pacific segment delivered robust 22% year-over-year growth, led by a 32% increase in net transaction and clearing fees. For Europe specifically, Cboe was the largest European stock exchange throughout the third quarter, with our share of continuous trading volume hitting 32.4%, up more than a four percentage point versus last quarter. Two products in particular speak to the success Cboe has had bringing alternative market mechanisms to investors. Periodic auctions achieved another market share record, accounting for 8.7% of continuous trading during the third quarter. In addition, Cboe BIDS Europe retained its position as the largest large in-scale venue, adding eight new buy-side clients during the quarter. Turning to Asia Pacific, we continued solid contributions from both Australia and Japan. In Australia, Cboe grew market share to 20.8%, up 2.9 percentage points from the third quarter of 2023. In addition, net capture improved and our results benefited from a 28% increase in average daily notional value traded during the quarter. In Japan, market share hit 5.4% in the third quarter, a 2.1 percentage point improvement versus the third quarter of 2023. Volume trends remained robust, with ADNV increasing 117% on a year-over-year basis. The APAC region remains a key focus for Cboe as we move forward, providing a number of opportunities across our ecosystem to fuel growth. The solid cash market trends have helped us better monetize opportunities in our D&A business as evidenced by the 8% year-over-year third quarter growth in the market data and access services in the region. And lastly, we anticipate continued strategic investment in the region to translate into increased brand awareness and improved sales effort for the import of Derivatives activity into the US. Turning to Data and Access Solutions, net revenues grew 6% as compared to the third quarter of 2023. The first two months saw a continuation of the slower trends that hindered the first half growth, but activity changed notably for us in September, as net revenues grew a strong 9.7% as compared to September 2023. We anticipate that these stronger activity levels will carry through the fourth quarter, help us hit the lower end of our 7% to 10% D&A guidance range for 2024. The September strength on a year-over-year basis has been broad-based, with the index analytics and international businesses all producing solid year-over-year increases. As we look forward, we expect growth will be driven by a continuation of the solid international trends, with over 40% of new sales coming from outside of the US in the third quarter. In addition, the uptake from dedicated cores continues to exceed our expectations as we roll the functionality out across additional markets. And finally, the redeployment of technology resources to revenue-generating activities is already translating to new data sets and sales in our D&A business. Cboe’s third quarter results highlight the power of the entire ecosystem, with Derivatives, Cash and Spot Markets, and Data and Access Solutions, all delivering durable results. The fourth quarter is off to a solid start as we look to cap a robust year at Cboe. With that, I'll turn the call over to Jill."
},
{
"speaker": "Jill Griebenow",
"content": "Thanks, Dave. As Fred and Dave highlighted, Cboe posted a strong third quarter, with adjusted diluted earnings per share up 8% on a year-over-year basis to a record $2.22. The third quarter results continue to illustrate the complimentary and diversified nature of our business model, with solid contributions from across the Cboe ecosystem. I will provide some high-level takeaways from this quarter's operating results, before going through an assessment of the segment results. Our third quarter net revenue increased 11% versus the third quarter of 2023, to finish out a record $532 million. The growth was driven by strength in our Derivatives and Cash and Spot Markets categories, as well as solid results from our Data and Access Solutions business. Specifically, Derivatives markets produced 13% year-over-year net revenue growth in the third quarter, as our proprietary product franchise again produced the same growth. Cash and Spot Markets organic net revenues grew 12% versus the third quarter of 2023, with all geographies contributing solid year-over-year growth. Data and Access Solutions, net revenues increased 6% on an organic basis during the quarter. As Dave highlighted earlier, we saw an acceleration of activity in September, and remain confident in our ability to hit the lower end of our 7% to 10% targeted net revenue growth range for 2024. Adjusted operating expenses increased 13% to $204 million for the quarter, with the year-over-year growth driven by higher compensation-related expenses, as well as travel and promotional expenses, partially offset by a decrease in professional fees and outside services. And adjusted EBITDA of $342 million grew 7% versus the third quarter of 2023. Turning to the key drivers by segment, our press release in the appendix of our slide deck include information detailing the key metrics for our business segments, so I'll provide some highlights for each. The options segment generated record net revenue, with 10% year-over-year growth, led by higher index options transaction fees. Total options ADV was up 2%, driven by a 13% increase in index options volume. Revenue per contract moved 10% higher as index options represented a higher percentage of total options volume, and multi-listed option RPC increased 15%. North American equities net revenue increased 3% on a year-over-year basis, reflecting higher transaction and clearing fees, as well as access and capacity fees. Increased net transaction and clearing fees were driven by both higher industry volumes and stronger net capture rates. On the non-transaction side, access and capacity fees increased 12% as compared to the third quarter of 2023. The Europe and APAC segment produced a 22% year-over-year increase in net revenue, a result of strong growth across both transaction and non-transaction revenues. Transaction revenue in Australia and Japan benefited from continued market share gains, as well as increased volumes versus the third quarter of 2023. The futures segment recorded 17% net revenue growth for the quarter, with higher net transaction and clearing fees reflecting a 19% increase in ADV. On the non-transaction side, market data revenues were up 9%. And finally, the FX segment delivered another quarter of record net revenue, with 9% year-over-year growth, driven by higher net transaction and clearing fees. Turning now to Cboe’s Data and Access Solutions business, net revenues were up 6% on an organic basis in the third quarter. International sales continued to underpin the growth, with over 40% of new sales coming from outside the US over the quarter. We continue to believe D&A is well positioned, and anticipate an acceleration in trends during the fourth quarter, helping us deliver on the lower end of the D&A revenue growth guidance of 7% to 10%. More specifically, we expect to see continued strength from demand for access across our global markets, particularly as we increase our presence in new geographies and leverage the distribution capabilities of Cboe Global Cloud. The expansion of dedicated cores in our equities markets greatly enhancing our options access layer, and increasing capabilities around our data, access, and insights, as we reallocate technology resources from integration efforts to organic revenue-generating enhancements. Turning to expenses, total adjusted operating expenses were approximately $204 million for the quarter, up 13% compared to the third quarter of last year. The increase primarily resulted from higher compensation and benefits, given an increase in our short-term incentive accrual, driven by stronger revenue generation, as well as a $10 million benefit in the third quarter of 2023 from executive departures that did not recur in 2024. In addition, travel and promotional expenses were also higher on a year-over-year basis as we saw some acceleration in our marketing efforts. I would note that adjusting for the impact of the 2023 executive departures, total adjusted operating expenses would've increased a more modest 7% year-over-year for the third quarter, in line with our efforts to stabilize margins, given the 11% revenue growth during the quarter. As we look ahead on Slide 16 to our 2024 guidance, we are raising our full-year organic net revenue growth range to 7% to 9% from 6% to 8%. The updated guidance reflects our strong year-to-date results and a supportive outlook for the remainder of the year. Given the positive revisions to our revenue guidance, we are increasing our full-year 2024 adjusted expense guidance to $798 million to $808 million, up from our prior guidance of $795 million to $805 million. The $3 million increase captures the upward pressure on our short-term incentive bonus accrual, given our improved revenue guidance range, as well as some targeted marketing spend to capitalize on the expanded access of our index options product suite. We believe the refined revenue and expense guidance continues to strike the right balance as we look to drive long-term margin stability. Looking at our results on a year-to-date basis, we see that narrative reflected in the 80-basis point adjusted EBITDA margin expansion produced through the first three quarters of the year. Looking at our full-year guidance more broadly, we continue to anticipate hitting the lower end of our D&A organic net revenue guidance range of 7% to 10%. As Dave highlighted, September was a strong month for D&A revenue growth, and we expect to see those stronger trends carry through the fourth quarter. Below the line, we are increasing our expectation for other income to $7 million to $9 million from $4 million to $6 million, given an increase in dividend income we realized during the third quarter. Within our earnings on investments line, we continue to expect $33 million to $37 million from positive marks on our investments. In total, this raises our 2024 expected impact on non-operating income to $40 million to $46 million from $37 million to $43 million. We are also increasing our full-year guidance range for CapEx to $57 million to $63 million from $51 million to $57 million, primarily resulting from an acceleration of technology investments across our businesses. Depreciation and amortization is expected to remain in the range of $43 million to $47 million for the year. And finally, we continue to expect the effective tax rate on adjusted earnings under the current tax laws to come in at 28.5% to 30.5% for 2024. While we don't provide formal guidance on interest income or interest expense, I wanted to highlight that the third quarter included a benefit from a one-time true-up of interest earned from available for sales securities. Moving forward, we would expect a more modest impact, and anticipate that interest expense, net of interest income, will be in the $7 million to $8 million range for the fourth quarter. Turning to our balance sheet, our third quarter leverage ratio remained at 1.1x, and we remain comfortable with our overall debt profile and the balance sheet flexibility it affords. The effective allocation of capital has been a cornerstone of our ongoing strategic review. We strive to allocate capital to where we see the greatest long-term opportunity, whether it be investments in internal projects, or returning it to shareholders in the form of share repurchases and dividends. During the third quarter, we repurchased approximately $25 million in shares, bringing our year-to-date repurchases to $204 million. In August, we announced a $500 million increase to our share repurchase authorization, boosting our total capacity available for share repurchases to approximately $680 million as of the end of September. In addition to repurchases, we returned a total of $66 million to shareholders in the form of a $0.63 dividend during the quarter, a 15% year-over-year increase in our quarterly dividend. Factoring in both share repurchases and dividends through the third quarter, Cboe has returned a total of $387 million to shareholders, representing 56% of adjusted earnings year-to-date. As we move forward, our strong free cash flow generation and flexible balance sheet afford us the opportunity to allocate capital and resources in the most value-enhancing activities, striking the right balance between investing in future revenue growth and improving shareholder returns. We look forward to building on our year-to-date progress and delivering durable growth in the quarters ahead. Now, I'd like to turn it back over to Fred for some closing comments, before we open it up to Q&A."
},
{
"speaker": "Fred Tomczyk",
"content": "In closing, we are pleased to report another strong quarter, delivering 8% adjusted diluted earnings per share growth year-over-year. Fundamentally, our business performed very well, with year-to-date net revenue up 9%, and adjusted expense growth at 6%. As we head into the final quarter of the year, our balance sheet is strong, and we're well positioned to take advantage of opportunities as they arise. With our new strategic framework, coupled with the strong fundamentals we are seeing across our business, we are very encouraged about the opportunities ahead of us, and look forward to sharing more as we move in to 2025."
},
{
"speaker": "Ken Hill",
"content": "At this point, we'd be happy to take questions. We ask that you please limit your questions to one per person to allow time to get to everyone. Feel free to get back in the queue, and if time permits, we'll take a second question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Patrick Moley with Piper Sandler. Please go ahead."
},
{
"speaker": "Patrick Moley",
"content": "Yes, good morning. Thanks for taking the question. On the D&A revenue guidance, Jill, you said you expect to see a step-up in the fourth quarter that's going to get you to the low end of that 7% to 10% range. Could you maybe just elaborate on what you're seeing there and the drivers? And then is this indicative of a more sustainable step-up or acceleration in D&A revenues, or is it more so just related to timing of some of those cash collections and enterprise sales? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks very much for the question, Patrick, and well done for keeping up the tradition of being at first in the queue there. As we look back over time, as you rightly point out, we do see inflection points and timing when it comes to the recognition of certain D&A revenues under that line item there. So, that's certainly a factor that will come into play as we go forward. In terms of the confidence and the drivers for hitting the 7% to 10% guidance this year, it's really around about four categories. The first is new sales. The new sales there we talked about it on the call, 40% coming internationally there, and the pipeline and the hiring that we're doing there internationally to really continue that pipeline of sales, is where we draw confidence in terms of the new sales item. Then there's pricing, the pricing changes that we put in place earlier this year as we periodically review pricing across our franchise and to make sure we're extracting the appropriate value from products. Those impacts will be seen continuing through this year and of course into next year. Then the third area is technology investments. The results from the investments of our technology resources, freeing up from migrations over the last year, bearing fruit this year. Those investments in the first half of this year really begin to pay off again this year and into next year. I'll point out dedicated calls, that new access layer architecture for our equities venues in the United States, really performing above our expectations, and we're rolling that out through to other markets later this year and into next year. And then finally, from those technology investments and enhancements in the core platform, that allows us to have new insights generated, new data sets that really represent value for customers that they’re willing to pay for. And those data and insights allow customers to optimize their interaction with the core platform there. So, those four factors really giving that confidence as we see the short-term bringing this through into the new year where we'll see more growth."
},
{
"speaker": "Patrick Moley",
"content": "Great. Thanks for the color."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ben Budish with Barclays. please go ahead."
},
{
"speaker": "Ben Budish",
"content": "Hi, good morning, and thank you for taking my question. I imagine in the near-term you're focused on some of the more recent opportunities, Robinhood and some of the other global brokers you've announced, I think earlier in the year that added some Cboe products. But as you think farther out, how do you think about continuing to expand that opportunity set? Are there other major brokers in the US or elsewhere that don't have access to the full suite of Cboe products? Or is the opportunity really about sort of bringing more education to that kind of big chunk of customers who are either not enabled for options or are not using them regularly? How do you think about those two different opportunity sets? Thank you."
},
{
"speaker": "Dave Howson",
"content": "Yes, thanks very much for the question. It's both. So, we continue to see growth in new customer acquisition. You mentioned those Asia Pacific brokers we've talked about earlier on in this year coming on board, those new customers, as we talked about, really leaning into that secular growth trend of foreign assets invested. They have appetite for access to the US capital markets. So, we're going to continue to lean into that long-term trend to deliver long-term value. We're doing that through hiring, putting boots on the ground. We're doing that through extended marketing in region and education going hand in hand there. And then secondly, when it comes to that retail brokerage platform and network you mentioned there, it's really about further penetration of those user bases, and we think we're in the early innings of adoption by users of retail brokers. When we see the facts there, we look at, for example, Robinhood, 24 million funded accounts, 4% of those trading options. So, you see a real runway there. And in general, we see retail brokers having that long runway of customers that don't utilize options, but are being educated on their benefits as an additional tool in their toolkit. And that's where we're also investing, in education and marketing, both on our own but also jointly with those retail brokers. And so, what we've seen is history is to inform us is that as our products are rolled out to retail brokers and their trading platforms mature, as we've heard from Robinhood, they have plans to continue to roll out new features throughout next year, we see durable growth there and we expect to see our products really coming to light because of the differentiation of the products themselves, really being quite a compelling additive to our customers’ portfolio as they begin to learn the attendant benefits, the simplicity of a cash-settled index option."
},
{
"speaker": "Ben Budish",
"content": "Alright, got it. Thanks so much, David."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Dan Fannon with Jefferies. Please go ahead."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. My question is for Fred. A year ago on your first call, you talked about narrowing focus and margin improvement and capital return, and then as we sit here today, we see inorganic back on the table again and I think talking about that a little bit more. So, curious about kind of what the change in the strategic focus really was from a year ago to today, and how we should think about inorganic versus organic growth priorities and capital return going forward."
},
{
"speaker": "Fred Tomczyk",
"content": "Yes, I think relative to a year ago, if you go back, we had done a lot of acquisitions. We were doing a lot of migrations, and a lot of those acquisitions were small and were consuming a lot of the resources of the organization. So, we definitely slowed that down and took time to sort of say, well, where do we really want to go here? And as I said, we've kind of gone back. That M&A can't be the strategy. It can supplement a strategy or be additive to a strategy, but you have to have a strategy focused on organic growth. And that's what we've been trying to do. So, you've seen us get back to the Derivatives business, back into the Data and Access Solutions business, investing in our technology, et cetera. We also now have our balance sheet in a good shape. In terms of our leverage ratios are low, we're in a good position there. And I think on top of all that, our margins have stabilized and we've sort of, and we've moderated the expense growth, which is down significant year-over-year. So, we're now on a path where we're trying to drive organic growth. I've always said we were going to slow down the M&A, but I've never said we were never going to do M&A. And the only reason for bringing it up is just to keep all of our options open as you think about where we are today in terms of how we deploy capital, our debt's in good position, so we really don't see us paying down debt here. There's really not - it's not a good use of our capital. So, we're very much focused on dividends, which we increased 15%, share repurchases, investing in organic growth and considering inorganic opportunities provided they make a difference and they have a strategic and financial rationale to them, or they fit inside an area where we have a bigger strategic ambition. The example I would use there is the investment in Japanx in Japan. We do see Japan as a big market and a changing market. And when you see a big market that's undergoing a lot of changes, that usually creates opportunities for players like Cboe. And so, we're quite happy with that investment, and that's the way we kind of think about it. And so, we're just keeping all of our options open as we look forward."
},
{
"speaker": "Dan Fannon",
"content": "Understood. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Kramm with UBS. Please go ahead."
},
{
"speaker": "Alex Kramm",
"content": "Yes. Hey, good morning, everyone. Just in terms of some of the new initiatives, maybe give us an update on the VIX options on futures. I know it's only been a couple of weeks, but obviously very limited volume so far. I know there's a lot going on in the world, but just trying to get an update where you are in terms of bringing on market participants and liquidity, and what's the feedback been so far? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Alex. Yes, we've had two product launches in the last couple of months, and one of them is Options on Futures. And just a reminder there, the aim there is to bring VIX optionality to non-securities customers. And because of the construct of the product itself, we're able to offer shorter-dated trading to introduce daily explorations of a VIX Options contract. So, an expanded user base and really leaning into that shorter-dated need and want of the customer base there. Variance futures another new product additive to that S&P 500 index core there to allow the pure play between implied and realized volatility. So, two additive products. Both will need time to seed, and the early signs are really good though. We've got prices on the screen. We've got customers engaging, testing out strategies and testing out the plumbing works, with a good pipeline of customers coming through. So, these will take time to season and germinate throughout the course of 2025 as customers begin to use them. We wanted to get them out there just before the election so people could see how they might be priced and how they might perform rather than expecting any great deal of trading. But really that history through this particular time period is really useful to customers to really think about how they can use them in the strategies going forward, because we've got no shortage of uncertainty coming both this year and into next year."
},
{
"speaker": "Alex Kramm",
"content": "Makes sense. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Blostein with Goldman Sachs. Please go ahead."
},
{
"speaker": "Anthony Corbin",
"content": "Hi, good morning. This is Anthony on for Alex. You mentioned pricing's role and D&A revenue acceleration. I was wondering, like what is a typical percentage increase we should be expecting across this revenue base from pricing increases? And then what are your expectations for pricing increases into 2025? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Yes, thanks for the question there. The pricing that we've put through, it varies. We have a vast array of access pricing, both physical and logical. We have market data products packaged and bundled in different ways for different customers. So, there's really not a kind of blanket percentage increase I could point you to. It's really about assessing the relative value today versus competitor or comparable products, but really making sure we keep those in line. Maybe a better reference point for you would be that in Q3, pricing contributed around about a third of the overall growth in Q3. And as we look forward to 2025, as discussed a little bit earlier on the call, harder to really call necessarily, but we'd expect that one third pricing kind of contribution to the overall growth there. So, what does that tell you? That tells you that actually we see growth in the distribution and the runway of selling our products, rather than needing pricing to be the strategy for growth there."
},
{
"speaker": "Anthony Corbin",
"content": "Helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Owen Lau with Oppenheimer. Please go ahead."
},
{
"speaker": "Owen Lau",
"content": "Good morning and thank you for taking my question. So, going back to Robinhood, I think it's an exciting partnership, but when do you expect Cboe to get more meaningful volume? You mentioned 24 million users, 4% trader options, but how big is the addressable market and is there anything Cboe can do to help drive higher volume in this channel? Thanks a lot."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Owen. Yes, there's certainly a few things we can do, and we've been doing them both this year, with some incremental investment towards the end of this year and into next. It's going to be a journey though. It's a journey for us. It’s a journey for Robinhood and their customer base. So, Robinhood have a new platform to roll out, which will take place throughout next year and begin to add increased functionality. More generally, that brings increased competition amongst the vibrant group of retail brokers that we have as customers. So, increased competition is a good sign there in the industry. When we think about the customer base and the runway, yes, the numbers are in front of us, 24 million funded accounts, 4% trade options today. What we're doing to help with the education, which is really, really important here, and Fred and I got to see it in physical manifestation at the Robinhood conference, as customers were eager to learn how to trade spreads, how to sell premium to generate income and have a diverse range of strategies in their portfolio. So, the education is where we're investing, both on our own and jointly with retail brokers like Robinhood and others to help get that evergreen education in the hands of the retail base so that they can really achieve their own financial literacy and financial independence. Then there's marketing. Marketing's really important, both, again, jointly and individually to really feed into that education piece, because the products are important here. The cash-settled index options product is really, really key. The simplicity of cash-settled trading bell to bell, the certainty of the European exercise, knowing that one leg of your spread won't get called away. And then there's a tax treatment, the potential for 60/40 tax treatment benefits, really helping with the economics. So, it's important we educate on that and that we market the benefits of that as well as we go through. So, where are we investing? Education, marketing and broadening out that access by putting more boots on the ground around the world to help feed what has already been a strong secular trend and one that we see continuing out into the future."
},
{
"speaker": "Owen Lau",
"content": "Got it. Thanks a lot."
},
{
"speaker": "Fred Tomczyk",
"content": "Yes. What I'd just like to add, Dave covered very well, but as they add our products and they mature their platforms, continue to grow the usage of our products, they're also - they and other brokers are going international, which feeds right into our import strategy. And then one thing that we haven't mentioned is defined outcome ETPs that are out there don't have usage of our products, but the customer doesn't have direct usage. So, if they're not going through a retail broker to directly trade our index options products. they may be using them through another product like defined outcomes, which we think is a long-term secular trend that will carry on for a long time. So, a lot of growth we see yet to come."
},
{
"speaker": "Chris Isaacson",
"content": "Yes, and I'll just sort of add on here for a second is just, while we're excited about the launch of index options, I think in the longer-term, their new trading platform, which is the first time they’ve brought a real sort of active trader platform to their clients, over the longer-term will carry trading and options quite a bit over time."
},
{
"speaker": "Owen Lau",
"content": "Thank you all."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Craig Siegenthaler with Bank of America. Please go ahead."
},
{
"speaker": "Craig Siegenthaler",
"content": "Thanks. Good morning, everyone. My question is on the strategic review. So, now that it's complete, how is the board thinking about divestment? And we know you shut down the spot Crypto exchange earlier this year. Are there other non-core assets that you can divest or close that would enhance margins and profits?"
},
{
"speaker": "Fred Tomczyk",
"content": "Look, I mean, first off, I mean, the board's very much focused as we think about it, now that we've stabilized our margins, we're very, very much focused on growth and growth into areas where we see secular trends that Cboe has core strengths that it could lean into. And I talked about their early. So, that's where the focus is right now. As Dave said, the fall strategy - this is a journey, it's not an event. And over time, as businesses evolve or the market evolves, that may or may not happen. But right now, we're very much focused on growth as opposed to divesting."
},
{
"speaker": "Craig Siegenthaler",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ashish Sabadra RBC Capital. Please go ahead."
},
{
"speaker": "Ashish Sabadra",
"content": "Thanks for taking my question. I just wanted to drill down further on the D&A acceleration, and wanted to better understand the plans for further expanding the dedicated cores, as well as the rollout of the Cboe Cloud. How's that coming along? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Yes, I'll take that one. Thanks for the question. So, dedicated cores, we're excited for the growth we've seen in the US. We currently just have that rollout in US equity markets or for US equity exchanges. We'll be bringing that to Europe, to the UK first in the fourth quarter. And then in the first quarter of next year, we plan to bring that to Australia and then eventually hopefully to Japan and Canada. So, staggered rollout here, but the demand we've seen from customers and the improvements we've seen in the US, have been above our expectations. And then, what was the second part of your question?"
},
{
"speaker": "Ashish Sabadra",
"content": "The rollout of Cboe Cloud. Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thank you for the clarification. So, Cboe Global Cloud, we're quite excited. As mentioned in our prepared remarks, 79% of that growth is coming from outside of the US. We see more of that, and as we end this year and head into next year, we plan to invest further and greater distribution around the world to grow Cboe Global Cloud. The amount of data that folks want into the US is just continuing to grow because people want access to the US, and usually the precursor for wanting access to the US markets is wanting to get our data. So, that's why we think a lot of the growth in people Cboe Global Cloud is coming outside of the US. So, we think this bodes well, not just for D&A revenue, but for long term transaction revenue."
},
{
"speaker": "Ashish Sabadra",
"content": "That's great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes in the line of Kyle Voigt with KBW. Please go ahead."
},
{
"speaker": "Kyle Voigt",
"content": "Hi, good morning. So, introducing everyday expirations in SPX has obviously been really successful in growing the SPX volume pie, introducing new strategies and hedging opportunities for your clients. I'm just curious if you've seriously considered adding additional expirations to SPX from here in terms of intraday or multiple expirations per day. What are the operational challenges with potentially doing that, and how close could that be?"
},
{
"speaker": "Dave Howson",
"content": "Thanks very much for the question. As we think about product development more holistically, it's about looking to simplify the complex, bringing transparency to anywhere there's opacity or any information kind of barriers, bringing OTC trading on-exchange and really allowing for a more flexible trading styles and trading patterns. And that's really looking to bring both the smaller users, every investment strategy to every wallet size, but also having a suite of products in the volatility toolkit that can really allow customers to be nimble around market cycles and volatility regimes. So, when it comes to that product development, you can see we added fixed options on futures and variance futures, which really build around that core. And when we think about where we go next, it's really driven by the customers. And the customers at this point are not asking us for an extra expiry during the day. They're looking for extra flexibility and precision that they can bring to managing that risk over time. And that's the benefit of a variance future, as well as a VIX options on a future. You can have more precision over the management of your risk profile over time. Once a day for the moment seems to be enough for the customer base. So, we don't see any compelling demand to try and add expirations during the day. But I would point out that the benefit is with a cash-settled product. Intraday expirations would be way more easy to achieve than a physically settled product, which would have attendant complexities which wouldn't allow it to go there."
},
{
"speaker": "Operator",
"content": "Your next question comes from line of Bill Katz with TD Cowen. Please go ahead."
},
{
"speaker": "Bill Katz",
"content": "Great. Thanks very much for taking the question. So, I've heard two themes today. One is sort of top line growth, but the second one is a fair amount of investment spending, I think you've said, boots on the ground for a bit of time as well. How should we be thinking about at least preliminary the rate of core expense growth for next year? And I noticed your EBITDA margin actually slipped a couple of percentage points both quarter-on-quarter and year-on-year. So, are we close to peak margin for the business as you think about maybe the interplay between revenue and expense growth? Thank you."
},
{
"speaker": "Jill Griebenow",
"content": "Thanks for the question. I think we did mention in the prepared remarks that the third quarter expenses did trend a bit high due to some comparables from the third quarter 2023 favorability that did not recur in third quarter of 2024. So, looking at it more holistically on a year-to-date basis, very much in line with where we projected to be. And while I won't comment quite yet on 2025 guidance, we'll share more on that with you in early February, what I will remind you of is just our focus on disciplined expense management and stabilizing the margin. So, you do see our expense growth rate here in 2024. The range is 6% to 8% compared to 15% expense growth from 2023 to 2024. So, again, not going on record with a number for 2025, but just know that we continue to be focused on stabilizing that margin, and are very much aware that the operating expenses are indeed a key component to stabilizing that margin."
},
{
"speaker": "Bill Katz",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Worthington with JP Morgan. Please go ahead."
},
{
"speaker": "Madeline Daleiden",
"content": "Hi, this is Madeline Daleiden on for Ken. Good morning and thanks for taking our question. We have a quick one on multi-listed options. The market share loss that you've been seeing 2024 to date versus 2023 comps, we think from competitions, seems to have reaccelerated in the third quarter. First, is this the correct read? And second, is there anything you can do or are doing to combat such share loss? Thank you."
},
{
"speaker": "Dave Howson",
"content": "Thanks very much. We've seen a number of new entrants into the US multi-list space over time. Those new entrants have really been focused on lower capture rate flows. And what we focus on as a business is really optimizing revenues through a balance of share and capture. And what you saw also in the numbers is a 15% increase year-over-year in that capture rate. And then when it comes to what we can do to stay and remain competitive, certainly that is a focus for us. We compete, of course, as we mentioned on pricing, with pricing dials to really fine-tune the market quality and the interaction on each one of our options of a dalliance. Secondly, there's functionality, new order types and differentiated capabilities, which draw certain types of flows to our exchanges versus others. And then finally it’s technology, and that's really been the focus this year. We mentioned it earlier in the call, the new options access architecture coming to be the options earlier in the quarter. And Chris might have a couple of things to say about that in a moment. But those technology enhancements have really benefited the platforms, but actually also opened up the capability to add new data and insights. And that's important because then customers are then able to further optimize their strategies and how they behave in the platform. And then the last thing I'll say there before passing to Chris for any thoughts is, we're investing in talent. We're investing in talent to really help us think about how we become more competitive, and we're investing some of our data and analytics, our quantitative analysts resource into assessing how we can be even more competitive there. But I will point you back to the capture increase there that we did see with the market share."
},
{
"speaker": "Chris Isaacson",
"content": "Yes. And I just add to Dave's comments on multi-listed options market share. It’s a competitive space, but we're here to compete on pricing, functionality, technology and data. We did roll out a new options access architecture on one of our four options markets. That was in mid-August. So, the results are still early. We're a couple of months in, but we're very encouraged by what we've seen on one of our exchanges thus far. We've seen better market share. We've seen a lot of efficiency of the use of the system and a lot of use of data as well. And as Dave mentioned, we're investing in talent here. We're going to use that talent to focus on data in this competitive marketplace. But we're here to win and we like our position from here."
},
{
"speaker": "Madeline Daleiden",
"content": "Great. Thank you so much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Chris Allen with Citi. Please go ahead."
},
{
"speaker": "Chris Allen",
"content": "Yes. Morning, everyone. Thanks for taking the question. Just kind of following up on a couple of the prior questions, just trying to think about how much - the investment needs for growth moving forward. I mean, you obviously have a strong balance sheet, strong free cash flow, flexible balance sheet, good position there. You basically have a lot of talent that has been integrated, but you can repurpose them to drive growth. And then you're investing overseas in the international front. Just wondering, like if you could frame out like the magnitude of investment you need to drive growth from here and maybe some color just where are you investing on the talent side or internationally specifically?"
},
{
"speaker": "Dave Howson",
"content": "Yes, thanks for the question. I think a few of us might have a couple of things to say here, but I'll kick it off. So, the investment is really in line with that strategic framework. It's into Derivatives, it's into data and access, and it's into technology. And when you look at Derivatives, some of the key strands of the growth there are the growth in retail that we've talked about earlier on the call. So, we're investing behind that. That's education, that's marketing, that's talent. We're investing on that need, that desire to access the US markets. That's the import strategy. So, that's boots on the ground, that's sales folk people, that's knowledgeable Derivatives salespeople with a network in-region, natural language speakers who can have eye level conversations with customers around the world. It's also investment on the import side in terms of breaking down any pathway barriers that might exist, whether it be access to data or whether it be legal approvals to be able to market in-region. Multi-list, we just covered that quite thoroughly in terms of where we're investing in data analytics and talent there. And then product for Derivatives, product innovation is a key thing for us. That's a marginal and opportunity cost for us, but we listen to customers and we'll forever be innovating around products and looking for new products to launch. And we've got some in the pipeline for next year that we've already talked about, whether that be the dispersion futures or other capabilities. Data and access, we've talked about that on the call as well. That's investing in analytics, investing in index capability around that defined outcome space, that embedded option space in Derivatives for our index business. We get a lot - we own about 80%, 90% of the ETFs that are listed with Cboe in the defined outcome space. And then it's looking for incremental insights that Chris talked about that. And then on the technology side, I'll hand over to Chris and maybe to Jill for any particular insights she might have."
},
{
"speaker": "Chris Isaacson",
"content": "Just a couple of comments here on the redeployment of resources. As mentioned in the prepared remarks, we'll finish our Canadian migration here in March. That'll be our last migration to the Cboe technology platform. We're excited about that. We've spent a fair amount of time, a lot of resources this year making that happen. We think that's worth it, but those will free up a substantial amount of them to focus on high growth areas like Derivatives and D&A going forward. And Jill can probably talk to the CapEx, but we've accelerated some CapEx, like she mentioned. And then I'll just end with data and AI. We are investing heavily in our data analytics platform, and also focused on AI, not just to drive productivity within the organization, but to explore and enhance revenue opportunities to our customers. I'll hand it to Jill."
},
{
"speaker": "Jill Griebenow",
"content": "Thank you. And just to wrap us up here, you correctly alluded that our balance sheet is in very strong position. We do have a lot of strategic flexibility there, which is a great position to be in. I think where we sit today, we're aiming to just allocate that capital and our resources in the most value-enhancing way, just trying to strike the right balance between investing in the future revenue growth and then optimizing our margin."
},
{
"speaker": "Operator",
"content": "Unfortunately, we have run out of time for questions. I will now turn the conference back over to the Cboe management team for closing remarks."
},
{
"speaker": "Fred Tomczyk",
"content": "Thank you and thanks, everyone, for joining our call today and for your questions. I think you'll see from our tone and the questions that came to us, we are pivoting basically to get very focused away from the migration work onto investing in organic growth and very much leaning into where Cboe has core strengths, but also where we see the long-term secular trends. And we're going to continue to do that. And as we've said earlier, our balance sheet is in a great position here so that we can take advantage of opportunities as we see them. And so, we'll see you next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for joining. You may now disconnect."
}
] |
cboe | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. My name is J.L., and I will be your conference operator today. At this time, I would like to welcome everyone to the Cboe Global Markets' Second Quarter Earnings 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 would now like to turn the conference over to Ken Hill, Treasurer and Head of Investor Relations. You may begin."
},
{
"speaker": "Ken Hill",
"content": "Good morning, and thank you for joining us for our second quarter earnings conference call. On the call today, Fred Tomczyk, our CEO, and Dave Howson, our Global President, will discuss our performance for the quarter and provide an update on our strategic initiatives. Then, Jill Griebenow, our Chief Financial Officer, will provide an overview of our financial results for the quarter as well as discuss our 2024 financial outlook. Following their comments, we will open the call for Q&A. Also joining us for Q&A will be Chris Isaacson, our Chief Operating Officer. I would like to point out that this presentation will include the use of slides. We will be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the Investor Relations portion of our website. During our remarks, we will make some forward-looking statements, which represent our current judgment on what the future may hold. And while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks and uncertainties. Actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. Please refer to our filings with the SEC for a full discussion of these factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise after this conference call. During the call this morning, we will be referring to non-GAAP measures as defined and reconciled in our earnings materials. Now, I'd like to turn the call over to Fred."
},
{
"speaker": "Fred Tomczyk",
"content": "Good morning, and thanks for joining us today. I'm pleased to report on strong second quarter results for Cboe Global Markets. During the quarter, we grew net revenue 10% year-over-year to a record $514 million and adjusted diluted earnings per share by a robust 21% to $2.15. These results were driven by a contribution from each part of our ecosystem with improved volumes in our Cash and Spot Markets, solid volumes across our Derivatives franchise, specifically our proprietary index option and futures products, continued expansion of our Data and Access Solutions business, and disciplined expense management. Our Cash and Spot Markets category performed very well in the second quarter, with revenue increasing 15% on a year-over-year basis. The contribution was broad-based with each of our global regions posting solid growth as compared to the second quarter of 2023. Our Derivatives business delivered another solid quarter as organic net revenue increased 11% year-over-year. We saw solid volumes across our suite of S&P 500 index option products, with second quarter ADV and the SPX contract increasing 9% year-over-year to 3 million contracts. We also saw a strong year-over-year growth in our volatility product suite during the second quarter as ADV increased 8% in VIX options and 30% in VIX futures. Given the secular and cyclical tailwinds in place, we believe we are well positioned as investors continue to utilize options in their portfolios and trading strategies. Our Data and Access Solutions business continued to deliver durable results, with organic net revenue increasing 5% year-over-year for the second quarter, and running at approximately 7% through the first six months. We are optimistic on our outlook for this business, as we look to further leverage our global network of ecosystem to drive growth. Overall, it was another solid quarter for both transaction and non-transaction revenues, wrapping up a strong first half of the year, which has seen us grow adjusted diluted earnings per share by 17%. We look forward to building on these strong results in the second half of 2024. From a strategic perspective, I remain centered on sharpening our strategic focus in areas where we see the most valuable growth opportunities for Cboe. Throughout the strategic review process, we have made a number of adjustments to our strategy, including dialing back on M&A activities, reallocating resources to align with our core strengths, including winding down our digital spot market and refocusing on digital asset derivatives, lowering our expense growth, stabilizing our margins and changing our capital allocation strategy away from M&A activities to increase investments in organic growth initiatives and returning capital to our shareholders. The strategic review has provided us with the framework to hone our strategy and determine how to best leverage our core strengths, reallocate our resources internally, including investing at our global technology platform, and position the company for continued growth over the longer term, and returning capital to our shareholders through a combination of dividends and share repurchases. To that end, refocusing our view of the company as both an import and export business helps enable us to unlock even more of our global growth potential. Over the last few years, we have been very focused on the export type of business, expanding into new geographies and deploying our exchange technology and data to create better trading experiences for our customers across the globe. We've also exported our US derivatives market model to Europe, leveraging our proven blueprint for success in the US to build out new markets and reach new customers. As we enter these markets and listen to our customers, we found opportunities to grow our import business. From my traveling and talking to our global client base over the last nine months, I've learned there is a huge appetite to invest in the US market and our analysis confirms this trend. While our customers want to trade and invest in their local markets, they are also eager to gain access to the investment opportunities in the US market. They are excited about the innovation that Cboe has brought to their local markets and our investments in our technology, and they are optimistic about the investment opportunity that they continue to see in the US market. Representing nearly 45% of the $109 trillion global equity market cap, the US equity marketplace is by far the largest and one of the fastest growing markets in the world. Foreign holdings of US equities reached nearly $14 trillion last year, growing at an approximately 10.5% CAGR over the last decade. And we expect this trend will endure as the growth of the retail investor globally continues and different markets implement legislative changes that are expected to create opportunities for Cboe. The S&P 500 Index is the dominant global equity benchmark with an estimated $16 trillion benchmarked and indexed to it, more than any country's individual market cap globally. Through our SPX options complex, the ability to facilitate risk management and the import of foreign investment back into the US market is a significant and growing opportunity. We continue to see significant opportunity in the Asia Pacific region specifically, where we see growing demand for our index options products, which serve as an efficient and accessible way to gain exposure to the US market. In the first half of this year, three global brokers, Futu Hong Kong, Weibo Thailand and Samsung Futures added various Cboe products to their platforms, including SPX options, further expanding access to our product suite. We see this as a long-term secular trend, and we are eager to help facilitate access to the US markets. International participants are highly valuable to the US market, as diversity of opinion and goals helps to lead to a better trading ecosystem. Whether it be through global trading hours, new products or education, we'll continue to help investors access the liquidity and efficiency of the US markets, while also providing trusted markets and local regions worldwide. We believe the secular trends that are reshaping trading at capital markets, including the globalization of markets, the rise of the retail investor, the increased use of options by market participants to manage risk efficiently, generate income and take speculative positions, and the technology and data revolution create excellent opportunities for Cboe. The strategic review process has enabled us to examine long-term growth and value creation opportunities and reposition and redeploy resources to leverage our strength against those opportunities we see in the market. The strategic review should be viewed as a journey and not an event, and you will see us continue to refine our strategy over time. Finally, we remain well positioned due to our strong balance sheet, combined with our disciplined approach to the allocation of our capital. Our approach to capital allocation focuses on a balanced mix of reinvestment in core operations, including our technology platform, prudent expense management, strategic investments that drive sustainable growth and returning capital to our shareholders. During the second quarter, we repurchased $90 million of shares, and we'll continue to be opportunistic with our share repurchase efforts. Overall, we remain committed to maintaining a strong and flexible balance sheet while investing in organic growth initiatives, our technology capabilities, operating efficiencies, and thereby, driving durable revenue growth, optimized margins and earnings growth for the firm. I'll now pass the call over to Dave to discuss the business line results in more detail."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Fred. Starting with our Global Derivatives category, Q2 was a tale of two halves. Volatility spiked in April on the back of rising geopolitical tensions in the Middle East with the VIX index hitting a year-to-date high of $19, before falling precipitously in May and June, with June ranking as the least volatile month since November of 2019. Not surprisingly, index option volumes were particularly strong in April, with SPX recording its highest monthly ADV of 3.3 million contracts, driven by a notable increase in put volumes as hedging demand picked up. While activity normalized in May and June, overall second quarter SPX ADV was still up a solid 9% year-over-year for 3 million contracts. 0DTE options made up 48% of overall SPX activity in Q2, unchanged from the previous quarter. VIX option volumes, on the other hand, surged higher in Q2, up over 18% quarter-over-quarter to an ADV of 843,000 contracts, making it the third largest quarter on record behind the first quarter of 2018, and ahead of even Q1 2020's COVID-driven spike. Investors have flocked to VIX options to help hedge against potential tail risks, whether it be geopolitical shocks or macroeconomic surprises with year-to-date ADV on track to exceed even last year's all-time high. On the back of this unprecedented interest in VIX options trading, we're excited to expand the access and utility of Cboe's VIX product suite with our planned October launch of options on VIX futures, subject to regulatory review. These will be options that physically settle into the underlying front month VIX future and they will trade on our futures exchange CFE. This is important for two reasons. First, it allows us to provide access to VIX options products to a wider set of market participants in the US and abroad that may not have access to our securities and options exchange. And second, it allows us to offer more tenants to meet customer demand. We're especially excited to expand our volatility toolkit ahead of this year's US election, which has historically been a meaningful volatility catalyst for markets and where demand for options to help manage risk is particularly strong. For example, the VIX index jumped over 10 points in the month leading up to both of the last two elections. In addition to introducing options on VIX futures, we also plan to launch Cboe S&P 500 variance futures in September, subject to regulatory review. Cboe's variance futures will provide an exchange-listed alternative to over-the-counter variance swaps and introduce yet another way to trade volatility around the US election as well as other key catalysts. Our commitment to continually innovate is often cited by customers as one of the key reasons they're eager to partner with us. As we continue to make investments in our products and our markets, our customers are responding by increasing their collaboration with us, whether it be making enhancements to better compete in SPX 0DTE options, setting up to trade in GTH ahead of the US election or the international import of business as more retail brokers come online for options trading in different geographies. Strong client engagement and an exciting product pipeline makes us confident that we're well positioned to continue to grow our derivatives business for the rest of the year. Outside of the US specifically, we continue to make sustained progress exporting our US derivatives model to Europe, leveraging our blueprint in the US by deploying our exchange technology to create better trading experiences for customers in Europe through our European derivatives platform, CEDX. We saw the first equity options trade on CEDX in June with nearly 14,000 lots traded in 201 distinct options during the first month of trading. On the index side, spreads tightened on the back of our recently implemented liquidity provision program, helping improve the quality of our book for index options. From a participant perspective, during the second quarter, we announced two noteworthy developments with the addition of Interactive Brokers as a direct trading participant of CEDX and the clearing participant of the Cboe Clear Europe, in addition to IMC becoming new direct trading participant in June. While we still have a great deal of work ahead, we are pleased with the milestones hit during the second quarter and look forward to building on that momentum in the quarters ahead. Taking a look at the Cash and Spot businesses across regions, second quarter results were very strong with year-over-year net revenue growth reaching a robust 15%. Each region saw year-over-year increases as Cboe leveraged its scaled infrastructure to monetize a healthy market backdrop. Looking at the various regions, in North America, US on-exchange net capture rates improved markedly as a result of pricing changes we made in the first half of the year, as well as a dramatic shift in customer mix given the meme stock activity. Moving forward, we expect to continue to look to strike the right balance between market share and capture to maximize the revenue outcome. In Canada, we produced another 50 basis points of market share improvement as compared to the second quarter of 2023, and remain on track with our final technology integration, the migration of our Canadian market to Cboe technology in early 2025, subject to regulatory review. Moving over to Europe, while closing auction activity hit another record high, constituting an estimated 27% of on-exchange market share unavailable to Cboe in Q2, we retained our leading market position during continuous trading, accounting for 31% of intraday activity for the quarter. Periodic auctions also notched another market share record, and Cboe BIDS Europe retained the distinction of the largest platform of its type for the 27th month in a row in June. As we look to adjacent areas of the market for future growth, we remain on track for our fourth quarter launch of our Securities Financing Transactions Clearing services subject to regulatory review. And finally, turning to Asia Pacific, we saw continued strong momentum in Australia and Japan. In Australia, Cboe continued its market share gains with market share for the quarter finishing at 20.8%, up [2.4] (ph) percentage points from the second quarter of 2023. In Japan, market share continues to set records, reaching 5.5% for the second quarter, a 1.4 percentage point improvement versus the second quarter of 2023. In addition, volumes increased by a very strong 71% as compared to Q2 of 2023 levels. Cboe's positive momentum in Japan has continued into the third quarter with solid volumes and market share. The APAC region remains one we are incredibly excited about moving forward. Not only do we see the opportunity to more effectively monetize our ecosystem of transaction and non-transaction businesses in local markets like Australia and Japan, but as we grow, we look forward to fueling the import of derivatives activity into the US. We anticipate making measured investments to maximize our brand and sales efforts in developing regions. While we are in the very early stages of realizing this opportunity, the onboarding of three new brokers out of Asia Pacific earlier this year highlights the underlying demand for exposure to Cboe's US benchmark products. Turning to Data and Access Solutions, net revenues grew 5% as compared to the second quarter of 2023. The slower second quarter growth was as a result of longer sales cycles and an outsized one-time [backfill] (ph) payment in our index business hitting in the second quarter of 2023, creating a more difficult comparison against softer-than-expected collections in Q2 of 2024. And whilst the first half results are trending slightly below our guidance range of 7% to 10% for the year, we anticipate the slower trends will prove transitory, given initiatives we have in place to accelerate revenue expansion in the third and fourth quarters. Given the year-to-date results and our second half expectations, we anticipate hitting the low end of our 7% to 10% guidance range in 2024. Specifically on the Access Solutions side, we are excited about the momentum behind our dedicated cores offering, greatly enhancing our exchange access layer. Dedicated cores is a new offering launched this year to help market participants improve determinism, reduce latency and enhance their ability to effectively navigate markets. We are currently live on all four of our US equities markets with strong initial interest and have plans to roll-out the technology in Europe in the fall. Dedicated cores is another example of leveraging Cboe's strong global technology infrastructure to provide scaled solutions to customers across our ecosystem. Looking internationally, approximately 40% of this quarter's growth came from outside of the US. We saw a notable uptick in Canada behind sales of our Cboe One data product, as well as a solid momentum in Europe and Australia. As we think about expanding our global footprint, Cboe Global Cloud has been instrumental in extending our connectivity with clients. During the second quarter, nearly 80% of Cboe Global Cloud sales came from outside the Americas. Moving forward, we anticipate being able to shift greater resources to the development of D&A opportunities as we move from the integration efforts with our technology resources to revenue-enhancing capabilities in our Data and Access Solutions category, particularly as it relates to enhancements around US options in the quarters ahead. The breadth of our cash and derivatives markets provides us with the unrivaled position to harvest, aggregate and deliver custom datasets and services closer to customers, both current and prospective, and we look forward to investing behind those opportunities. Cboe's second quarter results highlight the power of the entire ecosystem with Cash and Spot Markets, Data and Access Solutions, and Derivatives all delivering durable results. And the third quarter is off to a great start. We look forward to leveraging the global footprint of our scaled infrastructure to enhance revenue generation across cash, data and derivatives. With that, I will turn the call over to Jill."
},
{
"speaker": "Jill Griebenow",
"content": "Thanks, Dave. As Fred and Dave highlighted, Cboe posted a strong second quarter with adjusted diluted earnings per share up 21% on a year-over-year basis to $2.15, equaling our previous quarterly record. While the second quarter results are notable for a number of reasons, I believe the most powerful message they illustrate is our focus on driving margin stabilization as a result of durable revenue growth against diligent expense management as well as the robust capital return results on display throughout the first half of 2024. I will provide some high-level takeaways from this quarter's operating results before going through an assessment of the segment results. Our second quarter net revenue increased 10% versus the second quarter of 2023 to finish at a record $514 million. The growth was driven by strength in our Cash and Spot Markets and Derivatives categories as well as solid results from our Data and Access Solutions business. Specifically, Cash and Spot Markets organic net revenues grew 15% versus the second quarter of 2023, with all geographies producing solid year-over-year growth. Derivatives markets produced 11% year-over-year net revenue growth in the second quarter, as our proprietary product franchise continued to provide increasing utility to the market. Data and Access Solutions net revenues increased 5% on an organic basis during the quarter. Despite the second quarter slowdown, we are confident in our ability to hit the lower end of our 7% to 10% targeted net revenue growth range for 2024. Adjusted operating expenses increased a modest 2% to $197 million for the quarter with the year-over-year growth driven by higher compensation-related expenses given the strong year-to-date revenue results as well as professional fees and outside services, offset by favorable results in travel and promotional expenses. And adjusted EBITDA of $341 million grew a healthy 16% versus the second quarter of 2023. Importantly, as a result of our strategic focus on revenue generation and diligent expense management, we continued to make meaningful progress in stabilizing our adjusted EBITDA margins during the quarter. Our second quarter adjusted EBITDA margin expanded by 3.5 percentage points on a year-over-year basis to 66.3%. Turning to the key drivers by segment. Our press release and the appendix of our slide deck include information detailing the key metrics for our business segment, so I'll provide some highlights for each. Net revenue in the Options segment grew 8%, led by higher index options transaction fees. Total options ADV was up 1%, driven by a 9% increase in index options volume, and revenue per contract moved 9% higher, as index options represented a higher percentage of total options volume. North American Equities net revenue increased 8% on a year-over-year basis to a record level in the second quarter, reflecting higher net transaction clearing fees and access and capacity fees. Increased net transaction and clearing fees were driven by stronger US exchange and off exchange net capture rates, as well as higher volumes than market share in Canadian equities. On the non-transaction side, access and capacity fees increased 6% as compared to the second quarter of 2023. The Europe and APAC segment produced a 15% year-over-year increase in net revenue, resulting from strong growth across both transaction and non-transaction revenues. Transaction revenue in Australia and Japan benefited from continued market share gains as well as greater volumes versus the second quarter of 2023. The Futures segment reported 19% net revenue growth for the quarter with the higher net transaction and clearing fees reflecting a 28% increase in ADV. On the non-transaction side, market data revenues were up 10%. And finally, the FX segment delivered a quarter of record net revenue with an 11% year-over-year increase driven by higher net transaction and clearing fees. Market share was 20.2% for the quarter as compared to 19.5% in the second quarter of 2023. Turning now to Cboe's Data and Access Solutions business, net revenues were up 5% on an organic basis in the second quarter. Net revenue growth continued to be driven by sales outside the US with approximately 40% coming from international growth, the largest increase coming in Canada related to our Cboe One product. The strong second quarter international sales growth helped more than double overall sales annual contract value as compared to first quarter levels and highlights the many ways we can monetize our ecosystem of exchange networks across the globe. And while new sales may only provide a partial benefit in the quarter they occur, we believe the sales trends are a strong leading indicator of potential future revenue growth for the business. We continue to believe D&A is well positioned and anticipate an acceleration in trends in the third and fourth quarters, helping us deliver on the lower end of D&A revenue growth guidance of 7% to 10%. More specifically, we expect to see continued strength from demand for access across our global markets, particularly as we increase our presence in new geographies and leverage the distribution capabilities of Cboe Global Cloud, the expansion of dedicated cores, greatly enhancing our exchange access layer, and increased capabilities around our US options data and access solutions as we reallocate technology resources from integration efforts to organic revenue generating enhancements. Turning to expenses, total adjusted operating expenses were approximately $197 million for the quarter, up a modest 2% compared to the second quarter of last year. The increase was a result of higher compensation and benefits as well as an increase in professional fees and outside services, partially offset by a decline in travel and promotional expenses. Looking forward, we are reaffirming our full year 2024 adjusted expense guidance of $795 million to $805 million. Our guidance factors in stronger-than-expected revenue trends we have seen to start the year in support of revenue expectations for the second half of 2024, putting some upward pressure on our short-term incentive bonus accrual, but is balanced by our strong expense discipline, leaving our overall guidance unchanged for the year. Importantly, the guidance provides opportunity for continued investment in the businesses. We anticipate that the continued reallocation of resources from integration efforts to areas like the D&A enhancements I just covered or derivative technology upgrades and marketing spend will provide attractive returns in the quarters ahead. Outside of our adjusted expense results, we recorded a number of one-time accounting adjustments I want to briefly touch on. Following the digital business realignment we announced in April, Cboe recorded an $81 million charge representing the non-cash impairment of intangible assets related to the Cboe Digital spot market wind down. In addition, we reported a $60 million impairment as a result of a routine review of the carrying value of Cboe's other minority investments. These charges are considered one-time and are excluded from our second quarter adjusted operating expenses. As we look ahead, on Slide 16, to our 2024 guidance, we are increasing our full year organic net revenue growth range to 6% to 8% from the higher end of 5% to 7%. The updated guidance reflects our strong first half results, solid July activity, and a supportive outlook for the second half of the year. Looking at our full guidance more broadly, while we anticipate hitting our D&A organic net revenue guidance range of 7% to 10% for the year, we are guiding to the lower end of the range given the softer second quarter results. We anticipate a steady increase in D&A revenue growth throughout the back half of 2024, given incremental demand for our dedicated cores offering, as well as continued geographic growth in our D&A business. Our expectation for non-operating income is unchanged at $37 million to $43 million in 2024. We continue to anticipate $33 million to $37 million from positive marks on our investments to help our earnings and investments line and $4 million to $6 million in largely dividend income to flow through our other income line. Our full year guidance range for CapEx remains at $51 million to $57 million for 2024, and depreciation and amortization is expected to be in the range of $43 million to $47 million for the year. And finally, we continue to expect the effective tax rate on adjusted earnings under the current tax laws to come in at 28.5% to 30.5% for 2024. Turning to our balance sheet, our second quarter leverage ratio remained at 1.1 times. We remain comfortable with our overall debt profile and the balance sheet flexibility it affords having locked in low-, medium- to longer-term fixed rates averaging roughly 2.8% on our outstanding debt. As Fred highlighted earlier, a core tenant of the ongoing strategic review is the effective allocation of capital. As such, you have seen us pull-back on our M&A activity, choosing to allocate capital to higher-return internal projects or to shareholder returns in the form of share repurchases and dividends. In the second quarter, we repurchased $90 million in shares, bringing total repurchases for the first half of 2024 to $180 million. We have continued our repurchase activity to start the third quarter, buying back an incremental $25 million in the month of July. Moving forward, we plan to continue to opportunistically repurchase shares as appropriate, given our expected strong free cash flow generation and flexible balance sheet. Also in the second quarter, we returned a total of $58.2 million to shareholders in the form of a $0.55 per share quarterly dividend. Factoring in share repurchases and dividends paid in the first half of 2024, Cboe returned nearly $300 million to shareholders, representing an attractive 65% of adjusted earnings being paid out as repurchases and dividends. As always, we aspire to allocate capital and resources in the most value enhancing way, striking the right balance between investing in future revenue growth and optimizing our margins. We look forward to building on our first half trends and delivering durable shareholder returns in the quarters ahead. Now, I'd like to turn it back over to Fred for some closing comments before we open it up to Q&A."
},
{
"speaker": "Fred Tomczyk",
"content": "In closing, we are pleased to report another strong quarter delivering 21% growth in earnings per share year-over-year. That caps a strong first half with 8% net revenue growth and 17% earnings per share growth year-over-year, as we have continued with strong revenue growth, brought down our expense growth and stabilized our EBITDA margins. We allocated our resources to invest in technology and organic growth initiatives and allocated our capital away from M&A towards strengthening our balance sheet and returning capital to our shareholders. For the first half of 2024, we have returned 65% of our adjusted earnings to our shareholders through a combination of dividends and share repurchases. Our balance sheet is strong, and we're well positioned to continue to return capital to shareholders and take advantage of opportunities as they arise."
},
{
"speaker": "Ken Hill",
"content": "At this point, we'd be happy to take questions. We ask that you please limit your questions to one per person to allow time to get to everyone. Feel free to get back in the queue, and if time permits, we'll take a second question."
},
{
"speaker": "Operator",
"content": "Thank you. The floor is now open for questions. [Operator Instructions] Your first question comes from the line of Dan Fannon of Jefferies. Your line is open."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. I guess to start on the Data and Access Solutions, understanding that you think it's going to accelerate in the back half of the year, but still hoping you could elaborate on why we're coming at the lower end of the range here for the year. And what I think was mentioned as kind of transitory in some of the trends, if you could just elaborate on what's draw -- what drove some of the more moderate growth here in the first half of the year and then again, why you think that will change prospectively?"
},
{
"speaker": "Dave Howson",
"content": "Absolutely. Good morning, Dan. Thanks for the question. As we look at the first half of the year, so far, we're coming up around about 7% growth year-to-date. And the reasoning for the Q2 softer results there is a lot down to timing. Timing plays a big factor in the Data and Access Solutions business in general. We saw a different timing to some of the enterprise sales and we're seeing some longer sales cycles for some of our product services and offerings. We also saw a difference in timing, some of the cash collection timings during the quarter. And then, of course, as we mentioned on the call, there was a backfill, a large backfill in Q2 of 2023, which calls for harder comparisons. And then, the other factor this year has been a little bit of the larger customer consolidation that we saw take place having a small impact on the revenues there. And so, timing throughout, as we look forward, will also play its part. And the confidence we have in hitting that lower portion of the 7% to 10% guide comes from three or four key areas. And that's new sales, it's new products, it's pricing and it's the new technology efforts that we've really been able to focus on this year as a result of finishing off those technology migrations in Asia Pacific throughout last year. So, the full force almost of the technology team really coming back to focus on our core, focus on what Cboe is best at. So, I'll go through those sections and I'll also pass on to Chris to talk a little bit more about that technology investment that we see, giving us some durability throughout this year and into next year. So, those new sales, we doubled the amount of ACV sales in Q2 versus Q1, and we'll see the benefit of those sales coming through throughout the rest of the year. And we were really pleased to see the continuation of sales of Data and Access Solutions internationally with 40% of that growth coming from outside of the US. And when you think about the macro uncertainty for the rest of the year, we certainly see more demand for access and capacity and for data as we go throughout time here. New products, some packaging and bundling there of our new index channels and services that we see going forward. Of course, we were pleased to see the sale of our Cboe One data up there in Canada. Pricing changes will also play their part. As you know, we aim to have high-value cost-effective data feed, but we will perform price and price comparisons and review where we think we're undervalued. And then, when we come to technology, those system enhancements we've been able to book through for the equities markets that access layer improvements really important for this year and rolling out into Europe and the rest of the world into 2025. And that new technology effort really allowing us to produce new data insights, insights into the activity on our platforms, which provide value for customers that they're willing to pay for."
},
{
"speaker": "Chris Isaacson",
"content": "Great. And Dan, I'll dive down a little bit further on the technology improvement. So, we've been making some pretty substantial investments in leading-edge technology that are just starting to come to the market and bear fruit. As Dave mentioned, we've got even greater focus on organic efforts now that the migrations are largely done except for Canada that remains and will complete in the first quarter of next year. And these technology improvements are improving access data and insights. On the access side in US equities, we just completed dedicated cores across all four equity markets. That was finished on July 1st, so in the second half, we'll see the full benefit of that. And then in options, we are also in the second half, we plan to roll-out improvements in all access data and improvements -- a new access architecture for one of our four markets and then we hope to roll it to others in subsequent quarters. We're improving market data. In fact, we just made a rollout here at the end of July with improved market data, and then some new services to provide greater insights for our customers and their trading activity and how they can optimize their behavior. And finally, I'll mention as we enter this election season, and we're actually fully in the election season, uncertainties will continue both from elections and geopolitical issues. The demand for access and capacity is only anticipated to grow, and we're going to continue to invest to provide greater access for our customers as that demand grows."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from the line of Patrick Moley of Piper Sandler. Your line is open."
},
{
"speaker": "Patrick Moley",
"content": "Yeah, thanks for taking the question. So, I just had one on the international opportunity for index options. Could you help us size that opportunity overseas relative to the US? How do you anticipate the mix between institutions and retail to sort of evolve over there? And then just broadly, when we think about the competitive landscape in index options, Fred mentioned that $16 trillion in AUM that's benchmark to the index. How much of a competitive advantage is that for you when you think about other players that might try to replicate the success you've had in the US and overseas? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks very much for those questions. As we think about international expansion, the secular trends we mentioned in the prepared remarks are really important to consider that increase in assets benchmarked against the US capital market with the S&P 500 Index options complex, and all of the volatility talk that we put around that, Cboe really is the home to really manage that equity volatility risk for global participants. So, then that creates an appeal for both those institutional and those retail customers with three retail brokers coming on board this year, we can see a good runway for those efforts. Operating globally gives us the ability to talk to our customers globally about what they need and how they need to access our market. So, the runway for us, we feel is quite long. One of the markets we do use, but it's not the metric to use is the percentage of trading of SPX in Global trading house. That's around about 2% or 3% at this portion in time. But it's important to say that as we bring on those customers, they do trade a lot, of course, in the regular trading hours where the bulk of the trading activity takes place at this point in time. As you mentioned the competitive differentiator there, for us, that global complex of equity volatility at risk to be able to manage -- be able to manage that there. The toolkit that we expand when we think about our product development pipeline, really excited about VIX futures, variance futures coming on board later this year and VIX options on futures, which is an interesting one to mention because that is a futures product. VIX options on futures allows volatility as an asset class really now to be accessed by customers that cannot trade in the US security based options environment. So, that's interesting to institutional players around the globe. So, really, as we broaden out our product set, it becomes interesting to institutional players and that draw for retail players really continues throughout time. So, our focus will be sales footprint in the region, marketing, marketing and brand and focusing on how we can get our data closer to our customers internationally. And you see that coming through there with our 40% of data and access sales happening outside of the United States."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Bedell of Deutsche Bank. Your line is open."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thanks. Good morning, folks. Maybe just switch to the index options franchise on the revenue capture rate, just, I think that's been on your proprietary products increasing for the -- increasing sequentially for the last three quarter, kind of had a little bit of pullback in the second quarter. So, just maybe the drivers of that? And then, how you see that going forward? Do you see that re-expanding from here or it's going to be more volatile based on mix?"
},
{
"speaker": "Dave Howson",
"content": "So, really you hit it right at the end, the mix shift is the driver for the RPC changes there. We haven't made any pricing changes to affect anything. It's really about the mix of the products and that brings us back to talking about the beauty of the volatility toolkit we've got at Cboe with the SPX options and VIX options, and the -- as well as on future sides, the VIX futures providing a great suite of utility. For example, there we saw the rotation into small caps, this quarter, we saw a RUT, hit in record days and there, of course, a different capture for RUT versus SPX as well. So, we see that the mix shift as the ebb and flow of the toolkit as our customers use VIX or the SPX differently throughout time. So, nothing particularly to signal for the forward look there."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Kramm of UBS Financial. Your line is open."
},
{
"speaker": "Alex Kramm",
"content": "Yes, hey. Just wanted to come back to the international expansions you talked about. First of all, a little bit surprising that there's still stones to be turned over, but maybe you can be a little bit more specific. Is it from both a customer perspective? Is it more retail than institutional that's untapped? And then maybe from a regional perspective, where you see the biggest opportunities to expand sales and marketing? And since I mentioned sales and marketing, obviously, there's a cost to that. So, as you expand and focus more internationally, should we expect you ramping up spending or can that be absorbed by your cost base?"
},
{
"speaker": "Dave Howson",
"content": "Great. I'll potentially go in reverse. Alex, the spend as we look at sales and marketing growth there is really, I would call, incremental on top of that existing global footprint. You did of course see general expenses increase in the last few years, which we've really been focused on bringing down and focusing on margin. That expense allowed us to put in place the footprint that we now gain the benefit of that scaled infrastructure, really important for us to be able to leapfrog off as we think about increased sales and marketing here. So, the sales will be in terms of headcount, not 100 people, but really being able to cover that vast area. We say Asia Pacific, but it's a region of countries. And when we think about countries, in Asia Pacific, of course, we start from where we already are, which is Australia and Japan, but also opportunities we see in South Korea, in Taiwan and elsewhere, Singapore in the region to really have hubs of really focused activity. The three onboards this year were in the retail brokerage space and we do see increases in institutional access as we go through. As we've spoken on previous calls, we can't always see the origin of the orderer and the end user, but in our conversations around the world with customers, we do look to help break-down access barriers and those access barriers include a pathway to a securities options market in the US and it includes jurisdictional regulatory approvals for us to be able to market in country. And those are the things that we really focus on a country-by-country basis. So, which is why just to reinforce the point from before, having a VIX options on futures capability that we will eventually roll out on a 24/5 basis becomes very interesting to that institutional client base around the world."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Craig Siegenthaler of Bank of America. Your line is open."
},
{
"speaker": "Craig Siegenthaler",
"content": "Hey, good morning, everyone. So, Robinhood is the second largest options trading platform in the US and one of the biggest crypto platforms, too, with their 24 million accounts. They plan to launch index options to their clients in 4Q. And I know you're also seeking additional regulatory approval for both crypto ETFs and crypto index options with the Russell via the FTSE brand. Could crypto ETF options and index options be part of the initial launch at Robinhood later this year, which could have an even bigger impact to your volumes, or should we think about this more as a Phase 2?"
},
{
"speaker": "Dave Howson",
"content": "The short answer is think about it more as a Phase 2. There's a number of regulatory and structural and infrastructure-based obstacles we need to knock down, but we're really looking forward to working on those with our customers and the regulators to be able to bring ETF options on crypto ETFs to the marketplace. We're really pleased to offer listings, the five ETF listings on ETFs -- Ethereum listings that we brought to market recently, as well as the six Bitcoin ETFs we've already got on the platform. The Robinhood launch at the end of this year is really focused on index options and cash settled index options, which we think will be a really great new product set to access those 24 million funded accounts, in particular when you consider Robinhood's focus on the active retail trailing customer base. The characteristics of the cash settled index options really will appeal to that customer base, and we're super excited about that, and we'll be looking to lean into that with joint marketing and educational efforts with our Options Institute and in conjunction with Robinhood throughout the rest of this year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ben Budish of Barclays. Your line is open."
},
{
"speaker": "Ben Budish",
"content": "Hi, good morning, and thanks for taking the questions. I was wondering if you could unpack what's happening in July a little bit. Clearly, we've seen the VIX start to rise. Can you talk a little bit about the customer mix? I know for some time there's been a narrative around increasing adoption and consumption of data by new trading firms. So, to what degree are you seeing a pickup from any new customer sets in July? What does the mix look like? Thank you."
},
{
"speaker": "Dave Howson",
"content": "Thanks very much for the question. Yeah, certainly saw pickups into July with a number of records across the volatility toolkit coming through there. The makeshift is really in the usage of the products. There's no specific client shift that we've seen in July in its own right, but what it is worth saying is that the engagement from our existing customers and the inbounds from new customers is what really gives us excitement for the rest of the year. A couple of examples there we see with that two years' worth of data that you mentioned, an increase in the number of QIS desks looking to put out products and strategies there. We see a continuation of liquidity providers using 0DTE SBX options to hedge their positions, which is a really interesting development we've mentioned at times in the past. And then, you think about the new liquidity providers, major liquidity providers that are coming to us from other asset classes, whether it be futures or equities, really looking to get involved in the complex there. And then, with the makeshift with retail brokerages coming through, really, really exciting. And then towards the end of this year, as we just discussed, the addition of Robinhood as a customer is particularly exciting."
},
{
"speaker": "Chris Isaacson",
"content": "And Ben, I just might add a couple of points there. It's on VIX options we're seeing, we're on record for a record pace for the entire year as people see the utility of using our entire volatility suite. And then, the rotation into small caps a bit. We just saw a record in July, I think our second best month ever, best since 2018 in RUT options. So, we see some customer behavior there as they rotate and adjust to market conditions."
},
{
"speaker": "Fred Tomczyk",
"content": "And I just think we're seeing increased volatility in July, whether it's what's going on the political side in the U.S. with the election coming up, or whether it's geopolitical or the rotation from AI and into other asset sectors to small cap sector. So, there's a lot going on in the market right now, and that's helping in July."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Owen Lau of Oppenheimer. Your line is open."
},
{
"speaker": "Owen Lau",
"content": "Hi, good morning. Thank you for taking my question. Just want to follow up the last question about maybe talk about the VIX futures and options, ADV, were quite strong in the second quarter, especially in April. I just want to get a better sense about the driver of this trend. And then you talked about kind of these volatility continuing in July. I'm just wondering how you think about the mix between SPX and VIX going into the election in November. Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Owen. Yeah, this really is the story of the volatility toolkit. We're seeing investors gravitate towards that toolkit to be able to manage risk, both the upside as well as the downside. VIX options, particularly we've been talking about this for a little while, is that the lower VIX, the historically low VIX in general that we've seen for most parts of this year, when we see that volatility spike, such as we did yesterday, it's going over $19, or in during April we saw it pop to $19 around those volatility events that occurred, we see customers then monetizing or rolling those VIX call options or those VIX call spreads they got on place. And then we see the resetting and rolling of those as we go through time, looking to prepare for those tail risks that may well occur, particularly when you think about the macro environment. We've got geopolitical risks, we've got elections, which are historically a really big catalyst of volatility, and those daily economic data, whether it be CPIs, central bank rate decisions, or earnings calls. So, when we think about VIX options and VIX futures, when you see a spike in VIX, we see really large VIX futures days. Yesterday, we saw over 400,000 VIX futures contracts trade, the volatility popped over to $19.5 yesterday. SBX options always continue to play their part, whether it's at the shorter end of the curve, or managing that longer-term exposure in and through and beyond the elections there. So, the utility of each product, using conjunction as well as in isolation, is really what we see developing over time. And then, our job is to continue to innovate products around that. And so, when you think about the differences between implied and realized volatility, variance step forward, variance futures, on-exchange, transparent, capitally efficient for a trading strategy, which has recently become very hard to achieve OTC because of the unclear margin rules. So, bringing that on exchange, an exciting development there, along with those VIX options on futures, all before the US election. So, really interesting setup for the rest of the year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Kyle Voigt of KBW. Your line is open."
},
{
"speaker": "Kyle Voigt",
"content": "Hi, good morning. Thanks for taking the question. Maybe just a question on capital allocation. So, even with the $150 million or so capital return in the quarter, you still built up cash in the balance sheet now with about $600 million cash and net leverage continues to come down. So first, just in terms of building up some cash over the past year, I guess, is that being driven at all by wanting to retain some M&A flexibility or something else driving that? And secondly, even though M&A has been de-emphasized, I'm assuming that there could still be some M&A that would be attractive. I guess, can you comment on M&A hurdles and if you're seeing anything interesting in the market from an M&A perspective?"
},
{
"speaker": "Fred Tomczyk",
"content": "Look, Kyle, I'm not going to talk about anything we're looking at right now, if that's your question. However, having said that, I think building up some cash and having flexibility is always a good thing to have to deploy on opportunity, because you never know what tomorrow is going to bring here. Like I've always said, I did not say there will be no M&A, I've always said it'll be more selective, it'll be more significant M&A. What we've learned for the last three years is a lot of that small M&A causes -- it causes a lot of work, immigration work, particularly in our technology area, which is an important part of our business. So, if we're going to do M&A going forward, and that will continue to be one of our options and things we look at, it'll be more significant and much more targeted and in line with our strategy."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Stephanie Ma of Morgan Stanley. Your line is open."
},
{
"speaker": "Stephanie Ma",
"content": "Hi, this is Stephanie filling in for Mike. Maybe just one on Cboe Global Cloud. How meaningful is the contribution uptake today? How do you see that progressing over the next few years? And maybe you can just elaborate on some of your initiatives and steps you're taking to expand the Cboe Global Cloud? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Stephanie. Cboe Global Cloud has been a really interesting addition for us over the last couple of years. With nearly 80% of customers and revenue coming from outside the US, it's really part of that theme of putting data closer to our customers. In fact, putting data closer to more potential customers, and it forms a key part of our global expansion plans, as well as the diversification of revenue streams. The ability for us to have a one-stop shop for historical data, for package and bundled data insights, as well as data feed is really tremendously powerful. We don't break out the contribution of Cboe Global Cloud from the rest, but in terms of a strategic priority for us, it's certainly well up there. And I'll pass on to Chris to give some more."
},
{
"speaker": "Chris Isaacson",
"content": "Yeah, Stephanie, as Dave said, it's really important for us to get our data and access closer to customers where they can use our products, data and insights. So, we're very committed to this. We think we're still in the very early innings of this. As Dave mentioned, most of the growth of Cboe Global Cloud has come outside of the US. And maybe to Alex's earlier question, we're still very early innings in our global presence. We're a relatively young global company, having just expanded globally in the last two or three years. So, part of the secular trend, we think -- as far as that import opportunity that's been mentioned in the script, is that as we get our data closer to customers, they're going to get that data in and then be able to import their trading traffic into the US as they better understand our data. So, look for us to continue to make investments in Cboe Global Cloud and get our data and products closer to those customers."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Blostein of Goldman Sachs. Your line is open."
},
{
"speaker": "Alex Blostein",
"content": "Hey, good morning. Thanks for taking the question as well. I wanted to follow up on the expansion of the VIX product lineup you mentioned earlier in the prepared remarks. So, you talked a little bit about options in VIX future. So maybe some early feedback you're getting from the trading community on what the uptake there could be? I guess how you're thinking about just kind of expansion of that product set relative to VIX regular options and whether there could be any cannibalization or you truly see this kind of like opening up the broader market? Thanks."
},
{
"speaker": "Dave Howson",
"content": "Thanks, Alex. So, the VIX options on futures build capability to have that convexity for a broader set of customers, as we say, customers that cannot today access US security-based options. It's that new customer base that we're excited about. And with any new customer base, that's going to take time to seed and build. So, we're excited about the product, we're excited about when we expand that to 24/5. And also, the key point here is that we can extend the tenants to a shorter-dated tenants with this product as well. So, think about that general desire and the secular trend towards the shorter end of the curve, we can begin to access that with this product. So, those two are the key drivers for our level of excitement around this product is the new customer range internationally and within the US that can't access US security-based options and the ability to go to the shorter end of the curve. So that's a really interesting pathway for us."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Worthington of JPMorgan. Your line is open."
},
{
"speaker": "Ken Worthington",
"content": "Hi, good morning. To follow up on Patrick's question earlier in the call, as you think about the continued investment in European index options, I think the thesis has been that index options are a much smaller part of market cap than seen in the US. So maybe, first, remind us, when did Cboe launch local index options in Europe? What sort of ADV are you seeing right now there? And the strategy, I think, has been a build it and they will come. What is your conviction level that this vision really is the correct one?"
},
{
"speaker": "Dave Howson",
"content": "Thanks very much, Ken. It's worth saying, as we have from the start, that this is really Cboe taking a long view, a long view to the ability to grow the markets in Europe and bring the utility of options, that secular growth that we've seen in the US, we see that being really of great utility to the European economy, European retail investor and the European institutions, if we can bring that US-style market structure. So, exporting our capabilities and our know-how to bring that market structure of a US on-exchange and on-screen market in a capital-efficient manner to customers. The milestones we've hit since we've launched are really also worth pointing out. We think we're at the point of having a minimum viable product now, and that's really marked by the milestone of rolling out single-stock options. That then complements the index futures and options that we've had, and then the milestones this year, which are really interesting, showing that global major customers are aligned with that view. That includes Interactive Brokers, who came on board this quarter, as well as IMC, another anchor tenant liquidity provider. We talked about on the call the liquidity provision program, we've seen the market quality improve in futures and in index options. And then also, when we think about the ADV there, we did about 850 contracts a day in June coming into July, that's holding steady. Our goal forward is to focus on education with the Options Institute. And I guess the last point I would make on this is that this is all built on top of a scaled infrastructure in Europe. And so, it's an incremental investment, it's not making us sweat too much, so we can have patience as we build on that scaled infrastructure, and those key anchor tenants coming on board, sharing that vision with us, really gives us the confidence to continue the course."
},
{
"speaker": "Operator",
"content": "And unfortunately, we've run out of time for questions. I will now turn the conference back over to the management team for closing remarks."
},
{
"speaker": "Fred Tomczyk",
"content": "Well, thanks for joining us today, everyone. As we've said, we've had a strong quarter, we've had a strong first half, we've got lots of initiatives on the go here that we feel good about, and with the environment that we're entering here over the balance of the year, we've had a good start to the third quarter with July's trading results. As we look through the US election, geopolitical events and rotations between different parts of the market as events unfold, even as much as today, we feel pretty good about the rest of the year. The balance sheet is strong. We've got a good cash position, good EBITDA margins, so we feel very good about where we are. And we're in a good position to take advantage of opportunities we see in the market. We'll talk to you next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. You may now disconnect."
}
] |
cboe | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for standing by. Welcome everyone to the Cboe Global Markets First Quarter Earnings Call. [Operator Instructions] I would now like to hand the call over to Mr. Ken Hill, Vice President of Investor Relations and Treasurer. You may begin your conference."
},
{
"speaker": "Kenneth Hill",
"content": "Good morning and thank you for joining us for our first quarter earnings conference call. On the call today, Fred Tomczyk, our CEO; and Dave Howson, our Global President; will discuss our performance for the quarter and provide an update on the strategic initiatives. Then Jill Griebenow, our Chief Financial Officer, will provide an overview of our financial results for the quarter, as well as discuss our 2024 financial outlook. Following their comments, we will open the call to Q&A. Also joining us for Q&A will be Chris Isaacson, our Chief Operating Officer. I would like to point out that this presentation will include the use of slides. We will be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the Investor Relations portion of our website. During our remarks, we will make some forward-looking statements which represent our current judgment on what the future may hold. And while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks and uncertainties. Actual performances and results may differ materially from what is expressed or implied in any forward-looking statements. Please refer to our filings with the SEC for a full discussion of the factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, after this call. During this call, we will be referring to non-GAAP measures as defined and reconciled in our earnings materials. Now, I'd like to turn the call over to Fred."
},
{
"speaker": "Fred Tomczyk",
"content": "Thanks, Ken and good morning, everyone and thanks for joining us today. I'm pleased to report on strong first quarter results for Cboe Global Markets. During the quarter, we grew net revenues 7% year-over-year to a record $502 million and adjusted diluted earnings per share by 13% to $2.15. These solid results were driven by strong volumes across our Derivatives franchise, specifically our proprietary index option products, continued expansion of our Data and Access Solutions business and disciplined expense management. Our Derivatives business delivered another strong quarter as organic net revenue increased 8% year-over-year. We saw strong volumes across our suite of S&P 500 Index option products with first quarter ADV and the SPX contract increasing 17% year-over-year to 3.2 million contracts. We have also seen solid performance in our volatility product suite during the first quarter with VIX futures and options volumes further accelerating in April. Given the secular and cyclical tailwinds in place, we are well positioned as investors continue to utilize options in their portfolio and trading strategies. Our Data and Access Solutions business continued to perform well during the quarter with organic net revenue increasing 8% year-over-year. We continue to see durability in this business as we leveraged our global network and ecosystem of Data and Access Solutions to drive growth. Net revenue in our Cash and Spot Markets business were stable during the quarter as volume across global equity markets remain muted. Overall, it was a strong quarter for both, transaction and non-transaction revenue growth to start the year. I continue to remain focused on 3 priorities that I believe will further strengthen Cboe and support our longer-term growth strategy. First, sharpening our strategic focus on areas where we see strategic growth opportunities for Cboe. Second, the effective allocation of our capital. And third, developing talent and management succession. As part of our strategic review process coupled with the lack of regulatory clarity in the digital space, last week we announced plans to refocus our digital asset business to leverage our core strengths in derivatives, technology and product innovation, while realizing operating efficiencies for both, Cboe and our clients. We plan to transition and fully integrate our digital assets derivatives, currently offered by Cboe Digital into our existing global derivatives, harnessing the power of our global derivatives franchise and global technology platform to help support and fuel growth of the exchange-traded crypto derivatives market. We plan to migrate our cash-settled Bitcoin and Ether futures contracts trading on Cboe's digital exchange to the Cboe futures exchange in the first half of 2025 pending regulatory review and certain corporate approvals. Additionally, we plan to wind down operations of the Cboe Digital Spot Market, our digital asset trading platform in the third quarter of 2024, subject to regulatory review. The lack of clarity on the U.S. regulatory front for the cash spot business, combined with the lack of any timeline to provide that clarity among other considerations has given us cause to change our strategic direction in the digital business to focus on where we have regulatory clarity and leverage our core strengths of derivatives, technology and product innovation. With these changes, we are re-allocating resources to focus on where we see as the greatest opportunity for growth and profitability which is the continued expansion of our global derivatives franchise. On the clearing side, we plan to align and unify our clearing operations globally and intend to maintain Cboe Clear Digital which will continue to clear our Bitcoin and Ether futures. We believe these changes provide an opportunity to leverage our global derivatives platform, enhance efficiencies and sharpen our focus. Optimizing our business operations and product development across borders and asset classes enables us to better serve our diverse client base and sharpen our strategic focus. We continue to develop leadership in all functions across the company and optimize our organizational structure to support our global strategy. This realignment of our digital business into our derivatives and clearing business lines creates continued opportunities for development and growth within our senior leadership team. Finally, we continue to execute on a disciplined capital allocation strategy. The steps we are taking in our digital business illustrate our intent to allocate our resources and capital to the areas where we see the best returns for our firm. Also, as demonstrated during the first quarter and through April, share repurchases remain an important component of our capital allocation framework, one we plan to continue to use opportunistically in the market. Overall, we remain committed to maintaining a flexible balance sheet while investing in organic growth initiatives, our technology capabilities and operating efficiencies, thereby driving durable revenue expansion, optimized margins and earnings growth for our stakeholders. I will now turn the call over to Dave Howson to talk through how we are driving results within our strategy."
},
{
"speaker": "David Howson",
"content": "Thanks, Fred. Starting with the strong results in the global derivatives category. Despite the cyclical headwind of low volatility in Q1 with the VIX Index averaging just 13.7%, the lowest in over 5 years, SPX options volume remains strong. Average daily volume was up a robust 17% year-over-year to 3.2 million contracts, finishing just shy of the all-time high set in Q4 last year. In fact, January and February ranked as the second and third highest SPX volume month on record through the first quarter. We believe investors took advantage of the low levels of volatility to more cheaply hedge their portfolio with SPX puts making up a higher share of the total volume. Hedging demand was particularly strong in our VIX auction suite with VIX core volume ADV up 4% quarter-over-quarter to over 500,000 contracts as investors took advantage of the low levels of VIX to our cheap tail protection. The resilience of our index options volume in the face of cyclical headwinds speaks to the strength of the secular drivers of our business which we outlined in detail on the last earnings call. We continue to lean into these and see further room for growth. For example, in January we launched Tuesday and Thursday expiries for our Russell 2000 index options completing the set of daily expiries to small cap stocks. While still early days, Russell 2000 index options volumes hit a 5-year high ADV at 79,000 contracts in February. And the share of 0DTE volume grew from 8.7% in Q4 to now 12%. Within our more established SPX product, volumes increased 17% year-over-year and 0DTE options increased a robust 32% year-over-year and grew 3% from Q4 level to a new record of 1.54 million contracts. 0DTE options has made up 48% of overall SPX activity in Q1, up 2 percentage points from last quarter. The rise of retail options trading is another secular trend we're excited to build on, with more platforms coming online for index options trading later this year, giving retail investors expanded access to our products. To that end, we are thrilled to see our margin relief plan approved by the SEC recently which we believe will make it easier for investors to overwrite index options on ETFs that track the same index. This is expected to benefit not just our SPX XSP options complex but also our Russell 2000 and MSCI suite of index options as well. Overwriting funds have grown tremendously in popularity in recent years with total AUM jumping more than 6-fold since the pandemic to now over $130 billion. Anecdotally, we're also seeing more interest from the retail and RIA [ph] community in using these options to enhance their portfolio. We see this margin relief approval as an additional catalyst for wider adoption of options by the retail community. Even without a turn in the macro environment, we believe we are well positioned for the rest of the year as we continue to execute on our strategic initiatives. However, if we do get a shift in investor sentiment, as was the case in April, we expect to benefit as traders harness the full versatility of our S&P 500 volatility tool kit. For example, with the market set of April, VIX options volume surged to a 6-year high with daily volumes exceeding 2.6 million contracts on April 12 on the back of escalating Middle East tensions. That's higher volume than we saw during the 2020 COVID crisis, despite the VIX index hitting a high of just 19 last month versus 82 in March 2020. VIX options through April are on pace to report it’s second highest quarter on record at current levels. While Q1 was characterized by a consistent market running amidst low volatility, Q2 is looking a lot more precarious amidst heightened geopolitical tensions and greater macro uncertainty. As investors grapple with resurgent inflation, rising rates, not to mention the U.S. election later this year, we believe the need to use options to dynamically manage positions, hedge exposures and generate income only increases. And while trading metrics in North America remained strong during U.S. hours, volumes traded in U.S. products during non-U.S. hours continue to increase. During the first quarter, SPX global trading hours activity increased 41% as compared to the first quarter of 2023. And in April, we saw SPX GTH activity increase 73% versus Q2 2023 levels and VIX GTH increased 69% over the same period. With GTH activity accounting for just 3% of April's SPX activity and less than 1% of VIX options activity, we continue to see an attractive path forward for non-U.S. customers to increase access to the U.S. markets. Looking at the business more globally, we hit some notable milestones on our European derivatives platform CEDX. Total index derivative volumes again hit record levels in March, beating the prior record by 26% positioning us for future growth. We broadened the list of single-stock options traded on CEDX to more than 300 companies across 14 European countries at the end of March. And on April 1, we initiated and revamped our liquidity provider programs in the region. Client feedback has been promising, and we look forward to providing greater customer efficiencies through our Pan-European approach to trading and clearing. D&A net revenues grew 8% compared to the first quarter of 2023, driven primarily by client expansion and additional unit sales of our expanding portfolio of access and data products. Speaking to the breadth of D&A business, during the quarter each region and every business line outside of digital saw net revenue increase. In fact, 43% of data growth in the first quarter came from outside of the Americas. We saw outsized contributions from Australia where D&A net revenue grew 19%, and Europe where net revenue increased a strong 10% on constant currency basis. We believe future growth will be fueled by strengthening our distribution capabilities through areas like cloud, further expanding our index capabilities and providing greater access to our markets around the world. Taking a look at cash and spot businesses around the globe, first quarter results were solid. It's worth noting though, our ability to expand our cash and spot reach benefits more than just our transaction revenues. The continued progress we make in these markets has the potential to add additional revenue streams in tangential areas around the globe. In North America, we saw U.S. on-exchange net capture rates rebound from December lows to finish in line with first quarter 2023 levels. Furthermore, Canadian market share improved by 4 percentage points to 15.3% during the first quarter. And we remain on-track with our final technology integration, the migration of our Canadian market to Cboe technology in early 2025 subject to regulatory reviews. Moving over to Europe. During the first quarter, Cboe Europe was the region with the largest exchange by value traded, a testament to the strong breadth of our product offering in the region. As we look to expand our capabilities into related areas with untapped addressable markets, we remain on-track for a third quarter launch of our securities financing transactions clearing services, subject to regulatory review. Cboe's SST business will clear stock lending activities for market participants. With the introduction of stricter capital requirements, we believe now is the right time to leverage our clearing capabilities to bring a solution to the market with the potential to meaningfully reduce risk-weighted assets for our customers. We've [indiscernible] backing of 9 key industry participants spanning banks, clearing firms, asset managers and custodians, and look forward to bringing this service to market in the months ahead. And finally, turning to Asia Pacific. We saw strong momentum in Australia and Japan. In Australia, Cboe continued it’s market share gains with total market share for the quarter finishing at 20.4%, up nearly 2 percentage points from the first quarter of 2023. In Japan, not only did market share reach 5% in the first quarter, a full percentage point higher than the 2023 average but volumes grew a robust 72% as compared to year ago levels. Those trends have continued in the second quarter with Cboe Japan market share hitting a single-day high of 6.5% on April 23. With our APAC integrations behind us, we look forward to competing more aggressively in the market to expand our transaction and non-transaction revenues. Overall, Cboe remains incredibly well positioned to consistently grow revenue across the firms. This means not only leaning in a more established product areas like our index business but allowing newer areas to leverage a robust infrastructure already in place. Earlier, Fred spoke to some of the key strategic impacts of our recently announced digital reorganization. I want to provide some additional context on how the move leverages our global derivatives and clearing capabilities. On the derivative side, the reorganization reinforces the integrated global view we take with not only our derivatives franchise but all of our businesses at Cboe. By consolidating Cboe's futures products onto one market, Cboe's Futures Exchange, also known as CFE, pending a regulatory review and certain corporate approvals, we can leverage the totality of our derivatives capabilities to grow our businesses, while creating efficiencies for market participants. Specifically, that means reducing complexity for clients by allowing them to connect to one global platform for all of their U.S. futures trading needs. As part of CFE, newer products like digital asset futures can leverage tried-and-true CFE capabilities to accelerate the go-to-market timeline for products like options on futures and complex orders for digital products, expanding the toolkit of solutions available to clients. In addition, these products will be able to tap into a seasoned and global sales force, a resilient technology infrastructure and a unified management team under the leadership of Cathy Clay, our Executive Vice President of Global Derivatives. On the clearing side, we are equally excited about the opportunities presented by unifying our clearing operations on a global basis. Vikesh Patel, currently President of Cboe Clear Europe, will also oversee U.S. clearing. Cboe Clear Europe will continue to operate as a pan-European central clearing counterparty for European equities and derivatives. Adding Cboe Clear Digital under the global clearing umbrella provides a cohesive clearing approach that spans equities and derivatives in Europe to Bitcoin and Ether futures in the U.S. The result is Cboe having great control of its product development destiny from ideation through to clearing considerations. Across the firm, we continue to leverage our core strengths and find pockets of growth in our cash, data and derivatives categories. The first quarter of 2024 was very strong and we look forward to driving further growth in the quarters ahead. With that, I will turn the call over to Jill."
},
{
"speaker": "Jill Griebenow",
"content": "Thanks, Dave. As Fred and Dave highlighted, Cboe posted a strong first quarter with adjusted diluted earnings per share up 13% on a year-over-year basis to a record $2.15. I will provide some high-level takeaways from the quarter before delving into an assessment of the segment results. Our first quarter net revenue increased 7% to finish at a record $502 million. The growth was again driven by the strength in our derivatives market and Data and Access Solutions businesses with steady results from our Cash and Spot Markets categories. Specifically, derivatives market produced 8% year-over-year organic net revenue growth in the first quarter as we saw sustained growth in our proprietary product franchise during the quarter. Data and Access Solutions net revenues also increased 8% on an organic basis during the quarter. We are pleased with the revenue trends and are confident in our ability to deliver on our 7% to 10% targeted net revenue growth in 2024. Cash and Spot Markets net revenues were roughly flat to a year ago levels on an organic basis given stable results across our business segments. Adjusted operating expenses increased 4% to $193 million with the year-over-year growth driven by higher compensation-related expenses and technology support services during the quarter. And adjusted EBITDA of $337 million grew a solid 9% versus the first quarter of 2023. Importantly, given our strong revenue generation and diligent expense management, we made material progress in stabilizing our adjusted EBITDA margins during the first quarter. Our first quarter adjusted EBITDA margin expanded by 1.4% on a year-over-year basis and by nearly 3 percentage points sequentially to an attractive 67.2%. Turning to the key drivers by segment. Our press release in the appendix of our slide deck include information detailing the key metrics for our business segments. So I'll provide some highlights for each. The options segment delivered another robust quarter as net revenues grew 10%, led by higher index option transaction fees and growth in recurring non-transaction revenue. Total options ADV was up 1% driven by a 14% increase in index options volume. Revenue per contract moved 12% higher with index options representing a higher percentage of total options volume. And access to capacity fees were up 7%, while proprietary market data fees increased 15% versus first quarter of '23. North American Equities net revenue decreased 1% on a year-over-year basis in the first quarter, reflecting lower industry market data and steady net transaction and clearing fees. In net transaction and clearing fees, a decrease in Canadian equities market volumes and net capture was partially offset by stronger U.S. off-exchange to capture rate, up 24% versus first quarter '23, given positive mix shift seen during the quarter. On the non-transaction side, access and capacity fees increased 5% as compared to the first quarter of '23. The Europe and APAC segment reported a 10% year-over-year increase in net revenue driven by 20% non-transaction revenue growth across market data fees, access and capacity fees and other revenue. Transaction revenue in Australia and Japan benefited from another quarter of market share gains. The Futures segment net revenue decreased 2% in the quarter, primarily due to lower volume. On the non-transaction side, access and capacity fees continue to perform well, up 8% versus the first quarter of last year and market data revenues increased by 10%. And finally, net revenue in the FX segment decreased 1%, driven by a slightly lower net capture rate. Market share was 20.3% for the quarter as compared to 19% in the first quarter of '23. Turning now to Cboe's Data and Access Solutions business. Net revenues were up a solid 8% on an organic basis in the first quarter. Net revenue growth continued to be driven by solid new subscription and unit growth, accounting for 57% of market Data and Access Solutions revenue growth. We are pleased with the strong start to the year and believe that momentum across the suite of Cboe's businesses position us well to fuel our full year and medium-term D&A revenue growth guidance of 7% to 10%. More specifically, we expect to see continued strength from demand for access across our global markets, particularly as we increase our presence in new geographies, proprietary data sales and options analytics, benefiting from the sustained growth across our derivatives complex and finally, we anticipate a continued focus on our distribution capabilities, from market data to indices, adding to the enhanced distribution capabilities of Cboe Global Cloud. Turning to expenses. Total adjusted operating expenses were approximately $193 million for the quarter, up 4% compared to last year. The increase was a product of higher compensation and benefits and technology support services and partially offset by a decline in professional fees and outside services. As we look ahead on Slide 16 to our 2024 guidance, we are lowering our full year 2024 adjusted operating expense guidance range to $795 million to $805 million from $798 million to $808 million. The updated guidance reflects our first quarter results, some reduced cost expectations as a result of the digital realignment as well as a slightly higher bonus accrual moving forward given our expectation to be at the higher end of our total organic net revenue guidance range for the full year. On digital specifically, I want to walk through a few of the expected onetime and annualized impact of the announced realignment and revised digital strategy. Cboe expects a onetime estimated pre-tax charge of $39 million to $82 million, primarily related to the noncash impairment of long-lived intangible assets which is expected to be recorded in the second quarter of 2024. These charges are expected to be considered onetime and excluded from adjusted earnings. We do anticipate roughly $2 million to $4 million of adjusted operating expense savings this year as we carefully wind down the spot digital asset trading platform in the third quarter of 2024, subject to regulatory review. Moving forward, we anticipate the closure will generate annualized savings of $11 million to $15 million on an annualized adjusted operating expense basis. Overall, we believe the current expense guidance range gives us flexibility to invest in high-return areas of our business. Looking at our full year guidance more broadly. We are anticipating organic total net revenue growth to finish at the higher end of our 5% to 7% expected range for 2024. We are also reaffirming our D&A organic net revenue growth range of 7% to 10% for 2024, in line with our medium-term expectations. This quarter, we are breaking out our other income line into earnings and investments and other income. Importantly, though, the aggregate benefit we expect to realize for non-operating income is unchanged at $37 million to $43 million in 2024. We anticipate $33 million to $37 million from positive marks on our investments to help our earnings and investments line and $4 million to $6 million in largely dividend income to flow through our other income line. Our full year guidance range for CapEx remains at $51 million to $57 million for 2024 and depreciation and amortization is expected to be in the range of $43 million to $47 million for the year. We continue to expect the effective tax rate on adjusted earnings under the current tax laws to come in at 28.5% to 30.5% for 2024. And finally, outside of our annual guidance, we expect net expense to be in the range of $9 million to $10 million for the second quarter of 2024. On the capital front, we continue to maintain a flexible and attractive capital return policy for shareholders. In the first quarter, we returned a total of $58.5 million to shareholders in the form of a $0.55 per share quarterly dividend. In addition, we repurchased 89 million in shares during the first quarter. We have continued our repurchase activity in the month of April, adding an incremental $27 million in repurchases during the month. Moving forward, we will look to opportunistically repurchase shares given our continued healthy free cash flow generation. Turning to our balance sheet. First quarter leverage ratio declined to 1.1x from 1.2x in the prior quarter as a result of solid EBITDA generation. Overall, we remain comfortable with our debt profile and the balance sheet flexibility it affords, having locked in low, medium to longer-term fixed rates averaging below 3% on our outstanding debt. As always, we aspire to allocate capital and resources in the most value enhancing ways striking the right balance between investing in future revenue growth and optimizing our margins. We look forward to building on solid year-to-date trends and delivering durable shareholder returns in 2024. Now, I'd like to turn the call back over to Fred for some closing comments before we open it up to Q&A."
},
{
"speaker": "Fred Tomczyk",
"content": "In closing, I would like to thank our team for the continued progress made throughout the first quarter. 2024 is off to a strong start and we believe we are well positioned for another strong year."
},
{
"speaker": "Kenneth Hill",
"content": "At this point, we'd be happy to take questions. We ask you please limit your question to one per person to allow time to get to everyone. Feel free to get back in the queue; if time permits, we’ll take a second question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Patrick Moley from Piper Sandler."
},
{
"speaker": "Patrick Moley",
"content": "Good morning. Thanks for taking the question. So, you now expect organic total net revenue growth to be at the higher end of that 5% to 7% range. Revenues were up 6.5% in the first quarter, so it seems like the guide would imply there is an expectation that revenue growth is going to be as good or better than what we saw in the first quarter. But index option volumes did slow down, they've come back here a little bit in April, and you're facing some pretty tough comps for the rest of the year. So just -- can you speak to what gave you the confidence to point us toward the higher end of that range? And then just adding on to that, if you could, what are you baking into that guidance in terms of index option volume growth for the remainder of the year? Thanks."
},
{
"speaker": "Jill Griebenow",
"content": "Sure. You bet. Thank you for the question, Patrick. So if you saw, obviously, first quarter, very strong net revenue results coming in 7% higher than first quarter 2023, really fueled by the derivatives markets business, as well as D&A, very strong contribution there. So that, coupled with, again, the very strong April we saw just -- again, gave us confidence in guiding to the higher end of that 5% to 7% range. We'll obviously keep an eye on this and get another quarter of results under our belt and come back to the group in early August with refined projections. But feel good at the moment with that 5% to 7%, that higher end there."
},
{
"speaker": "David Howson",
"content": "And just, Patrick -- a little bit more -- I'm sure we'll talk a bit more about it in the call but we -- if you look at Q1 versus Q2, different volatility environments there and the complex continues to perform well through both of those. And then as we take that forward look through into the rest of the year, you can see a number of potential drivers; whether that be the geopolitical tensions, inflation, interest rates, and of course, the U.S. elections. So plenty of activity really in front of us there when we think about how customers are using the diverse ecosystem that we have in Cboe."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Alex Kramm from UBS."
},
{
"speaker": "Alex Kramm",
"content": "Just a quick follow-up here actually on the outlook on the D&A side. I know you did 8% in the first quarter but when I look forward I think -- if I look at last year, the comps are getting much tougher in the second quarter. I don't fully remember what happened there but I think there was definitely a step-up. So just wondering in terms of your confidence level given that that 7% to 10% is easily [ph] just your medium-term guide. So given the visibility you should have in that business, just wondering how you feel about where you may check out in the 7% to 10% given the tough comps here starting in the second quarter?"
},
{
"speaker": "David Howson",
"content": "Yes. Alex, thanks for the question. We remain confident in the 7% to 10% guide, and particularly as we had in the call notes [ph], the growth year-over-year in all asset classes in all regions that we saw throughout the quarter, solid growth from 57% from new subscriptions and new units. And then also encouragingly, 43% of the growth -- the market data and access services was from outside of the Americas; that's a record growth percentage was outside of the Americas. Continued strong engagement there with 79% of customers for the cloud from outside of the Americas as well. And so as we think through the rest of the year -- and as you say, Q2 last year was elevated versus Q1 in terms of growth somewhat but then continued throughout the year of last year. But when we think about this year, more data on net. We've got Cboe Australia with re-platformed just over a year ago resulting in 15% year-over-year growth from Cboe Australia D&A there. We've got more products to package and bundle from those 27 markets in different ways and be able to deliver them to our customers where they're at over the cloud. And then finally, it's an exciting year for Cboe as we've been able to turn attention towards technology enhancements in the core platform. And the access layer improvements that we're bringing to market this year and into next year, we think will represent incremental value that customers are willing to pay for, and should also enhance our competitive position within those venues themselves, in particular, in the U.S. options and equities landscape. So overall, confident with the 7% to 10% guide where we stand today but of course, we'll update you next quarter as well."
},
{
"speaker": "Alex Kramm",
"content": "Sounds good. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Craig Siegenthaler of Bank of America."
},
{
"speaker": "Craig Siegenthaler",
"content": "Good morning, everyone. Hope you’re doing well. My question is on 0DTE SPX. Volumes are up a lot over the last year but it looks like the mix has sort of stabilized in the 50% zone. So we wanted to get your updated thoughts on where the 0DTE mix maybe heading over the next 12 months? Also if the Robinhood launch could move it significantly higher; and what other factors you think are most sensitive to adoption?"
},
{
"speaker": "David Howson",
"content": "Great. Thanks very much for the question. You're right, 48% of SPX was 0DTE in Q1 and April was 50%. We see those variations as we go through the months, depending on what's actually happening in the environment there. But we think about the breakdown that we normally give you of retail to non-retail and where non-retail does include professional retail, we saw a continued increase year-over-year, whereas now just under 1/3 is retail and just over 2/3 is non-retail as versus round about 59% of non-retail in Q1 of last year. So what we see there is more funds, more strategies, more PMs coming to the marketplace, and more systematic strategies coming towards the shorter end of the curve. And as we think about it now, we're eclipsing second anniversary of adding the Tuesday and Thursday expirations and there is a tremendous amount of data now, and that data is used by institutional and systematic funds in order to be able to train models. And we're seeing some of the outcome of that in the complex as we go forward. And the interesting point as we grew 3% of 0DTE versus Q4 and Q1 is that that was across volatility ratings and market cycle; so it grew in a lower volatility environment in Q1. So as we look forward, we continue to see a shorter-term risk management strategies. People have been deploying less sensitive to the broader macro trends."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ben Budish of Barclays."
},
{
"speaker": "Ben Budish",
"content": "Hi, good morning and thanks for taking the question. I wanted to follow-up on the outlook. You mentioned that there are some kind of volatility related events coming up later in the year that could be drivers for the SPX complex. I also recall not too long ago, you were talking about 0DTE as being a more like recurring revenue stream, at least versus things like equities which are sort of you trade once and you can kind of settle it because it's got a shorter-time expiration, you tend to enter into a new contract. So, I guess what are your thoughts on sort of the recurring nature of the 0DTE complex? How much growth are you sort of seeing from that sort of user or users that are becoming more regular users versus how much do you perhaps expect will come from a pickup in volatility or normalization in VIX levels later in the year? Thank you."
},
{
"speaker": "David Howson",
"content": "So what we've got is in terms of the mechanics of options that we've talked about before is the fact that options do expire. So any position or exposure or view that you've expressed in the market needs to be refreshed at the expiry of that option. And indeed, also, if you put on a spread in the market, you may need to manage that position as the regime or pricing or your view changes over time. So those 2 factors really do result in a much higher engagement rate from customers as they utilize options to manage risk, to generate income, to take views, or to deploy systematic strategies. And as I mentioned just now, you see a lot of funds and bank QIS deploying strategies that have a much shorter-dated view coming forward in the curve from, say, 2-week to 6-week strategy to 0-day to a 5-day or 6-day strategy that they can deploy and redeploy. So you can see there that timing of the frequency of deploying those strategies really creating a more durable engagement in the platform. And then as you see volatility coming through, we've seen higher-volume days, interestingly, on volume of days in recent months. And so we don't just require volatility in the market itself to get activity in the platform. And we've seen diverse use being expressed in this year as we've gone from Q1 throughout into Q2."
},
{
"speaker": "Fred Tomczyk",
"content": "Just to add something to Dave's comments is, I think the comment we made before that we do see option trading revenue much more recurring than equity trading revenue. And the reason is, as Dave said, it's because they expire. You have to reput your position on. So to me, that applies to the whole option revenue stream, not just to 0DTE."
},
{
"speaker": "Ben Budish",
"content": "Appreciate that. Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Brian Bedell from Deutsche Bank."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thanks. Good morning. Thanks for taking my question. Maybe just speaking of recurring revenue and back on to the data and access. Just looking at Slides 8 and 14 and the comments on a couple of the drivers for 7% to 10% and I think this would be for medium term also. But can you comment on the -- one of the first ones there, the global access. What portion of your, say, data and access revenue or at least your customer base is asking for global access, really trying everything that you do globally together? I know, Dave, you talked about the portion that was coming from outside the U.S. But I know global access is a big initiative of yours. So can you talk about what portion of people are using that now and what you see as the opportunity going forward for that?"
},
{
"speaker": "David Howson",
"content": "Yes. Absolutely. The 43% growth rate from outside the Americas, that is certainly a good lead indicator as we see that grow quarter-over-quarter. A example for us where we have customers around the world taking one data set being drawn in by, for example, the access to the U.S. equity market data as, let's say, a CFD provider out in Australia. But once you're in, you've got a common platform, you've got the API access, you can then find a myriad of other data puts that you can find useful to yourself and your user base. And we do see users taking one data item from us from the cloud and then expanding laterally across interest across those 27 markets. And then we think about access to the derivatives complex, we've seen some really good onboarding this year from retail brokers out in the Asia Pacific region. So really encouraging that in order to onboard for the platform, you need access to data. And then when you get access to the platform, what we're seeing there is a really good beachhead for activity in the SEF, Southeast Asia Pacific region, bringing activity back into the U.S. core complex. So in summary there, we see -- we do see people taking data units from us on the cloud and then expanding laterally in that. And the benefits of having that single technology platform and that single consistent access point are really bringing great utility for our customers as they don't have to deploy technology resources for multiple APIs and multiple data sets. They can easily take new data sets that interest them with a very low to no incremental technology effort to do that."
},
{
"speaker": "Brian Bedell",
"content": "Got you. It's a land-and-expand strategy, whereby you get the customer and then you cross-sell multiple other data sets and analytics?"
},
{
"speaker": "David Howson",
"content": "Absolutely. And we certainly take a one-firm approach to our sales here at Cboe, where we're training all of our salespeople globally on all of the data and assets that we have within Cboe. So if you're in Australia, you know to talk about the risk market and analytics options capability that we've got that we can bring to the market, our index, our derivative index capability but also the raw data from those 27 markets and those incremental insights that we're able to produce on top of that body of data."
},
{
"speaker": "Christopher Isaacson",
"content": "Brian, this is Chris. Just my follow-up there, the pull-through that Dave is talking about, we land and expand and get them raw equity data and then we get them derivatives data and they start trading in GTH on Slide 7, as you can see that we're having really good pull-through with the expanded access with -- GTH increased 41% year-over-year and 73% quarter-to-date. So really excited about that growth that starts with data that moves to transactions."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thank you so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Owen Lau from Oppenheimer."
},
{
"speaker": "Owen Lau",
"content": "Hi, good morning and thank you for taking my question. I actually have a broader question about Cboe. So over the past 2 years, Cboe has benefited from high growth of 0DTE. And now we have identified many small incremental revenue and expense opportunities. You talked about land-and-expand strategy and doing more buybacks. It just feels like the profile has changed. So if you can help me over the next 2 years, what should investors focus on to gauge the investment there for Cboe?"
},
{
"speaker": "Fred Tomczyk",
"content": "Well, I, mean I think you're going to look at the same things that you've always looked at which is our revenue growth. And we're clearly sending the message about our view on our derivatives franchise and the globalization of that and that gives us lots of opportunities. And we continue to see lots of opportunities on the D&A side. And so those are the 2 growth platforms for Cboe. The equities markets, we continue to like that business. It has good margins, kicks off lots of free cash flow but it's harder to grow than the other 2 franchises. So we're focused on growing all 3 but mainly the top 2. We're going to have a more disciplined expense management process. And if you went back over the last couple of years, you would have seen us doing lots of, what I'll call smaller M&A that consumes resources. So resources inside the organization are now more focused on delivering organic growth initiatives that are integrating acquisitions that we've been doing in the last couple of years. And then, of course, not only the resources internally but then it frees up capital. Our balance sheet is in very good shape now. We're kicking off lots of free cash flow so we can do -- return capital to our shareholders through dividends and buybacks. So while we've had a nice win from 0DTE, we continue to see growth as we built this global footprint. And I think we've got a lot of, what I call, land and expand. We've got lots of opportunities to sell what we've got in different markets around the world. And then we're doing quite well in the markets that we entered, our market share. If you look at Japan, Australia, Canada, once they get on our technology, our market share seems to expand. So we're feeling good about that. So we have lots of things that we're looking forward to. Do we have another 0DTE up our sleeve? We might like to think we do but I'm not sure we do. But that franchise and the SPX complex, just the way we look at it is it has high demand around the world, not just in the U.S. capital and liquidity continues to flow in the U.S. And a lot of times, people that want to invest and trade in the U.S. are looking to the SPX complex."
},
{
"speaker": "Owen Lau",
"content": "Got it. Thanks a lot."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Michael Cyprys from Morgan Stanley."
},
{
"speaker": "MichaelCyprys",
"content": "Good morning. Thanks for taking the question. I just wanted to go back on the D&A revenue growth target, 7% to 10% just looking out over the next couple of years. Just curious where you see the biggest opportunity within there to drive growth ahead. What -- which product specifically do you think will be the biggest driver or contributor there? And is this new portion would be coming from new products versus from existing products that you're going to drive greater penetration of the existing customer set versus new customers?"
},
{
"speaker": "David Howson",
"content": "Certainly for us, the growth in the short term, the medium term continues to be, as Fred said, sell what we've got, we see a great runway for selling the data products that we have internationally in particular. And then the second and third sleeve of the D&A business outside of the data and access is the index business. It's a smaller portion of the overall but it's growing at a very good rate with our specialization in derivative index strategy -- derivative strategy benchmarks and bringing those to the marketplace. We've got what we think in the risk market analytics sleeve the world as global options analytics capabilities which we find greater adoption internationally for those there as well. And then when we think back to the core and basic, the access to our market continues to be high in demand and only going in one way, one direction seemingly, in particular as we broaden out that access globally. As Chris mentioned, 2% to 3% of SPX options trade in those global trading hours. We see a solid runway to be able to expand access during those time zones and during those parts of the trading day there. So we see good ability to push out new data there. And then when we think about new data products, it's really about packaging and bundling what we have. The great example from the 0DTE inception was the uptake of the open and closed dates which shows positions opening and closing throughout the day in the SPX options contract. That was a particularly insightful pivot on the data which we were able to provide to customers from the existing activity in the franchise. And as the franchise grows and that liquidity ecosystem grows, the demand for data and the opportunity to create innovative insights and products on that data really comes into its own. And of course, we'll be thinking about new technologies that we can deploy to help us generate those insights on a go-forward basis."
},
{
"speaker": "Christopher Isaacson",
"content": "Michael, it's Chris. I just might add here, as Dave mentioned, we're just very, very focused on increasing access and distribution of all of our data. The Cboe Global Cloud growth has been great, especially driven outside of the U.S. And we will be pushing to use distribution mechanisms like that to get our data closer to customers where it could be a win-win for them as they want more data, not just in real time but they want data at the time of doing research, et cetera, so that they can better trade on our markets. And then the access improvements that Dave spoke about, as now we can unlock this global network because all the platform migrations are done except for Canada which is coming in March of next year. We'll be rolling out those access improvements first in the U.S. and then around the world. These are material upgrades in our technology platform which speaks to the power of a global network and a global platform. We can build something once and then roll it out all over the world to the benefit of our customers."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Alex Blostein of Goldman Sachs."
},
{
"speaker": "Alex Blostein",
"content": "Fred, one for you. I just want to get your mark-to-market on where we are in this sort of strategic review journey you've guys have been on. After the decision on Cboe Digital, are there other areas where you think you guys are looking to sort of pivot away from? And if so, what could that look like? And just one follow-up for Jill. The $11 million to $15 million in annualized savings that you highlighted, is there a revenue offsetting impact as well? Or are you really speaking to the operating income effect from these changes?"
},
{
"speaker": "David Howson",
"content": "Why don't you take the second one first?"
},
{
"speaker": "Jill Griebenow",
"content": "You bet. So the $11 million to $15 million in contemplated savings on an annualized basis is really the expense portion. So not expecting anything material from a revenue impact perspective in 2024, very consistent with what we messaged last week."
},
{
"speaker": "Fred Tomczyk",
"content": "Okay. And then back to your first question, Alex, so I'd say in terms of the strategic review, we're in, I call the heart of the process now. We've done with all of our analysis of the trends we see in the markets around the world. We're taking a look at our SWOT analysis, our competitors and where we have strengths on a relative basis. And so we're now starting to really get down focused, okay. So now that we know all that. We've taken an outside-in view of Cboe and the market in case of what we do now. So we're getting right into the heart of the discussion and the management team. But we still have to debate that out and conclude on areas where we want to focus our time and attention. And then we have to review with the Board, obviously which will -- the first round will be in the summer but there'll probably be a second round in October because there'll be some questions. And I'll -- as I said the last time, we'll probably be in a position to talk about further later this year. I just want to remind everybody that the strategy review is all about finding which areas that we want to focus our resources on to drive revenue and earnings growth which over the longer term drive shareholder value. That, combined with a disciplined capital allocation strategy, should deliver good value for our shareholders. As I said, in an exchange like ours, you have high margins, it's a capital-light business model. And it's all about how you allocate your resources, particularly technology and capital, to drive value for the shareholders over the longer term."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Kyle Voigt of KBW."
},
{
"speaker": "Kyle Voigt",
"content": "Maybe I can just ask a question on CEDX. It sounds like you've realized record activity levels there in March which is good to see. I guess, can you just elaborate whether you still have incentives in place there for trading? And I'm assuming it may still be a bit of a drag on group profitability, while the business ramps and you try to gain further momentum there. I guess, any color on when we should start to see revenues and profitability ramp for CEDX?"
},
{
"speaker": "David Howson",
"content": "Thanks very much, Kyle. You rightly pointed out the record month in March for index derivatives and Q1 being up 30% year-over-year. We did revamp the liquidity provider program starting in Q2 to really refine those and focus on the type of liquidity, the concentration that we are looking for. That, along with the extension of the number of single-stock options coverage in Q1, we now cover over 90% of OI and ADV and -- on the European landscape. So what it gives is a full unit of offering now with single-stock options and futures and options on our index products. We've got more market makers coming on board as we go through the rest of the year and we're eagerly anticipating the knowledge of a major global retail brokerage platform in the coming months. All that will then begin to form the core liquidity ecosystem that we'll be able to build on, produce more sales and marketing efforts in conjunction with our customers and talk to those retail brokers that are looking to expand internationally as well as those funds that are looking to deploy capital into Europe. And so what we'll do throughout the rest of the year is monitor those volumes and that activity in the platform progresses. And as you speak to profitability and revenues in search is worth reflecting on the fact that this is all built on top of a scaled infrastructure, the scale of infrastructure in Europe that lies on top of the largest pan-European equities exchange which is profitable, the largest cash equity clearinghouse as well. So we've got scale. So the incremental investment here for us is relatively small and affords us the opportunity to be patient and continue to work with our customers to onboard to what is brand new exchange product set and clearinghouse which does take time. So it will be a journey. So we'll be continuing to review that as we go throughout this year and into next and keep you updated with that."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Patrick Moley of Piper Sandler."
},
{
"speaker": "Patrick Moley",
"content": "Just a modeling question on the buyback. Appreciate that it's -- you're being opportunistic but it was rather large in the first quarter relative to what you've done recently. And it seems like it was pretty strong in April. So can you help us just kind of frame and understand the size and pace of that buyback from here? Anything you can give us would be great."
},
{
"speaker": "Jill Griebenow",
"content": "You bet. So really in a very comfortable position from a balance sheet perspective. Paid off the last of our floating rate debt in the fourth quarter of 2023. Leverage ratio down to 1.1x here at the end of the first quarter. So the first quarter, as we've always -- or historically mentioned is -- has typically been heavier in share repurchases. So again, the first quarter this year was heavy and then also tacked on with that were some opportunistic share repurchases. So we generate a lot of free cash flow. We deploy the capital via various bells. So had a history of paying a quarterly dividend. In the past, we've increased that in the third quarter. We'll take a look at that again this year. And then again, any time we sense perceived weakness in the share price, we'll get behind it and back it for a repurchase perspective, especially given the comfortable balance sheet perspective we're in right now. So that's why you're seeing an elevated level. We stand behind the stock. We have the free cash flow there to back it. We're also mindful of organic growth initiatives. We want to keep a bit of dry powder to invest in the business to drive that long-term growth. So it's really a balance between those areas."
},
{
"speaker": "Operator",
"content": "We have a follow-up question from Owen Lau of Oppenheimer."
},
{
"speaker": "Owen Lau",
"content": "On the digital side, could you please remind us on why you think Cboe can be competitive on big -- futures trading without the spot offering? And then what does the -- this realignment mean to Cboe's broader strategy on how to tackle the digital asset ecosystem longer term?"
},
{
"speaker": "David Howson",
"content": "I'm sorry, could you repeat the second half of that question, please? We've got the competitive element for the first half. The second half, we -- the line broke a little."
},
{
"speaker": "Owen Lau",
"content": "Sorry, about wet. So I was just asking, how does this realignment, the digital assets realignment mean to Cboe's broader strategy on how to tackle the whole digital asset ecosystem longer term?"
},
{
"speaker": "David Howson",
"content": "Great. Thanks for the clarification there. So when we looked at the overall landscape here is we took into account our own assets, capabilities and strengths here at Cboe. And we looked at where we saw the greatest opportunity set which was in the correct term derivative space. And so once again, we look to lean on our scaled infrastructure and the existing global resources. What we think makes this move attractive for us is that we get to bring those crypto digital futures onto a single venue, a single venue with an existing broad distribution and customer base. It gets brought onto a single technology stack which runs all of our global equities, futures and options market, a familiar set of functionality which leapfrogs the functionality we have today on Cboe Digital Exchange to add a range of versatile functionality that futures customers want. We also get a clearinghouse that clears these products and potential other new product innovations in the crypto derivatives space which then allows us to define our own destiny. It allows us to have autonomy around that product duration and that timeline to market. And then as a global derivatives team, have scale and expertise around the world for derivatives but also that scale and expertise around the world for clearing to broad to bear in unison onto the digital asset space. So we think derivatives is where it's at for us. We think we're good at that. We've got the technology and the people to be able to give us an edge and create an alternative liquidity pool for people to express and manage exposure to crypto assets at Cboe."
},
{
"speaker": "Fred Tomczyk",
"content": "And maybe I'll just add a few comments here, why we moved on with digital strategy at this time. So first off, it wasn't lost on us that we were losing money on this. So it creates a greater sense of urgency to come to a strategic conclusion. We also realize that we do not have regulatory clarity in the spot and cash spot market. And we do not see when we're going to have regulatory clarity. And so when we went into all this, we wanted to build a trusted, liquid, efficient market. Everybody wants that. But if you don't have regulatory clarity, it's very hard to do that because you can't bring all of various participants into the market. So as Dave said, we've gone to where our strengths are and we have gone to where we have regulatory clarity. And basically, we see that as the best opportunity for us going forward."
},
{
"speaker": "Operator",
"content": "A final follow-up question comes from Michael Cyprys of Morgan Stanley."
},
{
"speaker": "Michael Cyprys",
"content": "Just wanted to ask about credit index products. Understand you have a few that you're launching. Hope you could update us on that. And more broadly, if you could speak to the opportunity set within credit index products and new partnership opportunities that can make sense over time. Just how are you thinking about that, particularly as credit markets continue to electronify with new investor types entering the marketplace? What's your vision for Cboe in credit?"
},
{
"speaker": "David Howson",
"content": "So for us today, we have 2 iBoxx futures contracts and we have options on those futures contracts as well available to customers. For us, having a futures product is particularly useful for those fixed income funds who can't trade securities and sort of the ETFs are locked off to them. So having the ability to manage and hedge exposure is particularly useful there but also for international customers to get those -- that access to an aligned future which align deeply -- which tracks very closely to the 2 key benchmarks here, the LQD and HYG, ETFs. So the underlying -- to allow access and exposure there to manage those exposures is particularly used for the international aspect also comes into play as a future to be able to access that from international participants as well. So for us, it's the, first, into credit as we go through that alignment to the core underlying exposure is the key differentiator to Cboe's credit offering because it does align the HYG and LQD products very, very closely and a touch of exposure there."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. I will now turn the call back over to the Cboe Global Markets team for closing remarks."
},
{
"speaker": "Fred Tomczyk",
"content": "Okay. Thanks, everyone. Thanks for your questions today and thanks for calling in. We're off to a great start to 2024. And we look to continue the momentum for the rest of the year."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you for participating and you may now disconnect."
}
] |
cbre | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Fourth Quarter 2024 CBRE 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, Chandni Luthra. Thank you. You may begin."
},
{
"speaker": "Chandni Luthra",
"content": "Good morning, everyone, and welcome to CBRE’s fourth quarter 2024 earnings conference call. Earlier today, we posted a presentation deck on our website that you can use to follow along with our prepared remarks and an Excel file that contains additional supplemental materials. Today’s presentation contains forward-looking statements, including, without limitation, statements concerning our business outlook, our business plans and capital allocation strategy and our earnings and cash flow outlook. Forward-looking statements are predictions, projections or other statements about future events. These statements involve risks and uncertainties that may cause actual results and trends to differ materially from those projected. For a full discussion of the risks and other factors that may impact these forward-looking statements, please refer to this morning’s earnings release and our SEC filings. We have provided reconciliations of the non-GAAP financial measures discussed on our call to the most directly comparable GAAP measures, together with explanations of these measures in our presentation deck appendix. Also in our press release, we have provided historical non-GAAP financial information for the new segments, which we will begin reporting with Q1 2025 results. We will provide more detail, including historical quarterly financial information by lines of business based on the new segments prior to releasing our Q1 results. I’m joined on today’s call by Bob Sulentic, our Chairman and CEO; and Emma Giamartino, our Chief Financial Officer. Throughout their remarks, when Bob and Emma cite financial performance relative to expectations, they are referring to actual results against the outlook we provided on our Q3 2024 earnings call in October, unless otherwise noted. Also, as a reminder, our resilient businesses include facilities management, project management, property management, loan servicing, valuation and recurring investment management fees. Our transactional businesses comprise property sales, leasing, market origination, carried interest and incentive fees in the investment management business and development fees. Finally, unless otherwise noted, whenever we cite growth rates, we are referring to the percentage change versus the 2023 fourth quarter in U.S. dollars. With that, I’ll turn the call over to Bob."
},
{
"speaker": "Bob Sulentic",
"content": "Thank you, Chandni, and good morning, everyone. Q4 of 2024 was CBRE’s best quarter ever for core earnings and free cash flow with broad strength across our business. We also made significant progress in executing our strategy, positioning the company to continue to deliver double-digit earnings growth on an enduring basis. First, we acquired Industrious, the premium flex workplace provider. This advances our ability to meet office occupier and landlord demand for flexibility and an elevated experience. The Industrious transaction also became the catalyst for us to consolidate all our building management businesses into one segment called Building Operations & Experience. This move allows us to build expertise and scale advantage across many areas that are common to the operation of buildings. Jamie Hodari, Industrious’ CEO, who has exceptional strategic, operational and entrepreneurial skills is leading this segment as its CEO. We also completed the combination of CBRE project management with Turner & Townsend. This creates a large uniquely positioned program and project management business with multiple avenues for resilient revenue growth in areas like infrastructure, energy and data centers. Finally, we took two additional steps to upgrade our senior leadership team. First, we gave our COO, Vikram Kohli, whose capabilities are evident in the major impact he had on our business in 2024, additional responsibility as CEO of our Advisory business. Second, we named Adam Gallistel, who will join CBRE in April and Andy Glanzman as co-CEOs of our Investment Management business. As a leader of GICS Americas business, Adam forged an exceptional track record and prominent industry profile, while Andy has proven to be a strong operational leader who has overseen CBRE Investment Management’s strategic evolution. With all these moves in mind, we have reorganized the company into four business segments. Two of the segments, Building Operations & Experience and Project Management, are entirely comprised of resilient businesses. Together, they generated $1.4 billion of SOP in 2024, and they are growing organically at a double-digit rate. In both segments, we have tremendous opportunities to scale our position in huge, fragmented and underpenetrated markets. Our Advisory segment, which includes leasing, capital markets valuations and loan servicing, is a cornerstone of our business. It is responsible for producing large profits, high margins, strong cash flow conversion and abundant data and market intelligence that is valuable across our company. Our Real Estate Investments segment, which includes our Investment Management and Development businesses, is underappreciated. This segment has significant embedded profits, and we expect it to become one of the leading contributors to our long-term growth. Additionally, it is an ongoing source of compelling investment opportunities for CBRE. Our confidence in CBRE’s future has never been higher, as evidenced by our considerable share repurchases since the end of the third quarter. Despite the strong appreciation of our shares over the last year, we believe the market is undervaluing our business relative to both its growth profile and dramatically enhanced resiliency. Now Emma will discuss the quarter’s highlights and our outlook for 2025. Emma?"
},
{
"speaker": "Emma Giamartino",
"content": "Thank you, Bob. We exceeded expectations with a record quarter across almost every metric. Our resilient businesses, which are facilities management, property management, project management, loan servicing, valuation and recurring investment management fees grew net revenue 16% in the quarter and 14% for the year, while delivering operating leverage. Resilient businesses contributed nearly 60% of our total SOP for the year, essentially matching 2023. This relative contribution by our resilient businesses is notable in a year when our transaction revenue grew considerably, yet capital markets activity is still well below peak levels. In our Advisory segment, results were driven by record leasing revenue and a continued rebound in capital markets. Globally, leasing revenue grew 15%, with notable strength in APAC and the Americas. U.S. office leasing delivered 28% revenue growth. Office occupiers are increasingly comfortable making long-term decisions given improved return to office momentum and a healthy economic outlook. The durability of office leasing growth was a prominent question as recently as October when we last reported earnings. While New York led most of the office leasing recovery in 2024, other markets accelerated substantially in the fourth quarter. Gateway markets comprised of New York, San Francisco, Los Angeles, Chicago, Washington, D.C. and Boston grew approximately 30% in aggregate. Other large markets like Dallas, Atlanta and Seattle grew even faster. And certain smaller Midwest markets, including Cleveland, Pittsburgh and Minneapolis, picked up considerably. This gives us confidence that office leasing will continue to increase as activity has spread broadly. Retail leasing also exhibited solid growth, while industrial leasing was essentially flat. Turning to global property sales. Revenue growth accelerated to 35%. Growth was strong across all asset classes globally with a notable increase in office sales in the U.S. and EMEA, albeit off a low base of activity. Our mortgage origination business was up 37%, led by a 76% increase in origination fees, partly offset by lower escrow income. We saw a strong pickup in loan origination volume across financing sources, most notably from the GSEs and banks. While acquisition financing is increasing, refinancings continue to lead the recovery, making up almost 60% of total volume for the quarter. Overall, Advisory SOP rose 34% with improved margin on net revenue. In the GWS segment, net revenue grew 18%. Facilities management net revenue increased 24%, with broad-based strength in both the enterprise and local businesses. We are seeing a good balance of new clients and expansions across enterprise sectors, especially technology, industrial, data centers and health care. Local revenue growth was led by the UK and the Americas. The Americas has emerged as the local business’ second largest region, up from the fourth largest in 2023. This is a direct result of executing our strategy to increase share in the U.S., a market that is still barely penetrated. Our project management business saw a solid net revenue increase, with particular strength in North America and the UK, led by real estate and infrastructure. For the full year 2024, project management net revenue grew 10%, with operating leverage driving faster SOP growth. This growth was dominated by Turner & Townsend, which achieved 19% revenue growth for the year, supporting our view that the aggregate project management business will achieve accelerated growth when combined. The GWS SOP margin improved for the full year, reflecting our cost efforts and focus on contract profitability. In our REI segment, SOP increased to $150 million in Q4, led by our development business. As expected, we had significant monetizations in the quarter, including several data center development sites. This is one of our development businesses’ strongest quarters and reflects our distinct capabilities as a land acquirer and developer as well as our proactive decision to invest in areas benefiting from secular tailwind when others were on the sidelines. Within our investment management business, Q4 operating profit declined, partly driven by a ramp-up of costs in anticipation of increased capital raising. We raised over $10 billion in 2024, with half of it coming in the fourth quarter. AUM ended 2024 at $146 billion, essentially flat for the year. Market sentiment continues to improve, with many investors positioning their portfolios to capture opportunities in the latter half of 2025. Before turning to our outlook, I’ll comment on cash flow and capital allocation. Free cash flow exceeded expectations, increasing to more than $1.5 billion for the year, and free cash flow conversion reached almost 100%, surpassing our 75% to 85% target range. We deployed approximately $2 billion of capital in 2024 across M&A, real estate co-investment and share repurchases. This is in line with our strategy to invest in resilient businesses that augment CBRE’s growth profile, expand our total addressable markets and generate high risk-adjusted returns. Besides several notable M&A transactions, we capitalized 29 development projects for the year, including 12 in Q4. Our significant efforts to build the pipeline over the past few years, while many investors were on the sidelines, has positioned our development business to break ground on more than 50 projects in 2025, almost double the number in 2024. We estimate that we have more than $900 million of embedded net profits in our development in process portfolio and pipeline as we capitalize a second large portfolio of development assets in the fourth quarter, this time focused on industrial assets. Our in-process and pipeline portfolio currently stands at more than $32 billion with outstanding balance sheet equity co-investments of approximately $800 million. And as Bob mentioned, we also continued to see significant unrecognized value in CBRE shares. This led us to repurchase more than $800 million worth of shares since the end of the third quarter. We have high conviction in our growth prospects and believe our ability to consistently generate double-digit organic earnings growth justifies a premium through cycle multiple. Looking ahead, we expect another year of strong free cash flow generation, approximating last year’s total of $1.5 billion. We anticipate free cash flow conversion within our 75% to 85% target range this year as the benefit from bonus timing we saw in 2024 reverses. Absent material M&A, we expect to end the year with net leverage below 1 turn, but are willing to lever up to 2 turns for the right M&A opportunities. Turning to our outlook. We expect to easily set a new peak in 2025 with core EPS projected to be in the range of $5.80 to $6.10. This would represent more than 16% growth at the middle of the range, supported by mid-teens SOP growth across our resilient lines of business, momentum in leasing and a continued rebound in capital markets. It is notable that we’re expecting this level of earnings when transaction activity is more muted than in other cyclical recoveries. We’re, again, guiding to a wide range this year because of uncertainties around the level of currency headwinds and the trajectory of interest rates. We’ve embedded a currency translation headwind of 1% to 2% in our consolidated outlook. Absent this headwind, expected core EPS growth would be in the high teens. Turning to our segments. We are providing guidance under our new as well as the old segment structure, as shown on Slide 8, to help investors transition their coverage. Note that all percentage growth rate estimates for the segments are in local currency. In our Advisory segment, we expect low to mid-teens SOP growth driven by solid leasing revenue growth and a steady capital markets recovery, both of which will underpin margin expansion. In our Building Operations & Experience segment, we expect above-trend mid-teens revenue growth, supported by local further expansion in the U.S. and a full year contribution from Industrious. We anticipate continued operating leverage resulting from 2024 cost initiatives, which will drive high-teens SOP growth. In project management, we foresee significant opportunities in the U.S. and UK across infrastructure and traditional real estate. Combining the Turner & Townsend and CBRE project management businesses requires a complex integration. As such, in the first year, we are anticipating strong but slightly below trend SOP growth in the low to mid-teens. Finally, in real estate investments, we expect to improve on 2024’s SOP. Investment management operating profit will likely be flat with 2024, which benefited from a large incentive fee that will not repeat. In the development business, we see continued elevated data center activity and have positioned the portfolio to benefit from this secular tailwind, with data center site monetizations expected to contribute more than half of this year’s development profits. As to the seasonal distribution of earnings, Q1 will once again be our smallest quarter in the year. However, the quarter should see core EBITDA increase at a high-teens rate, and it should contribute a low double-digit percentage of our full year core EPS. We also expect another strong fourth quarter in 2025, which should account for a similar portion of our full year core EPS as it did in 2024. In addition, we know that our restructuring efforts are largely behind us, and we are seeing the benefit of margin expansion across the company. As a reminder, we announced a major efficiency program in GWS in early 2024 to rapidly bring costs in line with revenue. This highly successful initiative resulted in an increase in onetime cash adjustments in 2024 that will not recur in 2025. M&A related amortization and integration costs will continue, but we are highly focused on minimizing other cash adjustments. Therefore, going into 2025, we expect to meaningfully narrow the delta between our GAAP and core earnings. With an improved market backdrop, we are poised to benefit from all the work we’ve done to create a resilient, growth-oriented enterprise capable of sustaining double-digit growth in 2025 and beyond. Now I’ll hand it back to Bob for closing remarks. Bob?"
},
{
"speaker": "Bob Sulentic",
"content": "Thank you, Emma. I’ll conclude with some thoughts on our participation in the data center sector for two reasons: first, we’re receiving many questions on this topic given the amount of activity in the sector; and second, our work with data centers clearly demonstrates how our strategy plays out in practice. A foundational element of that strategy is to focus financial and operational resources in areas benefiting from secular tailwinds. And we have brought this focus to the data center sector, growing its contribution to core EBITDA from 3% three years ago to almost 10% in 2024. Over that time, our total data center profit has increased over 2.5 times. Emma commented that our development business is capitalizing on its competency in acquiring, improving and monetizing land sites to take advantage of the data center opportunity. As a reference point, we did this with industrial land to great effect coming out of the pandemic. CBRE participates meaningfully in the data center sector across multiple other lines of business as well, including project management, facilities management, brokerage and, to a lesser degree, investment management. Turner & Townsend has more than 150 data center projects underway and has completed over 500 of these projects in the last decade. Data center revenue for Turner & Townsend has increased 50% annually in each of the last three years. Our facilities management group manages over 700 data centers. Within this business, we fortified our technical services capabilities with last year’s acquisition of Direct Line Global, which serves a large base of hyperscale clients. In our advisory business, we arranged $9 billion of sales, lease and financing transactions for North America data centers last year. While total data center inventory in the market has nearly doubled in the past four years, our data center profit growth has outpaced this market expansion and is poised for continued strong growth. With that, operator, we’ll open the line for questions."
},
{
"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 Anthony Paolone with JPMorgan. Please proceed with your question."
},
{
"speaker": "Anthony Paolone",
"content": "Thank you and good morning. First question relates to capital markets. Can you talk about just your guidance around a more muted sort of recovery there versus kind of what you’re seeing right now today? Trying to understand if this volatility in rates over the last couple of months is actually paused things or if you’re just being prudent kind of with the more muted rebound."
},
{
"speaker": "Emma Giamartino",
"content": "Tony, thanks for the question. I want to step back and say when we look at our transaction activity for the year, just like we did in 2024, we look at leasing and capital markets combined because we can get to our outlook with – across a broad range of scenarios and a broad range of rate outlook. And then the other comment I want to make on rates specifically in capital markets is that this is a much smaller portion of our business than would be implied by the number of questions we get asked about this business. So moving to capital markets specifically, what we saw in Q4 is transaction activity picked up across the board, but we’re still far below peak levels. We’re 40% of 2021, and we’re not back at 2019 levels. We expect a continued pickup in 2025. We’re very early in the year, but in the first six weeks of the year, we’re seeing 20% growth in U.S. sales activity. But we are being cautious because we don’t know the trajectory of rates will be through the remainder of the year. On the financing side, we saw very strong growth in the fourth quarter. We’re expecting that to continue. And one of the important components of financing is that there’s still a tremendous amount of refinancing ahead of us. Maturities in 2025 will be at the same level of 2024, so that will drive our loan origination revenue above our sales revenue. But to tie it all together, you’ve got to think about our leasing and capital markets revenue combination. And as long as the economy remains healthy and it’s growing, our leasing revenue is going to grow. There is upside to our numbers if rates come down more than everyone is expecting at the moment."
},
{
"speaker": "Anthony Paolone",
"content": "Okay, thank you. Thanks for that. Then if I – on that note, zoom out a bit for my follow-up to just the Advisory segment more broadly. How much of the growth in SOP that you expect there is from like, say, revenue versus some margin expansion? Just trying to understand how much come from each."
},
{
"speaker": "Emma Giamartino",
"content": "So on the top line, we’re expecting low double-digit revenue growth, and then we’re expecting margin expansion on top of that."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. Yes. Thanks for the color."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Michael Griffin with Citi. Please proceed with your question."
},
{
"speaker": "Michael Griffin",
"content": "Great, thanks. Appreciate all the color you guys have given on the project management business and the growth opportunity there. Obviously, I know there’s going to be some integration aspect of the Turner & Townsend part of that business in 2025. But as you look ahead to maybe 2026 and beyond, does the Turner & Townsend growth run rate of 20% makes sense for that business? Because it seems like there’s a pretty large TAM there. So maybe how should we think about kind of long-term organic growth potential with the integration of that business?"
},
{
"speaker": "Bob Sulentic",
"content": "Michael, this is Bob. The – we don’t expect that business to grow 20% on an enduring basis, but we do expect it to grow in the mid-teens. Turner & Townsend’s portfolio of projects and the capability set they bring to the table is in areas that grow faster than what our legacy business grows. So they are, obviously, based on our opening comments, very big in data centers. They’re very big in infrastructure, very big in green energy and in traditional energy. They’re very big in manufacturing, et cetera, areas that have lots of tailwinds. What our legacy business did was much more focused on tenant finish projects for our occupier clients that would be attendant to the campuses they have and so forth. We also did some data center work, and we also did assume more complex work. But Turner & Townsend tilt us heavily in the areas that are growing more rapidly, so we expect that business combined to grow in the mid-teens. The Turner & Townsend piece was growing closer to 20%. But when you combine the two and Turner & Townsend leads it, we see it as a mid-teens grower, and we’re confident in its ability to do that. We also think there’ll be some M&A opportunities that come out of that business."
},
{
"speaker": "Michael Griffin",
"content": "Thanks Bob. Appreciate the color there. And then, Emma, I just kind of want to go back to your comments around your development opportunities. It seems like you’re pretty optimistic about the industrial portion of that. But if it seems like industrial leasing, at least this past quarter, was flat sequentially. Should we take this as you’re getting ahead of an expected recovery? And should we – do you expect an inflection point in fundamentals maybe toward the back half of this year?"
},
{
"speaker": "Bob Sulentic",
"content": "Michael, I’m going to take that one. What’s happened forever in the development business is that when the very best time comes around to acquire sites for future development opportunities, because there’s not going to be big deliveries, because rental rates are going to recover over the next several years, many, many of the participants in the market go to the sidelines. Capital sources get – are afraid to invest. And developers can’t acquire sites and start projects because they can’t raise capital. I was just at a conference offsite this week, and there was a lot of talk about that. We have a business that, because of its track record, can do a good job of raising capital right now, but we also lubricate the raising of third-party capital by putting more of our own capital into those projects at this juncture. So last year, we’ve talked about it quite a bit. We – on balance sheet, capitalized two big portfolios, one office portfolio and one industrial portfolio – excuse me, one multifamily portfolio and one industrial portfolio. We think those projects are going to harvest at a time when there’s very little new product coming on, when rental rates will have recovered and when vacancies are down. We believe those projects will create great profit opportunities for us. There’s smaller investments we’ve made in other projects that we think will have the same dynamics when they harvest. We’re going to start 50 projects in Trammell Crow Company this year. We think they’re going to harvest at a great time, and that’s really the strategy in that business. So we have very seasoned developers. They’re very, very good at land acquisition. They’re very good at land development, which allows us to get land lifts on things like industrial at the right time and data centers at the right time. But we believe that business is positioned to do very, very good things for CBRE, as evidenced by Emma’s comments that we see $900 million of embedded profit in what we have underway in the business now."
},
{
"speaker": "Michael Griffin",
"content": "Great. That’s it for me. Thanks for the time."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Julien Blouin with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Julien Blouin",
"content": "Hi. Thank you for taking my question. There was mention of the investment management division being sort of one of the more underappreciated parts of the business and where there’s maybe the most opportunity. I’d love to dig in a little bit on that. And also when we sort of think about the guidance for 2025 being flat, I guess, just trying to understand what the drivers of that are. Is it more on the sort of cost side affecting the SOP growth? Is it top line? Is FX having a meaningful impact? Just sort of trying to unpick that."
},
{
"speaker": "Bob Sulentic",
"content": "Julien, we think the entire Real Estate Investment segment of our business is underappreciated. It includes Trammell Crow Company, our development business, I just commented on that. Why do we think that our investment management business is underappreciated? It’s a big business. It’s generated tremendous returns for our clients over the last decade. We have a number of funds that are very high-performing funds, a logistics fund here in the U.S., a core fund in the U.S., a core fund in Europe, value-add funds in the U.S. and Asia, a secondaries fund in the UK, all of which has – have performed extremely well. There are other funds that we would like to start that we have not been in a position to start because we didn’t feel that we had the experience in our leadership to do that. With the changes we’ve made to our leadership team, bringing Adam Gallistel in to be our Chief Investment Officer and elevating Andy Glanzman, who’s been on a rapid rise in his career in that business, and with our balance sheet strength that we now have, we believe we’ll be able to do additional funds to fill out holes that we have in our offering right now, and we believe we’ll be able to scale the funds that we have in place, again, by using co-investments to attract other capital. We don’t think that’s fully appreciated in the market, and we expect to see a lot of growth come out of that business and our development business over the next several years."
},
{
"speaker": "Emma Giamartino",
"content": "And I want to just comment on your question around flat SOP year-over-year. Two components. One is remember that in 2024, we had a large incentive fee in our highly successful U.S. logistics fund. If you remove that incentive fee from 2024, we would be at high teens SOP growth in 2025, which is a great outcome this early in the recovery. The other thing is this is a huge year for – we expect this to be a huge year for capital raising, and it already is in January. We expect to raise a near record amount of capital for our investment management business, which will position us very well to deliver really strong returns and strong growth in 2026 and beyond."
},
{
"speaker": "Julien Blouin",
"content": "That’s extremely helpful. I guess, maybe turning to share repurchase activity. The – It’s been really encouraging, the update since the end of the third quarter. I guess just zooming out, how do you think about share repurchase activity fitting into your strategy in 2025? And how do you see that sort of balancing against the acquisition outlook and sort of opportunities you see out in the market right now?"
},
{
"speaker": "Emma Giamartino",
"content": "So as you alluded to on the last call, we both declared that we believe our shares are significantly undervalued. We still think that’s the case given the growth trajectory of our business over the near and long-term. And so we took advantage of that over the past four, five months. Moving into 2025, as we’ve always said, we’re going to continue to prioritize M&A. We have a strong pipeline. It’s very challenging to time M&A, and it’s all about the timing of conversion and finding really great businesses that are going to help accelerate our strategy. So we’ll continue to prioritize M&A. If we get towards the latter half of the year and a number of those don’t come to fruition, we’ll fill in with buybacks."
},
{
"speaker": "Julien Blouin",
"content": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ronald Kamdem with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Ronald Kamdem",
"content": "Hey, congrats on a great 2024. Just two quick ones. If I look at the Global Workplace Solutions, so the facilities management and project management, looks like 2024 margin was sort of well above what you guys expected. So I guess, I’m curious as you’re thinking about forward, would love an update on what the pipeline is looking at, at this point of the year and what more opportunities for margin expansion there may be there."
},
{
"speaker": "Emma Giamartino",
"content": "So there’s two components of your question, I’ll start with the margin piece. So in 2024, in the beginning of the year, you’ll recall that we talked about our initiative to rapidly bring our costs in line with revenue in that business, and we were highly successful in getting those costs out in 2024 and resulted in solid margin expansion for the full year. The benefit of those impacts is not – has not entirely been realized in 2024. So we’ll see continued margin expansion in GWS and now the new BOE segment in 2025. From a pipeline perspective, our pipeline is very strong in enterprise. As I mentioned in my remarks, it’s across sectors, technology, health care. We’re seeing a bunch of renewals within financial services. And so we’re very optimistic about the organic growth within our enterprise business. And then in local, we have a really strong pipeline and a lot of growth to come in the U.S. market, which, as I’ve – as we’ve mentioned a number of times, really, is barely penetrating the U.S. market. And so we expect to continue to see a ton of growth there."
},
{
"speaker": "Ronald Kamdem",
"content": "Great. And then my second question, just staying on the Building Ops & Experience sort of segment and so forth. If I sort of think about the combination of those businesses, just would love a little bit more color on just the competitive dynamics in that business and sort of what CBRE sort of leg up is as you sort of go forward. Thanks."
},
{
"speaker": "Bob Sulentic",
"content": "Yes. Well, let me start by describing how we think about the opportunity to operate buildings around the world and then talk specifically about what we’re doing here and why we combine those businesses. First of all, we think the opportunity is defined by the base of commercial real estate buildings that exist around the world. Now obviously, there’s a whole lot less penetration in places like China than there is in places like the UK. But it is an enormous base of buildings, and it includes all kinds of asset classes, industrial, office, multifamily, hospitals, warehouses, manufacturing facilities. When you look across that base of assets, the management of that base of assets is very, very fragmented. Even though we manage 7 billion square feet, that’s just a small, small piece of that portfolio. When you manage all those different classes of assets, there are some very common things that go on: procurement; building engineering; maintaining records on the maintenance of the building and then responding to the – what you find in those records about preventative maintenance; accounting for the operations of the building. There’s all kinds of commonality, whether you’re managing a hospital or a complex warehouse. We think by bringing these businesses together that we’ll generate some strong synergies and strong learning across that kind of horizontal element to that portfolio of buildings. Then we’re building on top of that very specific capabilities. As we mentioned in our opening comments, we manage 700 warehouses. We manage a huge number of complex distribution centers around the world. It’s a huge amount of office space. We’re a very, very big manager of hospitals. And we have specific expertise on a – in a vertical sense in each of those types of buildings. What we think we’ll do by bringing this all together is grow our knowledge, grow the synergies across them, be able to scale our capabilities and, by the way, add experience to the mix with Industrious and Jamie Hodari and really grow that business faster than it’s been growing already. And it’s already been growing well into the double digits. We also think we’ll end up with a capability that’s different than has been seen in the market before. I would say it’s one of the areas of our future for CBRE that we’re most ambitious about."
},
{
"speaker": "Ronald Kamdem",
"content": "Thanks so much. That’s it for me."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Stephen Sheldon with William Blair. Please proceed with your question."
},
{
"speaker": "Stephen Sheldon",
"content": "Hey, thanks. Just wanted to follow up on industrial leasing. I think you mentioned flat industrial revenue in the fourth quarter, and I think that would maybe reflect some stabilization versus prior quarters. So specifically, how are you thinking about the outlook for industrial leasing in 2025? And are you seeing early signs of things there maybe starting to pick up?"
},
{
"speaker": "Bob Sulentic",
"content": "We are expecting to see some pickup this year in industrial leasing, not huge. There is still some sublease space or underutilized space with the big users of industrial that needs to be worked through out there. If that didn’t exist, it would – the leasing would grow faster. But we are – we expect to see industrial grow in the low single digits this year and we expect vacancies to be down by the end of the year, new deliveries to be down by the end of the year. And so as you get beyond 2025, we expect to see leasing pick up. And by the way, the opportunity for delivering new space into the market through our development business to be really strong."
},
{
"speaker": "Stephen Sheldon",
"content": "Got it. That’s helpful. And then on the – just as we think about talent within Advisory Services, I guess, how are you kind of managing headcount in this environment? Are you – have you been able to grow capacity, grow producer headcount? How much competition is out there for talent at this point? Is that getting more elevated? Or just curious what you’re seeing from a talent perspective and how that’s playing into the capacity you have as things recover."
},
{
"speaker": "Bob Sulentic",
"content": "There’s always competition for talent, and it’s a talent business. And there’s always competition for talent. That discussion comes and goes over the years and you think, oh, my gosh, it’s more competitive than it’s ever been before. I would say it’s about like it’s been before. We compete very effectively because, particularly given what’s happened in the last couple of years, the performance of CBRE, the stability of our whole business, the prominence of our brand, our ability to invest in the business, the leadership of – our new Advisory CEO, Vikram Kohli, brings to the table and his savvy around the technology that supports that business has been helpful to us in attracting people. So I would say we’ve got capacity in that business. We can grow our revenues without adding headcount. We are likely to add some headcount and do some recruiting. And you should expect the dynamics around that recruiting, the economics around that recruiting to be about what they’ve been, maybe a little better. Some of our competitors aren’t in a position to be as aggressive as they’ve been in the past on recruiting. So that situation is sorting out pretty nicely for us right now."
},
{
"speaker": "Stephen Sheldon",
"content": "Got it. That’s helpful. Great results."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Steve Sakwa with Evercore ISI. Please proceed with your question."
},
{
"speaker": "Steve Sakwa",
"content": "Great. Thanks. Emma, I guess, in terms of the guidance of the $5.80 to the $6.10, how much of that incorporates sort of the potential $2 billion of sort of capital deployment that you did in 2024. If you were to deploy that same amount in 2025, meaning, are all incremental buybacks, I guess, incremental to that earnings? Or have you factored in some benefits from M&A and/or buybacks?"
},
{
"speaker": "Emma Giamartino",
"content": "So the short answer, and I want to provide a longer answer, the short answer is there’s no incremental buybacks or M&A in that guide. So anything that we do above what we’ve already reported on will be incremental to our EPS this year. But I do want to talk more broadly about our outlook. Again, it is a wide range like we provided last year, but I want to provide some more context around it. So at the midpoint, if you look at this outlook, we believe it’s very strong. If you take out the FX headwind, we’re at a high-teens EPS growth rate, which is a really strong outcome in a year when we’re early in a recovery, but we’re not expecting the acceleration that you’d see when interest rates dropped to near zero. Our resilient lines of business in aggregate, we’re expecting to grow around 15% organically, which is a really fantastic outcome. And then there’s an upside to what we’re expecting. So to get towards the higher end of the range, more development monetizations could drive that increased sales activity. And we’re also doing a lot of work around our interest expense. So we’re doing a bunch of balance sheet hedging, which I expect should positively impact our EPS in the latter half of the year. The downside would be around the slowdown in the economy, which would drive leasing growth a little bit slower than we’re expecting. No one expects that to be the case. And so if you step back and you look at our entire outlook, we have more confidence that we’ll be at the upside, the higher end of our range from the downside."
},
{
"speaker": "Steve Sakwa",
"content": "Great, thanks for that extra color. I guess, I don’t know, Bob or Emma, just I was curious on the comments you made about office leasing and said you paced 28% gain in the U.S. I guess, my question was just more around the volume of improvement versus, say, doing a short-term renewal, pay CB one rate, but a 10-year deal where the company has got confidence pays you guys a lot more. So was the upside more driven by more volume or just length of lease or both?"
},
{
"speaker": "Bob Sulentic",
"content": "Well, we saw volume increase, Steve, across many markets. I think – I would argue there was a pretty profound shift in what was going on in office leasing toward the back half of last year. So it has been, let’s call it, a Park Avenue phenomenon that was really driving this thing, leases in New York, there’s big fees around leases in New York. Well, what we saw in the back half of the year was pretty strong growth in all the gateway markets and upward rental pressure in the Park Avenue type locations, except for, really, Boston and San Francisco. We saw strong growth in other markets like Dallas and Atlanta and Seattle. And even beyond that, in the next tier of cities, Minneapolis and Pittsburgh. So we saw something different happen. We spent a lot of time with our clients, and what our clients said is their view of their use of office space has kind of stabilized. And it wasn’t down as far as we thought. They were down about 8% per employee. We thought it might be settling lower than that. And the ones that weren’t certain about how much office space they were going to use suggested that it was more likely they would use more rather than less. And so I do think we’re seeing a little bit of a return to the mean post-COVID. I don’t think we’re going to go all the way back to where we were in 2019. But it also appears, based on empirical evidence, that we’re going to go further back than we thought we were before. And so that’s really what you’re seeing come through our numbers, and that’s what is causing us to – in 2025 the way we do in terms of the growth of the business. Emma, you might want to add to that."
},
{
"speaker": "Emma Giamartino",
"content": "Yes. And specifically to your question around term versus volume, it was a mix of all of it. So rent was, like Bob said, relatively flat year-over-year. We saw some increases in New York and other markets in – from a rent perspective. But we saw the big drivers were average square footage per lease, which a big deal. That increased significantly, and then term obviously increased as well. So it was a good mix."
},
{
"speaker": "Bob Sulentic",
"content": "Great, thanks. That’s it for me."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Alex Kramm with UBS. Please proceed with your question."
},
{
"speaker": "Alex Kramm",
"content": "Hey, good morning everyone. Just – I think this was mostly GWS or BOE related. But can you just remind us about your exposure to the U.S. government? I know you did the J&J acquisition last year to scale up that business. So with all this talk about DOGE, et cetera, just wondering how you think about any sort of risk or maybe near-term opportunities as all that is reviewed."
},
{
"speaker": "Bob Sulentic",
"content": "Alex, we don’t have a lot of government exposure. J&J was an important acquisition that did give us government exposure. But think about where the exposure was. It’s hospitals and defense. It’s in areas that we wouldn’t expect a lot of downward pressure. And more importantly, it’s just a little teeny piece of our business that gives us exposure to expand no matter how big the government is. It’s very, very huge compared to what we’re doing with them now. So we expect that to be an expansion opportunity. The other thing that comes to mind quickly in our business whenever the government slows down, we’ve got a big business in Washington, D.C. on the advisory side. We don’t own space in Washington, D.C. We’re doing – we’re not doing office development in Washington, D.C. But we did do a lot of leasing in Washington, D.C. And so if there’s churn in that market because of downsizing or exiting spaces to go into smaller spaces, we think the churn probably will help our business there. Now it’s not going to be big enough that it’s going to be a needle mover for our whole company, but that’s one of the good-sized markets we have. And we expect some churn there that might be helpful to our business. We just had our – all of our advisory local market leaders from around the country in Dallas for a meeting this week. And I met with the woman that runs our D.C. business, and she was feeling like the churn might be a good thing for them. So a lot of uncertainty about what’s going to go on there. But we’re not concerned that there’s going to be any meaningful downward impact on our business anywhere."
},
{
"speaker": "Alex Kramm",
"content": "Fair enough. Thank you for that. And then I understand that capital markets are becoming a smaller and smaller piece of your revenue and earnings base. But maybe given that it’s the beginning of the year, how do you think about the ultimate potential for that business? I heard you talk about slightly below 2019. And obviously, much below 2021. But obviously, the economy and your footprint has grown. So how – what’s your latest thought about the ultimate, I guess, TAM when we get into a much bigger environment? And what’s the latest thoughts on how that flows to the bottom line? Thanks."
},
{
"speaker": "Emma Giamartino",
"content": "So if you step back and you think about prior recoveries, I think you’re talking to what the growth rate should be over the next couple of years because of the recovery. We saw strong growth last year. Like I said, we’re seeing on the sales side 20% growth in the early part of this year. That should continue through the first half of this year, but then you get into the second half and you’re up against some challenging comps. And again, we have to remind everyone, we’re not seeing this flood of activity like you would see when the economy is challenged and rates dropped significantly, and none of us expect that to happen this year. But you could see the steady growth continue through this year and the next year. And we’ll get – it will take a few years to get back to prior peak levels. Coming out of prior downturns, even when we’ve had interest rates dropped significantly, it’s taken five years plus to get back to peak levels of capital markets activity. So once we get back there, the steady-state growth in that business is around a mid to high single-digit – mid-single-digit range, but we have a long way to go. We have a good amount of growth until we get back to that level of growth."
},
{
"speaker": "Alex Kramm",
"content": "Good, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from the line of Jade Rahmani with KBW. Please proceed with your question."
},
{
"speaker": "Jade Rahmani",
"content": "Thank you very much. I was wondering if you could comment on a few discrete earnings items, including integration and cost reduction charges, tax rate and share count. On the cost and add-back side, I think those items were around $350 million, half of which came in 4Q. So just wondering if that’s an ongoing item, if there’ll be some increase due to resegmentation. Second would be tax rate, which came in at 18%. And I noticed some tax and audit charges, if there’s anything there you would like to mention. And finally, share repurchase. You said $800 million since 3Q, which I think implies – most of that was actually so far in 2025. I estimated around 2 million shares repurchased in 4Q. So if you could comment on those three items, please. Thank you."
},
{
"speaker": "Emma Giamartino",
"content": "So starting with the adjustments, Jade, I provided a good amount of color in my opening remarks. We announced, as you recall, in early 2024 that we were going through a cost reduction initiative within our GWS segment to rapidly bring those costs in line with our revenue. That program was highly successful, but it is now complete. And so going into 2025, those restructuring costs that you see in our adjustments should largely go away. M&A integration costs and amortization will, of course, continue as we continue to do M&A, but we are very focused on bringing those onetime restructuring costs down to near zero in 2025. On the tax front, you’ll recall that in Q1 2024, we had a large tax benefit. And for the full year, that drove our tax rate below what we typically see to 18%. In 2025, we expect our tax rate to return to its normalized levels of 22%. On the share repurchase front, we did $500 million worth of share repurchases in the fourth quarter, and the remainder was in January and February."
},
{
"speaker": "Jade Rahmani",
"content": "Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. We have reached the end of our question-and-answer session. And I’ll now turn the call back over to CEO, Bob Sulentic, with closing remarks."
},
{
"speaker": "Bob Sulentic",
"content": "Thank you, everybody, and we’ll talk to you again when we report first quarter results."
},
{
"speaker": "Operator",
"content": "This concludes today’s conference, and you may disconnect your lines at this time. Thank you for your participation."
}
] |
cbre | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the CBRE Third Quarter 2024 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Chandni Luthra, EVP, Global Head of FP&A and IR. Thank you. You may begin."
},
{
"speaker": "Chandni Luthra",
"content": "Good morning, everyone, and welcome to CBRE's Third Quarter 2024 Earnings Conference Call. Earlier today, we posted a presentation deck on our website that you can use to follow along with our prepared remarks and an Excel file that contains additional supplemental materials. Today's presentation contains forward-looking statements, including without limitation, statements concerning our business outlook, our business plans and capital allocation strategy, the timing of expected asset sales and our earnings and cash flow outlook. Forward-looking statements are predictions, projections or other statements about future events. These statements involve risks and uncertainties that may cause actual results and trends to differ materially from those projected. For a full discussion of the risks and other factors that may impact these forward-looking statements, please refer to this morning's earnings release and our SEC filings. We have provided reconciliations of the non-GAAP financial measures discussed on our call to the most directly comparable GAAP measures, together with explanations of these measures in our presentation deck appendix. I'm joined on today's call by Bob Sulentic, our Chair and CEO; and Emma Giamartino, our Chief Financial Officer. Throughout their remarks, when Bob and Emma cite financial performance relative to expectations, they are referring to actual results against the outlook we provided on our Q2 2024 earnings call in July, unless otherwise noted. Also, as a reminder, our resilient businesses include facilities management, project management, property management, loan servicing, valuation and asset management fee in our investment management business. Our transactional businesses comprise sales, leasing, market origination, carried interest and incentive fee in the investment management business and development fee. Finally, Unless otherwise noted, whenever we site growth rates, we are referring to the percentage change versus the 2023 3rd quarter in U.S. dollars. With that, please turn to Slide 5 as I turn the call over to Bob."
},
{
"speaker": "Bob Sulentic",
"content": "Thank you, Chandni, and good morning, everyone. CBRE's performance in the third quarter was marked by strong financial results, operational gains across key parts of our business and continued advancement in our strategic positioning. I'll comment briefly on all 3 areas, starting with our financial performance. We posted our second highest third quarter core earnings on record with core earnings per share up 67%. All 3 business segments posted strong double-digit revenue and segment operating profit growth, along with significant operating leverage. Key drivers included our resilient businesses, where net revenue grew 18% to $3.6 billion, led by Turner & Townsend, as well as leasing, which posted a 19% revenue increase fueled by accelerated office demand. In addition, capital markets transaction activity has passed an inflection point and is in the early stages of recovery. Operationally, GWS' results reflect the cost efficiency efforts we discussed on our first quarter earnings call and put us on course for full year margin expansion. The integration of the CBRE project management business with Turner & Townsend is proceeding with pace and the combined business will start 2025 with considerable momentum. Consolidated free cash flow grew considerably, reflecting our focused efforts to improve cash conversion across our segments. On the strategic front, we have a strong pipeline of attractive investment opportunities both for M&A and our services businesses and co-investments in our REI businesses. Further, our efforts to scale and diversify our business have resulted in a growing total addressable market. We've widened growth avenues in managing data centers and federal government facilities through recent acquisitions in GWS and the Turner & Townsend, CBRE project management combination opens up opportunities in infrastructure, energy and data center projects. Geographically, our Japan and India businesses have grown to the point where they are the second and fifth largest contributors to advisory SOP. Our success and scale have positioned us for continued outsized growth in these huge economies, and we expect them to be disproportionate contributors to CBRE's future growth. For full year 2024, our strong year-to-date performance and momentum entering Q4 have prompted us to raise our outlook for full year core EPS to a range of $4.95 to $5.05, up from $4.70 to $4.90 previously. Now Emma will discuss our third quarter results and outlook in greater detail. Emma?"
},
{
"speaker": "Emma Giamartino",
"content": "Thanks, Bob. I'll start by providing context on how our business has greater earnings growth potential than at any point in our history. We focused on expanding our resilient earnings streams and as a result, our SOP from resilient businesses has increased from approximately 32%, coming out of the global financial crisis to around 60% today. These resilient earnings are significantly less volatile than our transactional businesses. And most importantly, we expect them to achieve enduring double-digit organic growth, which we believe can be boosted even further by M&A. Our investments in resilient businesses have changed the complexion of our company. For context, core EPS fell 30% peak to trough during the downturn we just experienced versus 80% during the GFC. And we are poised to surpass prior peak core earnings next year, less than 2 years from the trough of the downturn. Coming out of the GFC, it took 6 years to return to peak earnings. Now let me walk you through the highlights of each segment's results. I'll start with advisory on Slide 6. Advisory net revenue exceeded expectations, supported by leasing strength in the beginning of a recovery in property sales revenue. We continue to benefit from our strong position in the office leasing market. In fact, global office leasing revenue reached a new high for any Q3, increasing by 26% better than we expected. Greater certainty about the economic outlook is supporting occupier decision-making across primary and secondary markets, particularly in the U.S. and Europe. As expected, demand is skewed towards the highest quality space that will encourage employees to return to the office. Global property sales returned to growth with a 14% revenue increase, exceeding expectations. Revenue grew across all global regions. In the U.S., property sales revenue rose almost 20%, driven by stronger activity in multifamily and retail. This complemented strength across our mortgage origination business, which benefited from a 36% increase in loan origination fees. In addition to continued activity from debt funds, originations picked up notably with the GSEs. Overall, advisory SOP rose almost 50%, and net SOP margin increased by more than 350 basis points. Please turn to Slide 7 for a review of the GWS segment. Overall, net revenue for GWS increased 19%, in line with our elevated expectations. Within Facilities Management, net revenue increased 22% with broad-based strength in both the enterprise and local businesses. Through the third quarter, we secured more new enterprise business, including first-generation outsourcing wins and existing contract expansions than in all of 2023. This lays a strong foundation for net revenue growth in 2025. Project Management net revenue rose 12%, led by the Turner & Townsend business. Turner & Townsend exhibited strength across its geographies and asset types with revenue up 18%, once again exceeding expectations. Turner & Townsend's sustained outperformance reinforces our level of conviction in merging CBRE's project management business under Turner & Townsend's leadership. GWS's net SOP margin improved by more than 70 basis points, in line with our expectations, reflecting our cost efficiency initiatives. Please turn to Slide 8, as I discuss the REI results. REI segment operating profit was better than expected and meaningfully above the prior year. This was led by Investment Management, which benefited from incentive fees and significant co-investment returns, reflecting improving market conditions. AUM increased to more than $148 billion during the quarter and $5 billion of capital has been raised this year. At the same time, we have fully cleared our redemption queue in our core funds and are seeing increased interest and fundraising activity across enhanced return strategies. We expect the market backdrop for AUM growth to improve considerably in 2025. As expected, we did not monetize any significant development assets during the quarter. We remain on track to realize large development profits by the end of the year and continue to steadily increase the embedded profit in our development portfolio over the long term. We added $500 million to our in-process and pipeline portfolio in the quarter, which now exceeds $32 billion. Now I'll discuss cash flow and leverage on Slide 9. Free cash flow for the quarter improved meaningfully to $494 million, up more than 60% and trailing 12-month free cash flow conversion improved to 71%. The delta between our GAAP and non-GAAP earnings in Q3 was primarily driven by noncash items. Our free cash flow forecast for the full year remains unchanged at slightly over $1 billion. The increase in EPS guidance is not expected to convert to free cash flow primarily because of the large development gains slated for Q4 will be reported in cash flow from investing. Adjusting for this impact, our free cash flow conversion for the year would be within our target range of 75% to 85%. Finally, we are on track to end the year with about 1 turn of net leverage even after deploying $1.3 billion of capital across M&A and co-investments thus far in 2024. Please turn to Slide 10 as I discuss our outlook. Our new core EPS expectations of $4.95 to $5.05 for 2024 represent a 12% increase at the midpoint of the range compared with our original outlook in February. We believe higher full year earnings are achievable because of the outperformance in our businesses thus far this year and our confidence in our business pipeline. We expect to deliver our best fourth quarter core EPS ever, led by GWS, which should exceed its prior SOP record by a significant margin. It is notable that we expect to achieve this level of earnings in the fourth quarter without Advisory or REI returning to prior peak profits. All segments are expected to materially exceed their prior earnings peaks in coming years. Within Advisory, we now expect over 20% SOP growth for the full year, mostly driven by stronger-than-expected leasing activity. GWS is in line with our prior expectations, we are narrowing guidance and expect to grow SOP in the high teens range for the full year. And for REI, we continue to expect multiple development asset sales to be completed in the fourth quarter. Looking to 2025, the midpoint of our new 2024 guidance implies that we are only about 12% from our prior peak earnings. Absent an unanticipated market event, we will almost certainly exceed prior core EPS of $5.69 next year, fueled by continued double-digit growth in our resilient businesses and a further recovery in our transactional businesses. Now I'll turn the call back to Bob for closing thoughts."
},
{
"speaker": "Bob Sulentic",
"content": "Thanks, Emma. Given the market's strong focus on anticipated improvement in the real estate capital markets, I'll put this in perspective as it relates to CBRE's earnings prospects. While there are secondary impacts across our business, the capital markets directly affect our performance in property sales, loan originations, Real Estate Development and Investment Management. Since these businesses are interest rate sensitive, the Fed's start of a new monetary easing cycle has recently heightened investor enthusiasm for the real estate services sector. We share the market's enthusiasm and expect to benefit from a capital markets recovery over the next several years. But it's important to stress that CBRE's strong, short and long-term growth prospects are excellent regardless of the real estate capital markets impacts. This owes to the progress we've made in building our resilient businesses, our leadership in the global leasing markets and the large and growing total addressable market for our business that I commented on earlier. Our resilient businesses are expected to generate about $1.8 billion of SOP this year, reflecting double-digit growth. We expect these businesses to continue this pace of growth for the foreseeable future. In addition, leasing, our largest line of business by profits is close to surpassing prior peak revenue and earnings this year with considerable room for further growth. As a result, we don't need a capital markets recovery to surpass prior peak earnings in 2025 or to sustain strong growth beyond next year. Real estate capital markets are important to our business, but their lower relative contribution to our performance underscores the extent to which we have evolved and diversified CBRE's business and underpins our confidence in a strong long-term outlook. With that, operator, we'll take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first questions come from the line of Michael Griffin with Citi."
},
{
"speaker": "Michael Griffin",
"content": "Bob, I want to go back to your comments about kind of the capital markets activity passing an inflection point. As we kind of look into 2025, do you have a sense of how steep the acceleration of this recovery is going to be? Will we be sitting here a couple of quarters from now in lapping comps up 30% or 40% year-over-year? Curious just kind of what you're seeing from an acceleration perspective?"
},
{
"speaker": "Bob Sulentic",
"content": "Our current expectation is not that it's going to be a steep capital markets recovery. We think it will be a steady recovery, we think buyers and sellers have largely come together for most asset classes or very close to having come together, not for office, I think, obviously. There is debt available now. There is some positive leverage available now. There's increased interest in multifamily. We've actually seen a little bit of cap rate compression in multifamily and industrial, not much. So we think there'll be a steady improvement next year, but we don't think it's going to be a precipitous improvement. Our plan doesn't anticipate a precipitous improvement. And the anecdotal evidence that we're gathering would suggest that it's going to be more of a steady improvement."
},
{
"speaker": "Michael Griffin",
"content": "That's helpful. And then just going back to your comments around kind of the double-digit expected growth over the near to medium term in those resilient business lines. Can we get a sense -- was this really organic driven? Are you assuming some level of external growth and kind of that expected growth number? I'm just curious, I mean it seems that the stickiness of this -- the nature of these businesses, it seems like you do have pricing power for a lot of this stuff. Just if you could maybe comment on kind of where that growth is coming from?"
},
{
"speaker": "Bob Sulentic",
"content": "I'll comment and then I'll ask Emma to also comment. But you mentioned near and medium term, but it's near, medium and long term that we're expecting double-digit growth in these businesses, and it's organic getting us into low double-digit range that will be supplemented by investment -- M&A investment we feel very good about that. As I mentioned in our call today, which we haven't talked a lot about before, but we started to focus on it. Our total addressable market is growing. It was already a huge addressable market, total addressable market for outsourcing that had been only partially tapped. But with Turner & Townsend, with the acquisitions we've done, the total addressable market now for organic growth from where we sit is very strong. We've got these 2 businesses in India and Japan that have become quite prominent for us. an awful lot that we've barely gotten started with in those 2 markets. We've got great leadership teams there. We expect them to be able to grow significantly on a double-digit basis for years to come. But we do have a lot of capital. We do have an M&A strategy, and we think we can supplement that through M&A. So I'm going to let Emma talk about that a little bit."
},
{
"speaker": "Emma Giamartino",
"content": "And so I would add on our resilience SOP, I think we’ve talked about it before, but this is a big earnings stream for us. And for the year, we expect it to deliver $1.8 billion of SOP. So that’s grown at a double-digit rate over the past number of years, and we expect that to continue. That has been both organic and M&A, but to Bob’s point that organic growth has been in the low double-digit range, and we expect that to continue. I think what is not always appreciated is that we’ll end this year at about 60% of our SOP from resilient lines of business. And because of the growth in these businesses, even through a transaction recovery, we expect to remain around that 60% range over time. And then in terms of M&A, we are continuing to look at opportunities to expand mainly in the technical services space within Facilities Management, but also elsewhere, I look at deals like J&J that we did earlier this year, which expanded into the federal government space, and we believe that’s a $20 billion market. And then direct line in the data center space, which we believe is a $30 billion market. So we expect to – we’re looking at more of the same. But of course, as we always say, M&A takes a long time. We want to do deals that are right for us with really strong operating leaders in areas where we think we can deliver a really strong return."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Anthony Paolone with JPMorgan Chase."
},
{
"speaker": "Anthony Paolone",
"content": "My first question relates to leasing. I mean, how should we think about the potential to grow office leasing from here because you mentioned it being like, I think it was the best third quarter in the company's history. And so I'm just trying to understand if there was some clearing of the backlog or pulling forward of demand there, to kind of see like where it goes from here and what normalized might be?"
},
{
"speaker": "Bob Sulentic",
"content": "So, Tony, we don't pretend to have a great view as to exactly where office leasing is going to go. It's been a little bit of an unknown for all of us since we came through COVID, here's what we do believe. There's a lot of news around prime space being leased up in a number of markets at the highest rates ever. And because of our participation in those markets, we've done well. However, we don't believe that this leasing success we've seen recently is driven by prime space. We believe it's being driven by occupiers who want space and are targeting prime space first. And when that prime space is leased up, they will move on to the next best thing, which will give landlords owners of office buildings, the incentive to invest in B and B+ buildings to move them toward A. So we think we're going to see some sustained strength in office leasing. We think we're going to see a continued slow return to the office. We do not believe we're going to go back to pre-COVID levels. But I'll say what I've said on the last 2 or 3 calls, we spend a lot of time with occupier customers. We've got a big conference. We've got 900 people in Dallas this week with our GWS Enterprise business. And everybody is talking about office space as being important to their future. So we expect there to be a sustainable move toward office space that is creating good experiences to get people back in the office. And we think the leasing success we've seen is going to continue into next year and beyond."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. My second question is, if we look back earlier in the year, you guys had some cost pressures that emerged and you took some actions, it seems like, and we saw the margin expansion in the quarter. How should we think about whether you -- whether that's all dialed in at this point? Or how should we think about margin expansion as we look into next year? Is there still room for that? Or any thoughts there?"
},
{
"speaker": "Emma Giamartino",
"content": "So the majority of those cost actions were done across Q2 and Q3. So what you're seeing this year is not the full run rate impact. So of course, you'll see a continued impact to our margins -- really strong benefit to our margins in GWS in the fourth quarter. And for the full year, we're expecting our GWS margins to improve over last year. And then that should continue into next year. Again, this is a business that you're not going to see a step change in our margins, but we should see a continued improvement through next year."
},
{
"speaker": "Operator",
"content": "Our next question is coming from the line of Steve Sakwa with Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "Bob, I can understand why you don't want to forecast a sharp recovery in the Transaction business. It's certainly not in your best interest to predict that. But to the extent that one occurred, I guess what I'm just trying to figure out is, is it really predicated on just kind of the Fed easing cycle sort of unfolding as they've kind of laid out, is it really having the long end of the bond yield curve kind of coming back down? Is it more stability in the bond yield? Like what would get a sharp recovery in your mind versus a more modest recovery?"
},
{
"speaker": "Bob Sulentic",
"content": "Steve, I think all of that contributes to it. But I believe, and I commented on this last quarter, what would create a sharp recovery is more stability in interest rates, maybe them coming down a little bit, but some thought leaders among the investor community stepping into the market, doing some transactions and causing others to believe they had to get in and move quickly because in the absence of doing that, they would end up being buyers downstream at higher prices. And we have seen a little bit of compression for cap rates for the best multifamily and industrial assets already. So I don't think it's totally about interest rates coming down or interest rate stability. I think it's also partially about buyer-seller psychology, which it always is in cycles, of course."
},
{
"speaker": "Steve Sakwa",
"content": "Okay. Maybe, Emma, just on sort of the share buybacks, as we think about kind of you guys using free cash flow next year, assuming it's kind of at least $1 billion again. How should we just think about the benefits, acquisitions versus buybacks? And given that the stock is at a much higher price and a higher valuation today, does that sort of temper your enthusiasm for share buybacks? And if you don't do that, kind of where does the free cash flow go?"
},
{
"speaker": "Emma Giamartino",
"content": "So I’ll start by saying it does not temper our interest and share buybacks. We are continuing M&A balancing that with buybacks when it makes sense. I will say, as we look at where our share rate is today, valuation of today, it remains at this place, we will definitely consider more buybacks than we’ve done in the past. We believe that we’re trading at a significant discount to our intrinsic value."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Stephen Sheldon with William Blair."
},
{
"speaker": "Stephen Sheldon",
"content": "First, I wanted to ask about incremental margins in capital markets, as we are at the early stages of recovery. And specifically, will you need to do much rehiring within capital markets, especially in terms of supporting head count to be able to capitalize on higher volumes? What are you seeing there?"
},
{
"speaker": "Bob Sulentic",
"content": "We've got considerable capacity in our mortgage origination team. Although we're adding talent to that team, we've got a great leader in that area of our business who's doing a great job of recruiting. And we've got capacity in our investment sales team. So we don't need to add talent to grow those businesses materially. But it is important, and maybe I should make a clarifying comment. We talk so much about the growth of our resilient businesses because that's an important part of our strategy. But we are doing nothing to restrain the growth of our transactional businesses. We're the market leader in capital markets and leasing, and we're investing in growing those businesses. So you should expect to see us add talent to both the leasing side of the business and the capital markets side of the business, but we don't need to do that to grow significantly from where we are now."
},
{
"speaker": "Stephen Sheldon",
"content": "Understood. That's helpful. And I wanted to maybe -- second, I wanted to drill down into the margin in the GWS segment, great trends there this quarter. I think you talked about there's maybe still some flow-through impact that we should think about some of the actions you took in prior quarters. But just as we think about the next 2, 3, 4 years, what levers do you have to keep pushing margins higher there over time?"
},
{
"speaker": "Emma Giamartino",
"content": "So there’s a number of levers. This piece is really resetting. This first stage is really resetting, our cost base, mainly – primarily focused on our operating expenses overall across the business. The second piece that we’re extremely focused on, and we’ve seen some progress in is focusing on contracts, and these are very large contracts, especially in our Enterprise business at incrementally higher margins. So we should – you should continue to see a benefit from that over time, as we do M&A in these highly technical services, all those businesses operate at a higher margin than our traditional business. So that will continue to improve margins over time. And then there’s other things that we can do within our contracts, even our existing contracts to improve that margin. So it will be a steady increase over time, but know that we’re very focused on delivering that steady increase over the next few years."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Ronald Kamdem with Morgan Stanley."
},
{
"speaker": "Ronald Kamdem",
"content": "A quick one for me. Just going back to the GWS business, I was wondering if you could talk a little bit more about the pipeline, breakout between sort of first generation versus existing contract. I guess I'm wondering, are enterprises just overall engaging more? Or are you guys sustaining share?"
},
{
"speaker": "Emma Giamartino",
"content": "We are seeing an increase in first-generation outsourcing contracts. We've talked about it over the last number of quarters and even years. Those contracts typically take or those clients typically take, as you'd expect, longer to convert, sometimes they can take over a year. But we're seeing significant progress there. We're also seeing significant progress in expansions and new wins within our existing client base. Anything that you want to add to that, Bob?"
},
{
"speaker": "Bob Sulentic",
"content": "No. I think we're seeing -- as we've always said in that business, we get a lot of growth out of expansions because we get in the door with these enormous occupiers that have -- I'll give you an example. I was having lunch with one of our clients the other day, who runs real estate for a prominent U.S. manufacturer. They have 2,100 leases and facilities around the world. And we do a lot for them that there's a huge amount we don't do for them. And he was telling me how happy they are with what we do in various areas and how they want to expand the relationship. And if you're sitting in the seat, he's sitting in, the demands on you to make that portfolio of properties perform cost effectively to create great experiences on the manufacturing side, where we're able to do more and more to be more efficient from inside the yellow lines perspective. All of that creates opportunity for us. And all of that would come in the expansion area. And then there continues to be a good number of corporations, hospitals, universities, others who -- government entities who are considering outsourcing and haven't done it yet."
},
{
"speaker": "Ronald Kamdem",
"content": "Great. My second question was just going to be, you guys are leaders in multiple different business lines, and you sort of talked about the ability for sort of clients to engage in those business lines. I guess I'm just wondering from sort of the last 2 quarters where you've seen sort of acceleration in capital markets. Are you seeing that thesis sort of through that?"
},
{
"speaker": "Bob Sulentic",
"content": "Yes. Unfortunately, you're almost totally cutting out, and we didn't hear the question."
},
{
"speaker": "Ronald Kamdem",
"content": "Sorry about that. Clients being able to engage in multiple business lines, are you seeing that playing out as capital markets are recovering and any sort of anecdotes you could share?"
},
{
"speaker": "Bob Sulentic",
"content": "Well, we are seeing that play out especially on the occupier. But on the capital markets side, we -- on the occupier side, we see it more. But on the capital markets side, we do, do a lot of work for those clients. We do valuations work. We do property management work. Obviously, we do building sales work. We do debt financing work for them. So there is a lot we do for the investor clients. They're in the capital markets side of the business as well. Those solutions don't tend to be as integrated as the occupier solutions are, but there's plenty we do, and we have some enormous clients on that side that we interface with on an account basis as opposed to a one-by-one transactional basis."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next questions come from the line of Jade Rahmani with KBW."
},
{
"speaker": "Jade Rahmani",
"content": "Quite different to be talking about upside at this point in the cycle. I wanted to ask about Trammell Crow. First question would be, if you've identified significant parcels of land entitled currently for industrial, that could be repurposed for our data center use and our devising strategies either through sales or joint venture to monetize such investments."
},
{
"speaker": "Bob Sulentic",
"content": "Yes. Jade, it is a fact that the path to data center land does fairly regularly run through logistics land sites that happen to have adequate power. And because we have a big position in logistics land sites, that's one of the core competencies of Trammell Crow Company to identify and acquire logistics land sites. We are seeing some opportunity there that we're quite confident will result in strong financial returns for us. And we, not surprisingly, given that have a proactive effort underway to identify more of that land. We alluded to it a little bit over the last few quarters. This amount of pent-up profits in our in-process portfolio, the fact that we've put incremental balance sheet capital into the development business when others were on the sideline. That's a significant strategic initiative for us that's probably more prominent than appears on the surface."
},
{
"speaker": "Jade Rahmani",
"content": "And to take the question one step further, relates to some of your initial comments around M&A and infrastructure. Would you contemplate combining aspects of Trammell Crow or REI with something in the infrastructure management or data center space? Across real estate coverage conglomerate type businesses tend to have a discount associated with the development arm because investors struggle to find predictability to earnings. Perhaps that relates to Emma's comments that CBRE might be trading at an intrinsic value discount. But one way to unlock this could be through a strategic transaction in the alternative asset manager space as real estate asset managers tend to trade at very high multiples. Just curious as to your thoughts about potentially spinning off Trammell Crow or combining with something and really building out this data center capability."
},
{
"speaker": "Bob Sulentic",
"content": "Well, there’s some good insights in that question, Jade. I want to start by saying we are not contemplating trading off Trammell Crow Company because it does so – not only is it a really good, really well-run business that generates high returns and creates opportunities for them to invest our capital. But it does interface really productively with other parts of our business, and I’m going to give you an example. During the middle of the COVID stay-at-home era. We started a fund called USLP. It’s a fund that exists in our Investment Management business. We’ve told part of this story before, but it was seeded by a portfolio of Trammell Crow Company industrial development projects, plus also using our own balance sheet to secure a couple of portfolios. And anybody that watches the investment management business knows how hard it is to scale a core-plus fund early on. We started that fund in COVID, put the whole thing together by Zoom. None of the meetings, none of the interface was done in person. Started during COVID. From a standing start, that fund today is $5 billion. That fund would not exist in all probability without Trammell Crow Company. And Trammell Crow Company gives us opportunities to do that in other areas. We’ve got all kinds of things we’re looking at with Trammell Crow Company and our Investment Management business together. Another example, and we’ve alluded to this too, there – we got $2 billion-plus manufacturing plants that we’re handling the land acquisition, land development and project management on in a venture between Turner & Townsend and Trammell Crow Company. If you talk to Denselancy at Turner & Townsend, or Danny Queen and the Trammell Crow Company, they would tell you neither one of them would have done those deals alone. We think that positions them well to do more of that. That’s the kind of thing that gives us confidence about where this business is going to go. So not only is on a kind of freestanding basis is Trammell Crow Company, a really good business for us to have. It does a lot with our other businesses. The other thing I’ll say is it generates a lot of cash with immediate cash conversion that we can use to invest all over CBRE. So a lot that can be done with that business."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Peter Abramowitz with Jefferies."
},
{
"speaker": "Peter Abramowitz",
"content": "And congrats on a very strong quarter. Just wanted to dig into the leasing a little bit. You called out office globally, it was up 26%, which is very impressive. Just curious if we could go sort of broad-based. What are you seeing on the industrial side? How did that compare to the up 26% in office? And any sort of general comments on how things are trending for industrial leasing?"
},
{
"speaker": "Bob Sulentic",
"content": "Industrial leasing is trending up, not at the rate that office leasing is. And one of the reasons for that is there's some huge, huge users of industrial space that everybody is aware of. And they took down a lot of space over the last few years, and there -- and they've got vacancy in their portfolios that they're burning through. We think that, that's going to kind of come through the pipeline over the next year or 2 years and that demand will then pick back up on the leasing side after that. But we do expect leasing for Industrial to be better next year, although not dramatically better than it was this year."
},
{
"speaker": "Peter Abramowitz",
"content": "All right. That's helpful. And then maybe to go back to -- I think it was Steve's question, just about rate sensitivity in the capital markets recovery. I guess the Fed has put out this playbook, but the longer than the curve has kind of remained stubbornly high here. So just curious to hear your thoughts on if that continues to be the case, how that would impact sort of your thinking around the magnitude of the capital markets recovery?"
},
{
"speaker": "Emma Giamartino",
"content": "And Peter, we’re really focused on the next few months, what we’re seeing through the end of the year. In the guidance that we gave, with the midpoint of $5 of EPS, that embeds a high level of confidence in what we believe is going to happen in the capital markets. So our – we’re expecting our investment sales revenue to grow in Q4 by 30%. So that’s not a low number. I realize it’s off a low base. But – and we have high visibility into that number. I know there’s been lots of questions around rates have gone – the tenure has gone above 4 recently. We don’t expect that to have a huge impact over the next couple of months. We’ve had a record number of rate locks through August and September, and we’re seeing the – the sales activity come off of that. So there shouldn’t be a lot of volatility through the end of the year in our sales activity."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Anthony Paolone with JPMorgan Chase."
},
{
"speaker": "Anthony Paolone",
"content": "I just have one follow-up. I understand the data center team and the attractiveness there. I was wondering if you could spend a minute on just kind of where you see CBRE's biggest revenue opportunity in that ecosystem? Like what do you see yourselves really doing most there? And how do you make money at it?"
},
{
"speaker": "Bob Sulentic",
"content": "We’ve got a bunch of exposure to data centers, Tony. We already talked about the land plays that Trammell Crow Company is making that give us opportunities to profit there. Turner & Townsend has in excess of 110 hyperscale data centers that they’re project managing. We have a data center services business where we manage data centers on behalf of occupiers, we manage between 700 and 800 data centers in that business. We just did the direct line acquisition that has – the early returns on that are really encouraging, and we synergize that with that Data Center Services business. And that does small projects inside the inside the white lines and data centers. So that’s very strong. We have a data center sales business in our Advisory business that’s very, very capable. And with all those things going on in data centers where we have prominent positions, we are doing a decent amount of strategy work as to how we could extract more from that and where we can go from here. We’re not ready to describe any specific strategic initiatives yet, but we’ve got a lot of exposure, a lot of expertise, and we’re exploring opportunities."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Steve Sakwa with Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "Just one quick follow-up. Emma, just on the loan servicing business. I realize it's not terribly large, but it was basically flattish in the quarter. I know you sort of referenced it here in the press release, but just anything that kind of pushed that down that was abnormal this quarter?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes. The underlying growth is 5%. I think what you see is basically 1% growth, but the actual growth is 5%. We’ve moved from some escrow income had to be moved from loan servicing to the commercial mortgage origination line."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jade Rahmani with KBW."
},
{
"speaker": "Jade Rahmani",
"content": "With the 60% contribution from resilient businesses, which is expected to remain near that level, what are your thoughts around instituting a regular quarterly dividend?"
},
{
"speaker": "Emma Giamartino",
"content": "Jade, it’s something that we evaluate over time. Right now, we think that we love the flexibility of buybacks, and we’ve been able to execute on our buybacks over the past number of years. So as long as we expect to continue to do that, we don’t think that a dividend is necessary, but it’s something that we evaluate."
},
{
"speaker": "Operator",
"content": "We have reached the end of our question-and-answer session. I would now like to hand the call back over to Bob Sulentic for closing comments."
},
{
"speaker": "Bob Sulentic",
"content": "Thanks, everybody, and we look forward to talking to you again when we report our year-end results."
},
{
"speaker": "Operator",
"content": "Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day."
}
] |
cbre | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Second Quarter 2024 CBRE Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chandni Luthra, Executive Vice President, Head of FP&A and Investor Relations. Thank you, Sunny. You may begin."
},
{
"speaker": "Chandni Luthra",
"content": "Good morning, everyone, and welcome to CBRE's Second Quarter 2024 Earnings Conference Call. Earlier today, we posted a presentation deck on our website that you can use to follow along with our prepared remarks and an Excel file that contains additional supplemental materials. Before we kick off today's call, I want to say how excited I am to have joined CBRE last month. I know many of you will already and others I'm looking forward to getting to know better in the weeks and months ahead. Now I'll remind you that today's presentation contains forward-looking statements, including without limitation, concerning expected benefits and synergies from the combination of Turner and Townsend and CBRE project management and other M&A transactions, our business outlook, our business plan and capital allocation strategy and our earnings and cash flow outlook. Forward-looking statements are predictions, projections or other statements about future events. These statements involve risks and uncertainties that may cause actual results and trends to differ materially from those projected. For a full discussion of the risks and other factors that may impact these forward-looking statements, please refer to this morning's earnings release in our SEC filings. We have provided reconciliations of the non-GAAP financial measures discussed on our call to the most directly comparable GAAP measures, together with explanations of these measures in our presentation deck appendix. I am joined on today's call by Bob Sulentic, our Chair and CEO; and Emma Giamartino, our Chief Financial Officer. Now please turn to Slide 5 as I turn the call over to Bob."
},
{
"speaker": "Bob Sulentic",
"content": "Thanks, Chandni, and welcome to CBRE. Good morning, everyone. CBRE had a successful second quarter for 3 reasons: first, revenue, profitability and cash flow exceeded our expectations. Second, we made several sizable capital investments consistent with explicit elements of our strategy. Third, we made quick material progress on the cost challenges we identified last quarter. I'll briefly touch on all 3. As a reminder, when M&I referenced our performance relative to expectations, we are comparing results to the outlook provided on our last quarterly call. With this in mind, each of our 3 business segments outperformed expectations for both net revenue and segment operating profits. Highlights included Turner & Townsend, 18% and net revenue increase and revenue growth of 13% in U.S. leasing and 20% in mortgage origination fees. We believe that our advisory segment is on the cusp of an inflection point. On capital deployment, we made significant commitments in the quarter in support of our strategy. Combining CBRE project management with Turner & Townsend, will create an exceptional operator in an enormous space with significant secular tailwinds, given its scale this combined business will have a profound impact on the future of CBRE. I'll discuss the implications of this move in more detail following Emma's remarks. We continue to make investments that take advantage of the lack of capital available for well-positioned real estate opportunities by committing approximately $250 million in the second quarter to development projects, we believe can be harvested at favorable times in the cycle. Our investment management, development and brokerage businesses enable us to identify and execute these opportunities, and our balance sheet gives us the capacity to act on them. Finally, our acquisition of Direct Line Global enhances our capabilities in data center management, a huge market that is growing rapidly. Regarding progress on costs, actions taken in our GWS segment resulted in improved margin versus Q1. This, coupled with new business wins has put us back on track to achieve full year margin expansion, along with mid-teens top line growth and mid- to high teens bottom line growth in this segment. Taking all of this into account, along with our expectations of a strong second half, we have increased our outlook for full year core EPS to a range of $4.70 to $4.90, up from $4.25 to $4.65 previously. Now Emma will discuss our second quarter results and outlook in greater detail. Emma?"
},
{
"speaker": "Emma Giamartino",
"content": "Thanks, Bob, and hello, everyone. I'll begin by highlighting the strong performance of our resilient businesses and an improvement in transaction activity. As a reminder, our resilient businesses include facilities management, project management, property management, loan servicing, valuations and investment management fees. Together, these businesses increased net revenue by 14%, reflecting double-digit organic growth and a strong contribution from M&A. Notably, our GWS and Advisory segments together delivered double-digit net revenue growth for the first time in 18 months, with combined leasing and capital markets revenue increasing for the second consecutive quarter. Our REI segment has also seen an upturn in activity, contracting to sell multiple development assets at attractive valuations, which we expect to complete in the fourth quarter. Now please turn to Slide 6 for a review of the advisory segment. Advisory net revenue rose 9%, with growth in every line of business, except property sales. Globally, leasing revenue exceeded our expectations, led by 13% growth in the U.S., including a nearly 30% jump in office revenue. New York, a bellwether for CBRE was a key driver of the increase. Retail, albeit relatively small, also exhibited strength while industrial activity declined. Leasing momentum has continued in July, supported by a pickup in demand in many large U.S. office markets. Turning to Global Property sales. Revenue began to stabilize, declining only 2% on a local currency basis and 3% in U.S. dollar terms. A 4% decline in the U.S. was somewhat offset by growth in the U.K. where property values have largely reset. While APAC was down in dollar terms, sales revenue ticked up slightly in local currency. Our mortgage origination business produced very strong growth, supported by a 20% increase in origination fees. Loan origination growth was driven by debt funds, which are offering short-term refinancing to bridge the gap until interest rates decline. Advisory's net revenue from resilient businesses rose 11% in aggregate. And overall, advisory SOP rose 9% and net margins ticked up slightly compared with Q2 2023. Please turn to Slide 7 for a discussion of the GWS segment. The segment's net revenue rose 16%, above our expectations, and we are pleased that organic growth also improved by double digits. GWS delivered strong business wins with a healthy balance of new clients and expansions. In addition to robust sales conversion, our pipeline is up more than 6% from the end of 2023. And driven by technology and energy sectors. Product Management net revenue delivered double-digit growth. Bob will go deeper on Turner & Townsend, a business that we do not believe is fully appreciated later in the call. Turning to Facilities Management. Net revenue rose 18% and 11% on an organic basis. We committed nearly $300 million in facilities management M&A in the quarter. Most of the capital went to the Direct Line acquisition, which positions us to accelerate our growth in data center management, an estimated $30 billion market that is growing rapidly. We also acquired a small local facilities management business in Canada. Local Facilities Management started as a U.K.-focused business that had $630 million gross revenue in 2013. And is now a global business with $3.1 billion of gross revenue in 2023, a 17% compound annual growth rate. This business has significant headroom, especially in North America. GWS' net OP margin improved by 20 basis points from the first quarter to 10.1%, better than expected, reflecting our decisive cost actions. We expect to see year-over-year margin expansion in our full year results as those cost actions take effect. Please turn to Slide 8 as I discuss the REI results. Segment operating profit was slightly better than expected, although significantly lower than prior year, driven by the absence of meaningful development project sales. This is consistent with our plans going into the year, but we now believe we are approaching a period when we again generate significant profits from the sale of development assets. Investment Management operating profit was better than expected, largely due to higher co-investment returns. AUM is now at more than $142 billion. The $3.6 billion we've raised thus far this year was offset primarily by lower asset values as well as adverse FX movements. However, asset value declines have moderated, and we have seen evidence of valuation stabilizing in certain preferred asset classes in the U.S. and Europe. Investor sentiment continues to improve with increased appetite for both core and enhanced return strategies. Now I'll discuss cash flow and capital allocation on Slide 9. Free cash flow improved meaningfully to $220 million and conversion was nearly 90% for the quarter. We are increasing our free cash flow outlook for the year to slightly over $1 billion and now expect to be end the year with about 1 turn of net leverage even after deploying $1.3 billion of capital thus far in 2024 across M&A and co-investments. Our year-to-date 2024 capital deployment brings our 3-year total to approximately $4.8 billion, $3.7 billion in M&A and over $1 million in REI co-investments. M&A is integral to our strategy of enhancing our capabilities in parts of our business that are secularly favored or cyclically resilient. The acquisitions we executed in this quarter are clear examples of advancing this strategy. Our investments in development have accelerated and put us in a position to harvest as much as $750 million in profits over the next 4 years. Our combined in-process portfolio and pipeline now stands at nearly $32 billion. Over the last few years, when many developers were on the sidelines, our teams have taken advantage of this opportune time in the cycle to source industrial, multifamily and data center land sites in highly desirable locations. We anticipate strong growth and returns from M&A and co-investments and expect to continue making highly accretive investments supported by our strong balance sheet. Please turn to Slide 10 for a discussion of our outlook. As Bob mentioned, we are increasing our expectations for full year core EPS to the range of $4.70 to $4.90, driven by higher revenue in SOP in each segment. We anticipate a very strong fourth quarter, which should account for just over 45% of our full year EPS. Within advisory, we now expect mid- to high teens SOP growth driven by stronger-than-expected transaction activity. For GWS, we anticipate mid-teens net revenue growth and a full year net SOP margin that is better than the 11.3% we produced in 2023. Our improved outlook is driven by the facilities management acquisitions in Q2 and the effects of our cost actions. For REI, our improved SOP outlook is primarily due to the large development asset sales expected to be completed in Q4, which we believe portends an upturn in this business. Before I conclude, let me take a minute to update you on our longer-term outlook. We have increased confidence in achieving record EPS in 2025, assuming a continued supportive macroeconomic environment. A return to peak core EPS, just 2 years following our earnings trough reflects how well we've improved the resiliency of our business compared with prior downturns. We expect even stronger resiliency in the next cycle as a result of the moves we are making. There are several reasons for our increased confidence in our outlook. First, we expect continued double-digit growth across our resilient businesses, which are on track to contribute $1.8 billion of SOP for full year 2024, up from nearly $1.6 billion in 2023. Second, while it's difficult to predict the cadence of the recovery, we can achieve record earnings without an accelerated rebound in transaction activity. Finally, we expect additional strong growth from the capital deployment plans I described earlier. Taking all of this into account, we have great confidence in sustaining a double-digit long-term growth trajectory. With that, I'll hand the call back to Bob."
},
{
"speaker": "Bob Sulentic",
"content": "Thanks, Emma. I'll close with some thoughts about Turner & Townsend. While Turner & Townsend has some similarities to traditional commercial real estate project management businesses, its differences are significant and compelling. Beyond traditional corporate real estate project management, Turner & Townsend manages large complex programs in the infrastructure, natural resources and green energy sectors. Examples of this include their work for the Sydney Australia rapid transit system, the New York Metropolitan Transit Authority, Toronto and Abu Dhabi's international airports, and the first new nuclear power station to be constructed in the United Kingdom in over 20 years. These programs typically span many years and include an array of individual projects. When Turner & Townsend project work for corporate clients, it typically involves larger, more complex, strategically important assignments. For instance, they are currently program or project managing 112 hyperscale data centers and the creation of multiple billion dollar plus advanced manufacturing plants around the world. Turner & Townsend is also the world's largest cost consultancy, a rapidly growing practice that secures the best pricing from the marketplace and optimizes cost performance across large complex capital programs. The combination of Turner & Townsend and CBRE project management will create significant revenue synergies between the 2 businesses client bases and yield meaningful cost synergies through economies of scale and eliminating redundant functions. Turner & Townsend's leadership team will oversee the combined business. They have an exceptional track record in the areas of growth, strategic decision-making and risk management. Since Vincent Clancy took over as CEO in 2008, Turner & Townsend's net revenue has grown from approximately $225 million to $1.5 billion in 2023 and a compound annual growth rate of 13%. Since CBRE acquired our 60% ownership interest in November 2021 and Turner & Townsend's net revenue has grown at a compounded rate of nearly 20%, attesting to the benefits of being part of CBRE's platform. Finally, I want to stress that the combined business, which is positioned to provide years of resilient double-digit growth is large. It is expected to generate approximately $3.5 billion of net revenue and more than $0.5 billion of SOP in 2024. The business will be large enough resilient enough and rapidly growing enough to change the long-term profile of CBRE. Now operator, let's open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question is from Ronald Kamdem with Morgan Stanley."
},
{
"speaker": "Ronald Kamdem",
"content": "Congrats on a great quarter. Just starting with the GWS business. You talked about sort of the full year margin improvement being above last year, but all the cost sort of impact is going to take place in the second half, presumably second half is also going to be much higher than the first half. So how do we think about sort of annualizing the second half margin? Is that sort of a good run rate going forward for the business?"
},
{
"speaker": "Emma Giamartino",
"content": "So Ronald, what you saw in Q2 is that we took a lot of cost actions in our margin within Q2 and at 10.1% was above what we are expecting and above what we achieved in Q1. And it's obviously not near the run rate that we expect to target. For the full year, we're expecting the overall margin to be above that 11.3% that we delivered last year. So you're going to see higher margins in the second half. And then going into next year, that run rate will be even higher than where we get to for the full year. But we're not going to get to the second half margins on a run rate basis."
},
{
"speaker": "Ronald Kamdem",
"content": "Got it. That's helpful. And then just my second 1 is just on the Advisory expectations and transaction activity. Maybe can you just talk about what you're seeing on the ground? What are you seeing in the pipeline? Obviously, maybe a better rate backdrop but what sort of gives you confidence and conviction that you're seeing these green shoots given that we have had fits and starts in the past"
},
{
"speaker": "Bob Sulentic",
"content": "Ronald, first of all, thanks for picking up coverage on us. We're thrilled to have Morgan Stanley following us. The first part of the answer to your question is very anecdotal. We had the quarter, we had in leasing and mortgage originations in the second quarter. And the positive activity has continued into the first part of the third quarter, and I'm going to pass it to Emma to let you talk -- let her talk a little bit more about that. But there are some other things that are giving us confidence. So for instance, we get insight from the fact that we do a lot of different things. We're not only are we an intermediary, but we're a principal. And in our development business now, we are seeing demand for projects that we didn't expect and it's going to happen in the fourth quarter of this year. That gives us confidence that other parts of the capital markets are acting that way. Obviously, there's a sentiment out there that there's going to be a couple of rate cuts or at least one rate cut this year. the bid-ask spreads are narrower than they were before, except maybe in office. Our investment sales brokers and mortgage brokers are more active and have stronger pipelines than they did before. Our work with office tenants, where we measure through all kinds of different mechanisms and surveys sentiment has gotten better. So we have this anecdotal evidence from the second quarter starting and then the third quarter. And then we have more technical evidence that causes us to think that we may well have gone through an inflection point on transactions that's going to impact leasing. It's going to impact sales. It's going to impact mortgage brokerage, and it's going to have a really nice impact in the fourth quarter on the profitability of our development business. Emma, you might want to add to that."
},
{
"speaker": "Emma Giamartino",
"content": "Yes. So Ronald, what we're seeing on the leasing side is that continues to pick up globally. In the U.S., you're -- we talked about we're seeing the greatest strength in office leasing. Industrial has been declining slightly, but office is more than making up for that. And so continuing into July, we're seeing early signs of accelerating growth within leasing. And we think that would be a great outcome. So we're expecting that to continue through the remainder of the year. On the sales side, we do see strong signs that the sales market is stabilizing. Globally, we're still seeing declines, but you can argue that it's relatively flat globally. Sales activity for us revenue in the quarter was only down 2% on a local currency basis. And we're actually seeing going into July. And again, it's very early. So we're not going to call anything, but we're starting to see an uptick in activity in the U.S. sales market."
},
{
"speaker": "Operator",
"content": "Our next question is from Anthony Paolone with JPMorgan."
},
{
"speaker": "Anthony Paolone",
"content": "Bob, you talked about the distinction between Turner & Townsend and just the more traditional commercial real estate businesses. I mean -- is that something that you would consider spinning off at some point? I mean, you kind of talked quite a bit about those differences and making this disclosure change. So it seemed like maybe you do think of this as being a bit different than the rest of what CBRE does?"
},
{
"speaker": "Bob Sulentic",
"content": "Tony, it's different. But there's a lot of synergy between what Turner & Townsend does and what we do, and it's 2-way synergy. They're -- they operate in 60 countries around the world, and they're more substantial in parts of the world than we are. We've been able to introduce them to our client base in a number of places very successfully. And I'm going to give you an anecdote, and I'm going to give you some numbers, one that's repetitive. Turner Townsend grew over Vince Clancy's tenure 13% for many, many years on a compounded basis, more than a decade. Since they've been part of us, they've grown at 20%. Anecdotally, and I mentioned earlier, where we benefit from having a whole bunch of different businesses that we undertake. Anecdotally, there are a couple of major corporate manufacturing plants that Trammell Crow Company and Turner & Townsend, are cooperating on to deliver the development services work and the program management work billion-plus dollar plant, we believe at Trammell Crow Company, and we believe that Turner & Townsend, and Vince and his team believe that those projects wouldn't have been landed by us, had we not had the ability for those 2 businesses to cooperate. So Turner & Townsend would be a great public company, make no mistake about it. There's a lot of enthusiasm for companies like them in the public markets today. They're very unique even relative to other large program and project management firms and large engineering firms. But they fit really, really nicely with us. And we think there's going to be a great story long term there. We've put Vince on our board because we think there's so much synergy between what he and his business do and what the rest of our company does. So I hope they're a very long-term part of CBRE."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. And when the disclosure has changed, then have sort of the remaining facilities business and then the project management, how should we think about just organic growth for the facility is a piece of it, because it sounds like project management is going to be pretty high. Just where does that lead facility is?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes. Facilities management, we believe, has a low double-digit organic revenue growth trajectory for the very long term, and that's supported by 2 components. One, the enterprise side, which is where we manage large occupier clients globally, that business should grow at a high single-digit rate. And that's where you see most of our competitors play in that space. So where our facilities management business is different from our competitors is our local business. And that's, as you know, the regionally focused business that I talked about in my remarks that has grown in a 17% compound rate. over the past decade. And that business should grow at the low to mid-teens rate, which is bringing up and even higher over time, and we expect to do M&A within the local sector, so that on an organic basis, we are confident that we'll remain in the low double-digit range. And then M&A on top of that will get us higher."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. Got it. And if I could just ask one more question just on the guidance. How much of the [BOM] should we think about as coming from just the outlook for selling more stuff than Trammell Crow and the development gains there?"
},
{
"speaker": "Emma Giamartino",
"content": "So we increased guidance across all 3 segments. So I'll walk through all 3 of them. Within Advisory, as you'd expect, increase in transaction activity, and we're getting to mid- to high teens SOP growth. Within GWS, the increase is largely due to M&A. Our organic growth expectations are in line with what we expected going into the year. And we're getting to mid- to high teens SOP growth for the year within GWS as well. And then REI is probably about past of the contribution for the increase in guidance and those couple of very large development deals that we expect to monetize in the fourth quarter. And when you look at the second half, what you're seeing is accelerated growth across all segments. Advisory, you're going to see low double-digit revenue growth in the second half, but very strong SOP growth as we have very strong high incremental margins across our leasing and sales business. And then GWS, as we've talked about, we've expected very strong revenue growth in the second half as both M&A picks up in the second half and as the large contracts that we won earlier this year and late last year start to be onboarded. And again, we've done a lot of cross works. You're going to see higher than higher than our run rate margins within GWS in the second half as well."
},
{
"speaker": "Operator",
"content": "Our next question is from Jade Rahmani with KBW."
},
{
"speaker": "Jade Rahmani",
"content": "On capital market side, could you characterize the tone and tenor from participants in the quarter. Property sales were still down year-on-year, but commercial mortgage surged. Could you please provide some color on what you're seeing?"
},
{
"speaker": "Emma Giamartino",
"content": "So on the commercial mortgage side, we saw a strong uptick in loan origination, and that was primarily for refinancing. So there is a big uptick in loan source from debt funds. Volumes from debt funds increased by over 70% in the quarter. And that was all refinancing. They're offering very short-term bridge loans to bridge providers until the banks and the agencies pick up. We actually saw a decline in originations from banks and the agencies as well. So we expect that to pick up in the second half of the year as rates come down."
},
{
"speaker": "Jade Rahmani",
"content": "On the sales side, are you seeing an uptick in acquisitions yet? Or is it still pretty subdued there most of deal flows on the debt side?"
},
{
"speaker": "Emma Giamartino",
"content": "We're still seeing -- we're having a slight uptick in acquisitions, but it's off such a low base that it's not meaningful. It's not a meaningful contributor to our increase."
},
{
"speaker": "Jade Rahmani",
"content": "On the leasing side, many office tenants continue to shrink on average, somewhere around 10%, 12%. But activity was so substituted the past 2 years, you are seeing an uptick. Could you talk about that and also comment on retail?"
},
{
"speaker": "Emma Giamartino",
"content": "So on the office side, we are -- we think we've stabilized in terms of size of transactions, and we're really seeing an uptick in volume, and we're seeing our uptick in terms of regionally we talked about it, you're seeing most of that increase in New York as occupiers are transacting across larger deals. We aren't seeing big movements in terms of square footage per transaction in terms of, obviously, rent per transaction, all of those metrics seem to have stabilized."
},
{
"speaker": "Jade Rahmani",
"content": "And lastly, on the REI uptick, is that primarily driven by multifamily. I believe that's around 30% of the pipeline. Could you comment as to the percentage of gains. Are they going to be lower than historical due to the cost inflation we've seen as well as interest rates? Or do you think the demand for new products is outweighing that?"
},
{
"speaker": "Bob Sulentic",
"content": "Jade, let me ask you to clarify that. When you say REI, are you talking about development or the investment management business?"
},
{
"speaker": "Jade Rahmani",
"content": "Yes. Sorry, I should have clarified. Within REI, the Trammell Crow business."
},
{
"speaker": "Bob Sulentic",
"content": "The activity we're seeing is across 3 product types, data centers, industrial and multifamily. The stuff we harvest in the fourth quarter is going to be more skewed towards data centers than it ever has been before. That -- and what's happened there, and again, I don't mean to be too repetitive in what I say. But because of the number of things we're doing across our platform, we end up being in a very strong position to generate certain kind of benefits that we wouldn't other generate. We wouldn't otherwise generate. Trammell Crow Company, when you hear the headlines, there's a developer. We build this kind of building or that kind of building when we sell it. But one of the things that Trammell Crow Company is exceptional at is land acquisition, entitlements and then developing on the land or harvesting land sites at a profit. The development work they've done over time on the industrial side has put Trammell Crow Company in a position to end up with considerable amounts of land that can be used for data centers. When that happens, the transition from industrial land to data center land generally results in pretty significant profitability, and that's going to be a big part of the picture you see in the fourth quarter. Looking out a little further, though, what's really, really important to know is that there has been a real lack of capital for securing development -- new development opportunities in the market the last couple of years. We went through that ourselves third-party capital slowed way down. That started to come back significantly. We've capitalized a good number of development projects with third-party capital this year. But the other thing we've done is we've come in ourselves, and we've identified opportunities in a bigger way than we have historically to use our own balance sheet to buy development land and in some cases, fund components of the development process beyond the land -- and we are -- we study it very closely. We are quite confident that we are going to be developing projects and in particular, multifamily projects into markets where the number of new projects coming online has slowed down dramatically. And that's what you're seeing or hearing in our comments about profitability coming out of that business."
},
{
"speaker": "Jade Rahmani",
"content": "Can you say whether the increase in guidance or the uptick in REI in the fourth quarter is predominantly due to the data center sales. I have in my coverage team homebuilders, for example, sell land parcels, they intended for residential to data center developers and they've generated huge gains, but those really are not as sustainable as their regular business."
},
{
"speaker": "Emma Giamartino",
"content": "So the uptick in the fourth quarter is large -- in REI, is largely related to the data center asset sales. But the comment around is whether that's sustainable. I think one of the pieces that we really focused on in our remarks is the embedded profits within our Trammell Crow in-process and pipeline portfolio. And we talked about $750 million of profit that are in that portfolio today at relatively conservative underwriting assumptions that we expect to generate over the next 4 years. Now that will be more weighted towards the out years as it takes time to build these projects. But there is a significant amount of earnings embedded in that portfolio and is very much sustainable. And we do think that, that element of our business is underappreciated, the amount of profits that will be coming out of that. And so when you look at these data center sales that we're expecting this year, we believe that, that's a signal to us that there is an upturn in this business coming and there will be an uptick from here."
},
{
"speaker": "Bob Sulentic",
"content": "If I could, I may just add on to that. And Jade, to specifically address what you said and that $750 million does not depend on all kinds of good luck with industrial sites transitioning to be data center sites. That's an asset-by-asset review of our portfolio. For the purposes that we acquired it for unless we know today that it's going to move to another asset class and measuring where we think it will come out over time."
},
{
"speaker": "Operator",
"content": "Our next question is from Michael Griffin with Citi."
},
{
"speaker": "Michael Griffin",
"content": "Just want to go to capital deployment for my first question. Obviously, you guys have been so far this first half of the year, whether it's through M&A or buying back stock. I'm wondering if you can give us a sense of how you weigh kind of those opportunities against each other. Is there a time where your stock price might hit a certain dollar amount, you're like all right at the time to really get aggressive here and just kind of how you weigh those 2 factors against each other. Color there would be appreciated."
},
{
"speaker": "Emma Giamartino",
"content": "Yes. So our strategies remain consistent in terms of capital deployment. We prioritize M&A and we're focused on looking at strategic, highly accretive acquisitions that drive a very strong return and will enhance our capabilities, we've been very focused on facilities management and project management. We expect both of those to ticking up over the next few years. Our pipeline is very strong, though we always caution that it's very difficult to predict M&A, and we are extremely diligent in our underwriting. And so we focus on the deals that make the most sense and are going to drive the strongest return. And then in every single one of our deals, they have to exceed a hurdle rate that makes sense and they have to exceed the return that we would get from share repurchases. So we look at where we're [indiscernible] trading compared to your extrinsic value and make sure that those deals exceed that. If we don't have a tremendous amount of M&A in our pipeline or it's difficult to execute for whatever reason, and you've seen this in the past 3 years, we will buy back our shares. This year, we've done a lot of M&A so far, so I don't expect a tremendous amount of repurchases in the second half of the year, but that's simply a result of the amount of capital we've deployed this year."
},
{
"speaker": "Michael Griffin",
"content": "Emma, can you give us a sense of kind of those hurdle rates you're underwriting for potential M&A opportunities?"
},
{
"speaker": "Emma Giamartino",
"content": "So well above our cost of capital. Most of our deals -- I think all of our deals are underwritten at above the mid-teens returns. And that's pretty much all I can say about that."
},
{
"speaker": "Michael Griffin",
"content": "Great. That's helpful. And then my second question was just kind of on the leasing. I know you touched on it earlier, particularly for the office side. But -- are you seeing this greater demand coming from all office products broadly? Or is it just in kind of that [Tropin] Class A product. And then you called out New York as a relative bright spot, but I'm wondering if there are any other big markets either domestically or globally, that surprised you to the upside?"
},
{
"speaker": "Bob Sulentic",
"content": "Well, for sure, Class A office space is really attractive now because so many companies are focused on the experience of their employees, the productivity of their employees, the presence of their employees, et cetera, that's a well-documented dynamic. And it's easier to make that happen in better quality office space. But beyond New York, yes, in the tech markets, we're seeing considerable pickup. And I believe -- we believe that it's driven by AI and all the activity around AI, the Bay Area, Austin, Texas, et cetera. We're seeing a pickup in those markets."
},
{
"speaker": "Operator",
"content": "Our next question is from Steve Sakwa with Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "Most of my questions have been asked. But I guess 1 small just follow-up. I know the share buybacks was relatively light in the quarter, but I didn't necessarily see a the actual shares bought back or an average price on the buybacks. I don't know if you have that."
},
{
"speaker": "Emma Giamartino",
"content": "In the quarter, it was minimal. We repurchased $50 million worth of shares at an average price off $87."
},
{
"speaker": "Steve Sakwa",
"content": "Great. And then maybe, Bob, just on the cost containment, obviously, that seemed to maybe come through much faster than I think you expected and we expected, maybe just speak to that a little bit. And I guess just how are you thinking about talent retention and talent acquisition at this part of the cycle? And how does that maybe affect or not affect kind of the margins going forward?"
},
{
"speaker": "Bob Sulentic",
"content": "Steve, we have a philosophy about our business here that we want to drive this company in a way that we perform at a high level in everything we do. One of the things that we're doing in that regard is focusing more and more on getting rid of costs that don't contribute to the success of the company. Cost of every kind, technology projects that don't contribute, people that don't contribute office space that doesn't contribute. And the stuff that does contribute good office space, good technology, good people, we are aggressive buyers of those things to build our business. And what's happened is, and we have a transformation office that reports to analysts, so I ought to let Emma comment on that is we are aggressively looking for those things we can get rid of, and you saw that happen in the second quarter. But the stuff we need, we're aggressive buyers. We're aggressive buyers of land. We're aggressive buyers of talent. We brought on some spectacular talent in the last quarter. We have an aggressive technology investment program, but we are narrowing the things that we're investing in and being very careful. And Emma, if you want to add to that?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes, I will add. Our transformation office is focused on making long-term sustainable change in how we operate our business. And so we are not focused on episodic cost reduction we want to be focused on delivering consistent operating leverage over time. So you can see that margin expansion. And that's not an easy thing to do. It's something that we're very focused on. All of our business leaders are very focused on, so from here on out, everything is focused on really driving that efficiency. And as we add resources as we invest in technology, as we invest in people, those are extremely smart decisions so that we know that down the road, we don't have to cut back."
},
{
"speaker": "Operator",
"content": "Our next question is from Stephen Sheldon with William Blair."
},
{
"speaker": "Stephen Sheldon",
"content": "Nice work here. First, now that you'll have direct line, are there other pieces you might need to pursue a comprehensive facility management solution around data centers and GWS. And just generally, how are you thinking about that opportunity and the differentiation of your capabilities now relative to peers and others playing in that market?"
},
{
"speaker": "Bob Sulentic",
"content": "Stephen, to answer that question, I want to back up and talk about how we think about M&A. And I think M&I would agree that there's more work we have to do on our side to get the market that invests in CBRE's shares to understand how we do M&A. First of all, we don't have a group of businesses and a group of leaders that sits there and waits for something to come up for sale at a good price. We are a very strategy-driven company. Each of our businesses has a strategy for how they want to grow. And that strategy is very attentive to, a, adding capabilities and b, adding capabilities in areas that we think will sustainably do well in the marketplace, either because they're cyclically resilient or they are secularly favored. There's no better example of that, obviously than Turner & Townsend. So if you look at our facilities management business, doing things that the marketplace wouldn't expect us to do because we've asked the leaders in the various sectors within facilities management, so manufacturing, financial technology, et cetera, to understand their business and the capabilities that they can be in that business that will differentiate it and make it attractive to our clients in the long run. They wouldn't go out in the marketplace seeking out those acquisitions. So the deals that you've heard us make in the last year, those -- we do not do those deals through auctions. None of those deals came to Turner & Townsend, wasn't done through an auction, J&J wasn't done through an auction. Direct Line wasn't done through an auction. The local FM business we bought in Canada, during the quarter wasn't done through an auction. Those were -- none of those were done through an auction. We went to the sellers of those businesses or the owners of those businesses and pursued them because we thought they were a good fit. We have ideas around our business. We have an increasingly well-developed corporate development team led by 14, 15-year Morgan Stanley veteran that then acts on those ideas to acquire them and we integrate them after that. That's our approach to M&A. And as a result, you should expect us to see -- you should expect to see us do more deals in the facilities management space and other spaces that you didn't expect because they aren't highly visible by others in the market."
},
{
"speaker": "Stephen Sheldon",
"content": "Got it. Yes, that's really helpful. And then just, I guess, as a follow-up in investment management, can you just talk about what you're seeing on the fundraising side right now? Is the environment there changed as you look back over the last few months."
},
{
"speaker": "Emma Giamartino",
"content": "Yes. We've seen a pickup activity -- inactivity. We are expecting a pickup in activity in enhanced return strategies, but we've also seen a pickup in the first half in core and core plus. And I think you're hearing that broadly across the market, which we think is a very positive indicator for the remainder of the year."
},
{
"speaker": "Operator",
"content": "Now our next question is from Peter Abramowitz with Jefferies."
},
{
"speaker": "Peter Abramowitz",
"content": "I just wanted to ask about sort of the relative stabilization and resilience versus your expectation in the investment sales market. I guess could you just give more color on what you think is driving that? And could you comment and just give some more color on whether that's dry powder on the sidelines and how much kind of pent-up demand there is from the last couple of years a pretty depressed activity."
},
{
"speaker": "Bob Sulentic",
"content": "Yes. Peter, you just said something that's really important, pent-up demand. When we talk about investment sales activity coming back, the trading of assets coming back. It's not going to be a circumstance whether the marketplace is going to become more attractive because rates have stabilized, bid-ask spreads have come down. And therefore, a bunch of people that wouldn't have otherwise been in the market are going to say, \"Oh, it's a better environment. Maybe I should sell something. \" There has been a massive base of assets held by people that wanted to sell them for the last couple of years. There has been a massive amount of capital on the sidelines that wanted to get in and do real estate deals for the last couple of years. The buyers and sellers have been there. We don't have to find them. They're there. What has to happen is the environment needs to get to a place where you're going to see people jump in and act. And what's happened is the certainty around interest rates coming down has grown the bid-ask spread has narrowed. There's less volatility in the market. And that's why in a business like our Trammell Crow Company development business, where we're a principal not an intermediary, we're seeing action very real action that's going to take place in the fourth quarter. We've been there with those assets. Now we're going to trade those assets because the environment is going to be right."
},
{
"speaker": "Peter Abramowitz",
"content": "Bob. I appreciate the color. And then I wanted to ask about specifically on the office leasing side. I guess just kind of looking at the algorithm between pricing and volume, obviously, volume is improving to start the first half of the year. Overall, I mean, are you still seeing pricing continuing to go up on those trophy assets? And then overall, in the broader market, if you zoom out to look at trophy as well as kind of Class A minus and then commodity below that, how is pricing trending? And how does that sort of affect your outlook for leasing revenues?"
},
{
"speaker": "Bob Sulentic",
"content": "Peter, Emma is a good one to answer that question because in addition to all the other things she does, she actually handles our real estate portfolio, and she's in the market now. And so she can tell you as a consumer what that feels like."
},
{
"speaker": "Emma Giamartino",
"content": "So on the office leasing side, and Bob is talking about locking in New York. For trophy assets, yes, especially in New York, those prices are increasing. But if you look broadly across our office leasing portfolio of transactions, pricing is pretty much stabilized, but there are very -- there's big differences in what's happening by asset type and by quality of assets and by market."
},
{
"speaker": "Operator",
"content": "Thank you. There are no further questions at this time. I would like to hand the floor back over to Bob Sulentic for any closing comments."
},
{
"speaker": "Bob Sulentic",
"content": "Thanks for joining us, everyone, and we'll talk to you again at the end of the third quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
cbre | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Q1 2024 CBRE Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brad Burke, Head of Investor Relations and Treasurer. Thank you. You may begin."
},
{
"speaker": "Bradley Burke",
"content": "Good morning, everyone, and welcome to CBRE's First Quarter 2024 Earnings Conference Call. Earlier today, we posted a presentation deck on our website that you can use to follow along with our prepared remarks and an Excel file that contains additional supplemental materials."
},
{
"speaker": "",
"content": "Before we kick off today's call, I'll remind you that today's presentation contains forward-looking statements, including, without limitation, statements concerning our economic outlook, our business plans and capital allocation strategy and our financial outlook. Forward-looking statements are predictions, projections and other statements about future events. These statements involve risks and uncertainties that may cause actual results and trends to differ materially from those projected. For a full discussion of the risks and other factors that may impact these forward-looking statements, please refer to this morning's earnings release and our SEC filings. We have provided reconciliations of the non-GAAP financial measures discussed on our call to the most directly comparable GAAP measures, together with explanations of these measures in our presentation deck appendix."
},
{
"speaker": "",
"content": "I'm joined on today's call by Bob Sulentic, our Chair and CEO; and Emma Giamartino, our Chief Financial Officer. Now please turn to Slide 5, and I'll turn the call to Bob."
},
{
"speaker": "Robert Sulentic",
"content": "Thank you, Brad, and good morning, everyone. Before I begin, it's important to note that Emma and I regularly reference our performance relative to expectations during these quarterly calls. In office, the expectations we are referencing are based on the outlook we provided during our most recent quarterly call."
},
{
"speaker": "We started 2024 by delivering core earnings that exceeded our expectations. This was driven in part by solid net revenue growth. However, several notable elements of our performance differed from our time going into the year. I'll touch on 3 of them",
"content": "leasing strength, property sales weakness and cost pressure."
},
{
"speaker": "",
"content": "Leasing outperformed expectations, driven by office leasing growth globally, that reflects a resilient economy and companies making progress on bringing their employees back to the office. At the same time, persistent inflation kept interest rates higher than expected, which led to underperformance in our property sale transaction activity."
},
{
"speaker": "",
"content": "Our Global Workplace Solutions segment again delivered double-digit net revenue growth even as margins fell short of expectations. Our costs in GWS have increased at an unacceptable rate, and we have initiated actions to bring them quickly back into line with revenue trajectory. These actions include consolidating the management of advisory and GWS under our Chief Operating Officer, Vikram Kohli, with an explicit focus on rapidly ringing out unnecessary costs and better integrating the solutions we deliver for occupier clients. Significant progress has already been made on these efforts."
},
{
"speaker": "",
"content": "We expect GWS' cost challenges to be mostly mitigated by year-end with the majority of our actions being initiated in the second quarter. As a result, this segment remains poised to achieve mid-teens SOP growth for the full year. Looking across the whole business. We remain confident that we will generate core earnings per share in the range of $4.25 to $4.65. Our confidence is underpinned by our resilient business' continued strong performance, our rapid actions on costs and the fact that advisory services remains on track to achieve its growth target for the year despite a more uncertain economic outlook. Emma will discuss the specifics of our outlook in greater detail after reviewing our first quarter performance. Emma?"
},
{
"speaker": "Emma Giamartino",
"content": "Thanks, Bob. At a consolidated level, core EBITDA was in line with our expectations as slight outperformance in REI and lower-than-expected corporate costs offset margin underperformance in GWS. Advisory SOP performed as anticipated."
},
{
"speaker": "",
"content": "Core [indiscernible] exceeded expectations due to a onetime tax benefit. Please turn to Slide 6 for a review of the Advisory segment. Despite an interest rate outlook that's steadily worsened throughout the quarter, Advisory net revenue rose 3%, consistent with expectations, bolstered by its first quarter of transactional revenue growth in 6 quarters and growth from every line of business except property sales."
},
{
"speaker": "",
"content": "Leasing revenue rose in every region, and global growth exceeded our expectations. Office leasing grew by double digits globally as a resilient economy and progress on return to office plans have been both intended to make occupancy decisions. We have continued to see strong momentum in U.S. leasing in April."
},
{
"speaker": "",
"content": "Financial services companies are leading the recovery with active demand up more than 20% year-over-year of U.S. gateway markets, reflecting their considerable progress in bringing employees back to the office. Tech companies continue to lag with demand 50% below pre-COVID levels."
},
{
"speaker": "",
"content": "Globally, property sales revenue declined 11% with weakness in the U.S. and APAC. EMEA is showing early signs of recovery with sales up 8% year-over-year, where growth was led by the U.K., where property values have made more progress towards resetting as well as [indiscernible]. We saw strong growth in our loan origination business despite continued weak property sales activities."
},
{
"speaker": "",
"content": "Our growth was driven by loan origination activity and escrow income. Loan origination fees grew 16%, primarily driven by a heavier weighting of higher-margin loans sourced with debt funds. Escrow income is de minimis in a low interest rate environment, but acts as a hedge in the current economic environment. We saw this in Q1 when escrow income increased nearly threefold from Q1 2023."
},
{
"speaker": "",
"content": "The remaining businesses within Advisory, Property Management, Loan Servicing and Valuations together grew revenue by 5% as expected. For the full year, we expect these businesses to deliver low double-digit revenue growth led by property management, particularly as the Brookfield office assets are on-boarded beginning in Q2."
},
{
"speaker": "",
"content": "Moving to Advisory SOP. I'll call out 2 onetime impacts that weighed on margins in the quarter. First, we experienced elevated medical claims that should reverse later in the year; and second, we trued up interest income owed to a small number of clients. Absent these onetime costs and excluding [indiscernible] margin would have improved 25 basis points versus the prior year Q1. Please turn to Slide 7 as I discuss the GWS segment."
},
{
"speaker": "",
"content": "Net revenue rose 10%, in line with our expectations. Facilities Management and Project Management net revenue were up 11% and 7%, respectively. Project Management faced a particularly difficult comparison as net revenue surged 18% in Q1 2023. We had a second consecutive quarter of very strong business wins with a healthy balance between new clients and expense."
},
{
"speaker": "",
"content": "As of the end of Q1, we already have commitments for nearly $900 million of anticipated net revenue growth, representing the significant majority of our projected growth for the full year. Having already locked in this much of our expected growth gives us confidence in achieving our full year revenue plan."
},
{
"speaker": "",
"content": "SOP margin on net revenue declined by 90 basis points from the prior year Q1. More than half of the decline reflects a onetime impact to gross profit margin from the same unusually large medical claims we saw in Advisory. The remainder is related to 2 areas of higher costs."
},
{
"speaker": "",
"content": "First, we've made investments in certain initiatives that we are discontinuing. Second, our operating expenses have crept up over time as we've expanded into new sectors, entered new geographies and added redundant costs related to recent M&A. In response, we are taking a fresh look at GWS' cost structure and are already executing substantial actions across the business. The benefit of these cost actions, as well as our elevated new business wins, will be apparent in Q3 and particularly Q4. Please turn to Slide 8 for a discussion of the Real Estate Investments segment."
},
{
"speaker": "",
"content": "This segment's significantly lower earnings were slightly better than we had expected. As we previously discussed, last year's first quarter benefited from an unusually large gain on a development portfolio while project sales activity remained subdued in the current higher cap rate environment. The value of our development in process portfolio increased by $3 billion to $9 billion in total, due to the start of a particularly large fee development project."
},
{
"speaker": "",
"content": "Investment Management performance was in line with expectations and below the prior year, largely due to slightly lower AUM. Fundraising activity was up 50% compared with Q1 2023. Inventors are showing strong appetite for enhanced return and infrastructure strategies, although we expect fundraising to flow from the first quarter's robust levels. Recent fund raising is not yet reflected in AUM, which fell modestly in the quarter to $144 billion, driven by negative market and FX movements."
},
{
"speaker": "",
"content": "Before turning to our outlook, I want to briefly touch on free cash flow. Cash flow conversion has improved for the second consecutive quarter, and we are beginning to see the reversal of incentive compensation headwinds that we experienced last year driven by record earnings in 2022. We expect to generate approximately $1 billion of free cash flow this year and end the year with around 1 turn of net leverage. Now please turn to our updated outlook on Slide 9."
},
{
"speaker": "",
"content": "Although interest rate expectations have changed significantly and the economic outlook is more uncertain as Bob noted, we remain confident that we'll earn core EPS in the range of $4.25 and to $4.65 this year. Within Advisory, we continue to expect mid-teens SOP growth unless economic conditions take a sharp turn for the worst. Our base case scenario envisions that the economy remains resilient and interest rate cuts are delayed. Under these conditions, faster leasing growth compensates for subdued sales activities."
},
{
"speaker": "",
"content": "As Bob mentioned, we also still anticipate mid-teens SOP growth for the GWS segment. SOP growth will be very heavily weighted to the second half as recent wins are on-boarded, and we see the impact of our cost-cutting efforts. In REI, we now expect a more pronounced SOP decline, given continued higher interest rates. However, the range of outcomes is better than normal, with the key variable being whether the market for development project sales improved late in the year."
},
{
"speaker": "",
"content": "While REI SOP is unusually depressed right now, we expect these businesses to lead our growth once market conditions inevitably improve. Additionally, as per broad-based efficiency efforts, our COO, Vik Kohli and I are taking a hard look at corporate costs and expect them to be lower for the year than initially anticipated. Assuming the midpoint of our outlook range, we expect to generate nearly 70% of full year core EPS in the second half of the year. This heavy normal weighting reflects the expected cadence of GWS revenue and cost reductions and a slight recovery of our property sales and [indiscernible] businesses later in the year."
},
{
"speaker": "",
"content": "Our expectations for profit growth in 2014 are now driven to a greater degree by the cost components of our business, which are within our control. As such, we remain confident in our ability to achieve our earnings outlook under a range of reasonable economic assumptions. With that, operator, we'll open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Today's first question is coming from Anthony Paolone of JPMorgan."
},
{
"speaker": "Anthony Paolone",
"content": "I guess first question relates to just the guidance at your midpoint and the comments here around 70% in the back half. I guess it implicitly means that 2Q goes down notably. And so I was wondering if you could just give a little bit more color on that, whether EBITDA also goes down sequentially or if that's an EPS matter? Anything there?"
},
{
"speaker": "Emma Giamartino",
"content": "So Anthony, I do want to walk through the components of our 2024 outlook again. And the headline is that we've -- our -- the midpoint of our outlook is unchanged, but I do want to opt to the components that were -- that built to that outcome. From the Advisory line, you saw our SOP growth trajectory is in line with what we talked about in February. However, the path to get there is slightly different because what we're seeing is that leasing is stronger than we had anticipated because of the health of the economy and sales is weaker as rate cuts have been pushed out."
},
{
"speaker": "",
"content": "On the GWS side. Again, you see that our SOP targets for the year is unchanged. We have consistently talked about the fact that our revenue growth this year in GWS will be back-end loaded as these large lumpy enterprise contracts get on-boarded in the second half of the year. And additionally, what you're seeing is we're going to take out costs from GWS, and so we're going to see margin expansion in the second half of the year."
},
{
"speaker": "",
"content": "On the REI front, we are expecting a slight decline versus last year, and that's to talk about a 10% decline. But what's important to note about REI is that there is a wide range of outcomes. And right now, we're anticipating a large number of monetizations in Q4 within our development business. And as you know, there is uncertainty around when those will hit and if they'll get pushed into 2025 or stay in 2024."
},
{
"speaker": "",
"content": "And then on the corporate segment level. Those costs are coming in lower than we had initially anticipated. So if you put all of that together, you would get to an EPS midpoint that is higher than what we've indicated. But as we said in February, we do have some conservatism embedded in our outlook because of the wide range of outcomes, especially in Advisory and in Development."
},
{
"speaker": "",
"content": "As for Q2, yes, you'll see a decline year-over-year, and that's simply because both in GWS and in Advisory, that revenue growth and that margin expansion is back end -- is second-half loaded."
},
{
"speaker": "Anthony Paolone",
"content": "So even sequentially, though, does EBITDA kind of move down sequentially from 1Q to 2Q? Today just seems a little bit counter to the normal seasonality."
},
{
"speaker": "Emma Giamartino",
"content": "No. EBITDA will not be declining from Q1 to Q2."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. And should we think about just full year EBITDA margins still being up versus '23 at this point?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes. So EBITDA margin should be up across both Advisory and GWS and at the consolidated level."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. And then just last one. You mentioned a large development project because you saw the roughly $3 billion balance in Developments underway. But it sounds like that's a fee deals. Just wondering if you can give us a little bit more detail because it's a big increase, and I always looked at that as being something that could drive, promote and your share of gains, but it sounds like maybe there's also like fee projects in there as well where you may not participate. Just maybe some more details there."
},
{
"speaker": "Emma Giamartino",
"content": "Yes. The significant majority of that increase is related to an extremely large industrial deal in the Sunbelt. It's over 2 million square feet."
},
{
"speaker": "Operator",
"content": "The next question is coming from Steve Sakwa of Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "I just wanted to touch on capital allocation. Obviously, you had the J&J deal in the first quarter. I noticed you didn't buy back any stock. I guess, first, were you in much of a blackout period, which you didn't really -- weren't allowed to buy back stock? Or was that more of a conscious decision just based on where the stock was? And how should we be thinking about, I guess, stock repurchases going forward as well as capital deployment in the more kind of economic uncertain environment?"
},
{
"speaker": "Emma Giamartino",
"content": "Steve, what you saw in Q1 was related to J&J. We've always talked about we're balancing M&A and share repurchases, and our priority is to deploy capital towards M&A and strategic M&A. And so in Q1, we pulled back on repurchases as we were executing that transaction. We have started repurchasing shares in Q2 to a small extent. And for the balance of the year, you should expect that to continue. As we do more M&A, you'll see that come through. But if we're not seeing a strong conversion of our M&A pipeline, you'll see us repurchase shares as long as our prices remaining attractive. And our goal is, on a consistent basis, to deploy at least our free cash flow on an annual basis."
},
{
"speaker": "Steve Sakwa",
"content": "Free cash flow in total?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes."
},
{
"speaker": "Steve Sakwa",
"content": "Okay. But I mean the J&J deal was a large chunk of probably your free cash flow for the year. So that kind of puts limited buyback activities in totality. Is that a fair way to think about it?"
},
{
"speaker": "Emma Giamartino",
"content": "That is fair."
},
{
"speaker": "Steve Sakwa",
"content": "Okay. And then, I guess, Bob, just on the transaction side, it's not the biggest line item, but it probably has more to do with the sentiment around the stock and how people think about the business, even though you certainly diversified the company quite a bit and made it more resilient. I'm just curious, what are you kind of hearing from the field in terms of the transactions and just rates? And is it more about the actual Fed cut? Is it more about stability in the 10-year? I mean, I guess, is it the level of rate? Or is it more of the direction of rate and the uncertainty over that, that creates kind of the pause in the market?"
},
{
"speaker": "Robert Sulentic",
"content": "Steve, first of all, there's 2 areas of our business where it really comes through in our numbers. One is our sales business, one is our development business where we sell assets and generate profits from that. At the beginning of the year, the assumption of our teams was more bullish about the trajectory of interest rates than it is now without a doubt. That shouldn't surprise anybody. I'm sure that's true across the whole market. It's also true of buyers and sellers of assets in general. And as a result, it's just slowed down activity on the sales side."
},
{
"speaker": "",
"content": "And what we're thinking about as a seller of assets in Trammell Crow Company in our development business is exactly what others are thinking about. They've decided to stay on the sidelines longer. We decided to stay on the sidelines longer. We've got a portfolio of great assets that we're going to sell at some point, but we're not going to sell them until we think the environment is such that we can get the pricing we want, and it's hard to get that pricing when interest rates are higher. And that's really what you're seeing. And the sentiment is, in fact, different now than it was at the beginning of the year. Of course, the flip side is it's different because economy is better, and we have this very big leasing business that's benefited from that."
},
{
"speaker": "Steve Sakwa",
"content": "Okay. And then last, I just wanted to clarify. I think you said, I may have missed it, that there was a tax benefit in the in the reported core EPS number this quarter. But I don't know if you sort of quantified it, and I don't recall seeing a specific mention of that in the release. So could you just clarify that, please?"
},
{
"speaker": "Emma Giamartino",
"content": "Correct. It's about a $50 million tax benefit in the quarter that will not repeat."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jade Rahmani at KBW."
},
{
"speaker": "Jade Rahmani",
"content": "Taking a step back. From my vantage point, the big growth opportunities would seem to be infrastructure, investment management and commercial mortgage. Could you comment if you agree with that and where you see the most potential?"
},
{
"speaker": "Robert Sulentic",
"content": "Project management, in general, Jade, is a big, big growth opportunity, project and program management not limited to infrastructure. Corporates are doing a lot of work. There's work in natural resources. That's -- we see that as well into the double digits enduring grower, and it's now become a very big business for us."
},
{
"speaker": "",
"content": "Our whole auction business, our whole GWS business is benefiting from a long-term secular double-digit growth profile, and we expect that to continue. We expect that to continue for our -- what we call our local GWS business and for our enterprise business. So that's going to be a strong grower for us."
},
{
"speaker": "",
"content": "We do think -- if you look at where we're at with our development business and our investment management business, they should be -- Emma commented on this in her remarks. They should lead growth over the next few years just because where the -- those businesses are really at a cyclical low point."
},
{
"speaker": "",
"content": "And if you follow the -- yes, we had a big add to our in-process development through a few which, by the way, that's a deal that Trammell Crow Company and Turner & Townsend are doing together. And before the Turner & Townsend arrangement, we would have been less well positioned to do that, and you should see more of that."
},
{
"speaker": "",
"content": "But that big portfolio of in-process projects for Trammell Crow Company has a lot of pent up profitability. And so you should see a lot of profit growth coming out of that business. And yes, we think our mortgage business is positioned for a lot of growth. So we have confidence right across our business and our ability to grow. And I can tell you, we're going through a deep dive with our strategy team and some outside help. Looking at our strategy, we've got 9 lines of business that we're in. We're the global leader in 6 of them. We're the domestic U.S. leader in development, and we are bullish about growth in all of them, not equally bullish. And I spiked out the ones that we're more bullish about. But we think the growth profile for our business, the enduring growth profile is well into double digits, certainly in the next several years, but longer term as well."
},
{
"speaker": "Jade Rahmani",
"content": "Switching to GWS. The comment around the pipeline, that seems new. So I think investors are trying to [indiscernible] that how to interpret that. Could you give some color as to how much relates to J&J, which I believe was expected to add annual revenue of $825 million. And also just the regular rate double-digit growth that was expected, how much of the $900 million is new business that would be in addition to prior expectations? And then secondly, the medical claims and overall cost controls. If you could provide any color there and why that surprised management?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes. And Jade, on the pipeline comments, can you just give us more on what you're seeing -- or what you're hearing that's different from what we've said previous?"
},
{
"speaker": "Jade Rahmani",
"content": "Well, the $900 million that was mentioned, we're trying to understand if that's accretive to prior to our prior expectations. I think in our forecast, we have about $10.2 billion of net revenue, which is [ $1.5 ] million above last year, and that in some new revenue coming in from J&J, which probably would contribute $500 million to $600 million for the year. So stripping that out, trying to compare that to the $900 million and just see how much of that is really new information versus prior."
},
{
"speaker": "Emma Giamartino",
"content": "Got it. Okay. So that $900 million is not a new information. When we provided our outlook at the beginning of the year for GWS, it was for that $900 million of -- and more of net revenue growth. That was going to come in to GWS in the back half of the year. And that's why we've been talking about the growth accelerating above trend on the revenue line in Q3 and Q4."
},
{
"speaker": "",
"content": "That $900 million does not include J&J. J&J for the year is expected to contribute a little less than $450 million of net revenue. We closed that towards the end of Q1, and it had a very small impact to Q1, given that we had only a month of revenue and profits from J&J. And so that $900 million is simply the conversion of our pipeline. We've talked about really strong conversion and strong pipelines throughout last year and in Q4 and in Q1. So this is articulation of how much is locked in with this confidence that we're going to achieve our revenue forecast for DWS for the year."
},
{
"speaker": "",
"content": "On the cost front, you're right that the majority of the cost impact has been at the gross profit line, and it is related to those employee medical claims coming in higher than we expected. But this is -- we believe this is a seasonality issue or this is a cadence of those claims. I mean it's a unique situation related to the fact that we changed health care providers for our company over a year ago. And over the first year, what typically happens is as employees are looking for new health care providers that are claimed down. And so we knew they were going to tick up this year, we just didn't expect it to happen in Q1. And so that should reverse in the remainder of the year."
},
{
"speaker": "Jade Rahmani",
"content": "That's great. One last one would just be around GWS and office. I often get the question as to when the rationalization in the office sector in terms of reduction in square footage would impact that business. Do you see that as a potential headwind realizing also that there's a lot of growth opportunities, which you've commented on. But just office, in particular, would that be a potential headwind?"
},
{
"speaker": "Robert Sulentic",
"content": "Yes. Jade, it's not a headwind that we haven't contemplated in our comments about expected growth for that business. And I made the comment last quarter that we don't have a single client in GWS that I'm aware of, and we work with the biggest tech companies, the biggest financial companies, et cetera, that doesn't view their office space as a critical asset for the operations of their business."
},
{
"speaker": "",
"content": "They're all trying to get their people together more. They're all trying to get people to spend more time in the office and less time at home. And they're very focused on using those portfolios, those office portfolios to get that done. Yes, most of them are trying to figure out if they can operate with less office space. But to get from more to less office space, they're also thinking about reconfiguring their offices and upgrading their offices and taking different office space. That's why you saw leasing go up."
},
{
"speaker": "",
"content": "A lot of companies are trying to -- particularly in the gateway markets and the better office buildings where we play aggressively, they're trying to put their employees in more attractive space. So there's nothing going on there that would cause us to think that there's a downside dimension that we haven't contemplated already."
},
{
"speaker": "Operator",
"content": "The next question is coming from Stephen Sheldon of William Blair."
},
{
"speaker": "Stephen Sheldon",
"content": "And just one for me. Great to see the improvement in office leasing. So I just wanted to ask about the other major leasing sector industrial. Are you seeing things there get any better or worse? And what do you think they [indiscernible] for leasing activity to stabilize and return to growth at some point?"
},
{
"speaker": "Robert Sulentic",
"content": "Well, we expect it to grow slightly this year and likely more next year. There's some choppiness in certain coastal markets. But the fact of the matter is some big occupiers are coming back into the market aggressively, some well-known companies. And we aren't of the mind that leasing for the industrial asset class is going to decline this year or next year. We feel good about it. It's not going to have the explosive growth that it had in 2021, et cetera, but it's not going to be a declining leasing business, in our view."
},
{
"speaker": "Operator",
"content": "The next question is coming from Michael Griffin of Citi."
},
{
"speaker": "Michael Griffin",
"content": "Great. I wanted to go back to the commentary around office leasing. I think it definitely seems positive relative to what maybe our expectations were. But -- can you unpack that in terms of where you're seeing the leasing gets done? Is it mostly on the Trophy and Class A products? Or is it spread out between the higher quality stuff and then commodity space?"
},
{
"speaker": "Robert Sulentic",
"content": "A lot in the higher-quality assets, Michael. I mean we're seeing record rental rates in some of the bigger markets in the higher-quality assets in New York as an example. We're seeing financial institutions and business services companies, in particular, taking more space. Tech is way down. But for us to have this leasing picture in tech be off the way it is, we view that as good news for us because there is nobody that pays attention to tech that thinks long run. They won't, a, get more of their people back in the office; and b, grow -- be disproportionate growers relative to the rest of the economy."
},
{
"speaker": "",
"content": "So we expect that part of it to come back. And then there are some second-tier markets. They may not be second tier forever, but what's going on in Nashville is pretty well documented. And there are other places that have that flavor to them. So those are the things that are contributing to what we're seeing in office leasing."
},
{
"speaker": "Michael Griffin",
"content": "Emma, you talked about, I think, the $50 million tax benefit in the quarter. Just in for this, I think it would be about $0.61 of earnings in the quarter. Is that the right run rate and cadence that we should think about to get to the midpoint of the full year guide? Or how should we think about that?"
},
{
"speaker": "Emma Giamartino",
"content": "For the tax rate specifically for the year, it should be about, I think, a little over 19%. Excluding the tax benefit, it's around 22%. Does that answer your question? Or you had specific about..."
},
{
"speaker": "Michael Griffin",
"content": "Yes, yes, yes. No, that does it. And then just one last one. I noticed that you didn't provide the 2025 outlook, I think, relative to last quarter in your presentation. Is the expectation still to return to peak earnings growth in '25 or get close to it?"
},
{
"speaker": "Emma Giamartino",
"content": "Yes. And our -- all of our discussion around the path to reaching peak earnings in 2025 was to provide a framework around how we're thinking about the trajectory of our business. But that path has remained unchanged, and we believe it's achievable where it sits today. And that's driven by continued low double-digit growth across our resilient lines of business at SOP level. And then on the transactional side, the SOP does not need to get back to 2019 levels for us to achieve that record level of EPS next year."
},
{
"speaker": "Operator",
"content": "The next question is coming from Peter Abramowitz of Jefferies."
},
{
"speaker": "Peter Abramowitz",
"content": "So most of my questions have been asked, but just one on the transaction markets here. Cushman mentioned on their call, it seemed to be a pretty kind of direct relationship in that investment sales for them, at least, were stronger to begin the first quarter when the rate outlook was much better. And it kind of slowed in March and April as rate expectations have gone up. So just trying to get a sense from what you see in your business in terms of the relationship between rate expectations near term and how things are happening on the ground. Just curious, your comments on kind of what you saw in the business as it directly relates from a rate perspective?"
},
{
"speaker": "Emma Giamartino",
"content": "So it varies across regions in the U.S. That is what we saw later in the quarter. There was an uptick as rates increased. But in EMEA and APAC, we didn't see that trend just given that there is different dynamics going on there and EMEA is ahead of the curve in terms of their recovery in the sales market."
},
{
"speaker": "Peter Abramowitz",
"content": "Got it. And then one other on the transaction market. Could you just talk generally about kind of the role of distressed sales in the market? Have you seen that kind of start to thaw at all, whether in the first quarter or going forward?"
},
{
"speaker": "Robert Sulentic",
"content": "There's been some distressed debt activity, selling of distressed debt. There's also been some activity, I'd call it more pending activity of selling debt portfolios that aren't distressed just because people's concern about their debt portfolio, may sell non-distressed portfolios at a slight discount."
},
{
"speaker": "",
"content": "The assets that are really distressed are office buildings, B and C office buildings, and there aren't a lot of buyers in the market for those assets right now. We do expect that there will be buyers for those assets in the market, but the pricing probably has to come down more than that."
},
{
"speaker": "Operator",
"content": "The next question is from Patrick O'Shaughnessy of Raymond James."
},
{
"speaker": "Patrick O'Shaughnessy",
"content": "Just one question for me. In your prepared remarks, you spoke to investments in certain initiatives that you are discontinuing. Can you provide some color on what those are and to the extent that they were strategically important to you or not?"
},
{
"speaker": "Robert Sulentic",
"content": "Yes, Patrick, they weren't strategically important. We may have at one time thought they were more strategically important than we do now. In fact, that's almost inevitable given that we were spending money on them and we've stopped."
},
{
"speaker": "",
"content": "But what happens in a business that's growing, and even though our sector and our company have slowed down considerably in the last couple of years, our GWS business hasn't. That business has been growing. And when you have a growing business, you tend to look for opportunities to add initiatives, to address the growth opportunity. You also tend to, because you have a lot of growth opportunity, take your eye off them a little bit when they don't work. And we had -- we built up some of that across GWS."
},
{
"speaker": "",
"content": "The fact of the matter is though, if you look at that business for the quarter, that was a $5.8 billion revenue business. The cost problem that we had net of this medical issue that Emma described is in the $15 million to $20 million range spread across a $5.5 billion-plus business. So it's lots of little things here and there."
},
{
"speaker": "",
"content": "None of our strategically important efforts in that business have changed in any significant way. We have -- I mentioned earlier in my comments, we have a big strategy effort underway with our strategy team now. We're looking at the parts of the business, where we think there is real growth opportunity and where we intend to invest in a big way. And our view of the growth opportunity with enterprise FM customers, with project management for corporates, with project management for green energy and more infrastructure, with our local FM business, none of our broad-based growth aspirations or growth initiatives have been altered as a result of the cost issues that we're after now and what we've been talking about."
},
{
"speaker": "Operator",
"content": "The next question is coming from Anthony Paolone of JPMorgan."
},
{
"speaker": "Anthony Paolone",
"content": "I think you may have just answered this, Bob. I was just going to ask about that sort of the other half of the cost outside of medical that crept up on you in GWS, like kind of what happened there, and just how it changed so quick in like, I guess, the last few months. So I don't know if you had anything else to add on that front."
},
{
"speaker": "Robert Sulentic",
"content": "Yes, Anthony, I'll add. First of all, I really think to put it in perspective, you got to pay attention to the size of that number relative to the size of that business. Again, it's $15 million to $20 million of costs that hit the bottom line in a negative way relative to what we had expected, if you ignore the medical roughly. Is that right, Emma?"
},
{
"speaker": "",
"content": "Okay. And again, that was a $5.5-plus billion business. It's a little bit of cost here and there. But it's something we stay on very closely, and we've taken aggressive action in that business to already address it. We think most of what will need to be done to correct the problems that we saw in that business will be done this quarter."
},
{
"speaker": "",
"content": "And we've also done some rationalization across our whole services business, which resulted in those businesses reporting to our Chief Operating Officer, Vikram Kohli, and elimination of a leadership layer at the CEO level of those businesses, and there'll be other actions consistent with that down through the businesses."
},
{
"speaker": "Operator",
"content": "At this time, I would like to turn the floor back over to Bob Sulentic, Chairman and CEO, for closing comments."
},
{
"speaker": "Robert Sulentic",
"content": "Thanks, everyone, for being with us, and we look forward to discussing our second quarter with you in about 90 days."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for your participation and interest in CBRE. This concludes today's event. You may disconnect your lines and log off the webcast at this time, and enjoy the rest of your day."
}
] |
cci | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Crown Castle's Third Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Kris Hinson, Vice President of Corporate Finance and Treasurer. Please go ahead."
},
{
"speaker": "Kris Hinson",
"content": "Thank you, Dave, and good afternoon, everyone. Thank you for joining us today as we discuss our third quarter 2024 results. With me on the call this afternoon are Steven Moskowitz, Crown Castle's Chief Executive Officer; and Dan Schlanger, Crown Castle's Chief Financial Officer. To aid the discussion, we have posted supplemental materials in the Investors section of our website at crowncastle.com that will be referenced throughout the call. This conference call will contain forward-looking statements, which are subject to certain risks, uncertainties, and assumptions, and actual results may vary materially from those expected. Information about potential factors which could affect our results is available in the press release and the Risk Factors sections of the company's SEC filings. Our statements are made as of today, October 16, 2024, and we assume no obligation to update any forward-looking statements. In addition, today's call includes discussions of certain non-GAAP financial measures. Tables reconciling these non-GAAP financial measures are available in the supplemental information package in the Investors section of the company's website at crowncastle.com. With that, let me turn the call over to Steven."
},
{
"speaker": "Steven Moskowitz",
"content": "Thank you, Kris, and good afternoon, everyone. I'm pleased to report that for the third quarter, our teams delivered solid operating and financial performance across our towers and fiber businesses, including small cells and fiber solutions, which allows us to reaffirm our full year 2024 outlook for adjusted EBITDA and AFFO. We continue to expect consolidated organic revenue growth of approximately 5% for the full year 2024, which includes growth of 4.5% in towers, 10% in small cells, and 2% in fiber solutions. Our results in this quarter validate our ability to continue to deliver for our customers and shareholders while implementing the significant changes to how we operate and invest in our business that we announced in June. Our performance also demonstrates our ability to generate consistent underlying growth through wireless generational upgrade cycles and the ongoing demand for broadband connections. Looking out over the next several years, we continue to be excited about the prospects for continued demand of our assets since mobile devices have become essential tools for communication, information, and entertainment. And we continue to see more data moving than ever before across wireless and wired networks. CTIA, the Cellular Telephone Industry Association, recently reported that U.S. wireless data usage surpassed 100 trillion megabytes in 2023, marking a 36% increase from the prior year. This is the largest year-over-year increase in absolute data usage in the history of the U.S. wireless industry, continuing three decades of robust growth in mobile data traffic. With wired networks, broadband usage in the U.S. is also experiencing a continuous surge as businesses embrace heavy data consumption, and fiber optics continues to be firmly established as the leading wired technology to transmit greater amounts of data at the highest possible speeds. With these trends before us and the industry forecasts suggesting that wireless and wired data demand will drive significant network investments by our customers to keep pace, we are confident that our towers, small cells, and fiber assets are positioned well to benefit from these data usage tailwinds. In addition to these demand-oriented drivers, we expect to capitalize on future growth and drive value creation across each of our businesses as we continue to strengthen our own market position and relationships with our leading carrier customers. We believe that our current efforts underway to modify our organization and our strategy will ultimately bolster the long-term strength and stability of our cash flows and enable us to capture incremental revenue growth. Let me briefly outline some ways that we are evolving. Starting with the tower business. We have recently announced an organizational change that I'm excited about. We're welcoming back Cathy Piche as leader of our tower business. She will succeed Mike Kavanagh, who is retiring after 14 successful years with Crown Castle. On behalf of the Crown Castle team, I want to thank Mike for his many contributions over the years and wish him the best in whatever future endeavors he pursues. With Cathy, she brings significant sector experience, having started in the tower business way back in 2001. And she has deep institutional knowledge and strong relationships within Crown Castle's workforce and among Crown Castle's wireless customer base from her previous 12-year tenure at our company. We have the benefit of having Cathy and Mike work together over the next couple of months to ensure a smooth transition. Looking ahead, we are committed to building on the strengths of our company, particularly in serving wireless carrier customers as a trusted infrastructure partner built on quality service and integrity. Recently, I heard from an executive at one of our large national wireless carriers that our teams are recognized for being thoughtful, for being communicative, and for being dedicated to meeting their needs, feedback that reinforces our approach. As we move forward, critically important to our success in towers revenue growth. So we will be even more laser-focused on securing new organic revenue opportunities. One initiative that we are accelerating to help us to achieve our goal is digitizing our tower portfolio. Using the latest in drone technology and enhanced automation of our IT infrastructure, our teams are capturing digital images of our towers, which allows us to visualize marketable space and access reliable data more efficiently. We believe this will help us make faster and more informed commercial decisions, make our sites more friendly for co-location, accelerate the customer application to installation cycle time, and speed up the customer construction and installation process while keeping issues at our sites to a minimum. All of this is expected to lead to improved project management capabilities, so it is more seamless for our customers to add equipment or co-locate on our sites. We're also developing a new state-of-the-art process and software tool that our tower field technicians will use for tracking and expediting customer service requests and site events to operate more effectively and efficiently across our vast footprint. Refining our processes and leveraging technology will make it easier for our employees to deliver better for our customers, all in an effort to be known as a trusted supplier so we can win more business and drive profitability. In addition to operational improvements, we also plan to continue relying on comprehensive MLAs with our largest customers. By having these agreements in place, we expect to benefit from more stable and predictable revenue growth over time, while making it easier for our customers to budget their capital and operating dollars and also making it easier for our customers to access our sites promptly and with fewer hassles. When combined with our operating improvements, we believe these agreements will help us win a greater share of the market going forward. As we shift our focus to our fiber and small cell businesses, I want to reiterate points from our last earnings call. Our operational review of the fiber segment confirmed that our assets are in excellent strategic locations and equipped with the capacity necessary to support both existing and expanding wireless and broadband customers. Based on the virtues of our fiber footprint, we announced in June that we revised our operating strategy with the goal of maximizing financial returns on our investments. Our revised strategy includes focusing on opportunities to capture market share by selling more new business within and near our existing footprints. We believe this approach positions us to achieve higher returns in both small cells and fiber solutions and drives increased cash flow for our business. To that end, we have completed successful discussions with our customers and identified approximately 7,000 nodes in our contracted backlog that we, along with our customers, have mutually agreed to cancel. These nodes were largely greenfield builds in locations that had countless zoning and permitting delays or in high-cost markets that did not meet our investment parameters and required higher-than-normal capital investment from our customers. By removing these low-yielding anchor nodes from our backlog, we expect to save about $800 million in future capital spend. So, after making these changes, our backlog now stands at approximately 40,000 nodes with an improved risk/return profile since most of this backlog are colocations, which allows us to add revenue with less capital investment. We continue to believe that persistent growth in U.S. mobile data demand will necessitate additional network capacity and densification that macro towers alone cannot provide, particularly in densely populated areas where demand is most concentrated. As carriers continue to deploy their mid-band spectrum, densification will eventually play an increasingly vital role in enhancing network performance. And looking ahead, we remain confident in the market potential for these low-profile fiber-fed cell sites. Moving on, let me provide you with an update on our fiber solutions business, which focuses on delivering high-bandwidth communications connectivity to enterprise customers. Our primary clients include wireless and wholesale carriers, government entities, healthcare providers, educational systems, financial institutions, and other large organizations. Like we have done in our small cell business, we have recently made changes to enhance the profitability and efficiency of our fiber solutions offering. We are prioritizing colocation activities within our existing footprint, working closely with our customers to capitalize on what we call on-net and near-net opportunities in and around our networks. This strategy is enabling us to grow revenues with reduced capital investment compared to previous years. Since implementing these operational changes in June, we've been encouraged by the early results. In the third quarter, we delivered 2% organic growth, excluding $4 million of prior period revenue adjustments, and we expect to deliver 2% growth for full year 2024, excluding the impact of some Sprint cancellations. Our thesis is driven by emerging trends that indicate promising growth potential. Demand drivers, including from AI, suggest that the need for data transport will continue to rise, and our connection hubs in major cities are well positioned to meet this demand. And our revised operational strategy should drive higher profitability, allowing us to capitalize on these positive demand trends to generate sustainable growth. Lastly, I'd like to provide a very brief update on the ongoing strategic review. As I've mentioned before, this process is active and we are diligently evaluating our options. We are considering various paths, including potential divestitures, continued growth, or partnerships with strategic or financial investors. Our Board of Directors is committed to concluding this evaluation with the goal of unlocking the full value of these businesses. As I conclude my comments, I want to highlight 3 points. First, in the business of creating value with long-term assets and long-term contracts with our carrier customers, changes don't occur so quickly. The management team and I recently set some initial goals in motion and are making important decisions to change the trajectory of this company's success. While it will take time, we believe we are on the right track as we reassess our businesses, adjust our capital allocation strategies and improve how we operate. Second, as we continue to implement changes to our operating plans, it's crucial to acknowledge the effort of our employees, effort that they've put into delivering our third quarter results. Thank you to everyone for your hard work. Lastly, we were also thinking about all of those affected by the devastation and loss from Hurricanes Helene and Milton. And I would like to give a special thanks to many on our Crown Castle team who worked with great urgency through challenging conditions and some dealing with personal impacts. But they stayed safe and they maintained our communications infrastructure which is even more essential in connecting people, communities and emergency services during and after these tragic types of events. Now, I'll turn it over to Dan to walk us through the details of the quarter."
},
{
"speaker": "Daniel Schlanger",
"content": "Thanks, Steven, and good afternoon, everyone. We delivered third quarter results in line with expectations as we continue to perform well, while implementing the meaningful changes in our operating plan announced in June. Demand for our assets remained strong in the third quarter, allowing us to maintain our 2024 outlook for site rental revenues, adjusted EBITDA and AFFO. We did, however, lower our 2024 outlook for net income to reflect the impact of a $125 million to $150 million asset write-off anticipated in the fourth quarter related to reductions in our small cell business. As part of the changes to our operating plan we announced in June, we have been working with our customers on reducing contracted nodes with higher-than-expected deployment costs that negatively impacted both our customers' economics and our expected returns. Consequently, we have mutually agreed to cancel approximately 7,000 contracted small cell nodes previously in our backlog. These nodes, which were concentrated in a limited number of markets, would have required more than $800 million of anticipated capital expenditures, primarily in 2025 and 2026 that was expected to generate average yields below our previous return threshold of 6% to 7%. After removing these canceled nodes, we now have approximately 40,000 small cells in our backlog, more than 70% of which are colocation nodes. We believe our revised backlog is sufficient to enable us to deliver double-digit organic revenue growth over the next several years while the improved proportion of colocation nodes will generate expected returns in excess of the returns we have generated historically. Moving on to our results in the quarter and turning to Page 4 in our earnings materials. Excluding the impact of Sprint Cancellations, we delivered 5.2% consolidated organic growth in the third quarter, consisting of 4.3% from towers, 25% from small cells, and 1% from fiber solutions. I want to point out 2 things that impacted our organic growth in the quarter. First, our small cell growth included $15 million of previously disclosed non-recurring net revenues primarily related to early termination payments, without which we would have grown the business a little over 11%. And second, our fiber solutions revenues were negatively impacted by $4 million due to adjustments related to prior period revenue. Excluding these out-of-period adjustments, fiber solutions organic growth was 2%, exceeding the expectations outlined when announcing the changes to our operating strategy in June. Adjusted EBITDA increased 3% compared to third quarter 2023 as revenue growth and cost savings related to the reduction in force we implemented as part of our revised operating strategy were partially offset by non-cash items and one-time costs, including a $49 million reduction in straight-line revenues and prepaid rent amortization and $6 million of additional advisory fees primarily related to our recent proxy contest. On Page 6, our expected organic contribution to full year site rental billings remains unchanged with consolidated organic growth of 5%, excluding the impact from Sprint cancellations. The 5% consolidated organic growth consists of 4.5% from towers compared to 5% in 2023, 15% from small cells as we expect 11,000 to 13,000 new revenue-generating nodes in 2024 compared to 8,000 nodes in 2023, and 2% from fiber solutions compared to flat in 2023. As announced in June, the small cell organic growth of 15% includes a $22 million increase in non-recurring revenues primarily related to early termination payments. Excluding this impact, small cell organic growth is expected to be 10% this year. Moving to Page 7, we continue to expect to deliver $108 million of AFFO growth at the midpoint, excluding the impact of Sprint Cancellations and the non-cash decrease in amortization of prepaid rent. Turning to the balance sheet. In August, we raised $1.25 billion of long-term fixed rate debt, allowing us to end the quarter with an average maturity of seven years, 90% fixed rate debt, and approximately $5.7 billion of availability under our revolving credit facility with only $1.2 billion of debt maturities through 2025. In addition, we ended the third quarter with leverage at 5.5 times net debt to EBITDA, a reduction from 5.9 times in the second quarter of this year. We expect to remain close to this level for the remainder of the year as we continue to benefit from solid organic growth and operating cost reductions. Lastly, our 2024 outlook for discretionary capital remains unchanged at $1.2 billion to $1.3 billion, or $900 million to $1 billion, net of $355 million of prepaid rent receive To wrap up, the business continues to perform well, delivering solid organic growth and keeping us on track for our full year outlook. We remain encouraged by the early results of the operating plan changes we announced in June and the progress we have made with our customers to prioritize on and near-net opportunities in small cells and fiber solutions. Specifically, we are on track to deliver $65 million of operating cost reductions compared to the $60 million we had originally forecast. We have been able to generate better-than-expected fiber solutions growth while changing the focus of our fiber sales team to improve the capital efficiency of the business. We believe we will deliver on our expectation to reduce our 2024 net capital expenditures by $300 million compared to our initial full year 2024 outlook. And we have mutually agreed with our customers to cancel approximately 7,000 contracted nodes, reducing our future capital requirements by approximately $800 million while improving the expected returns in business. These results are in line with or better than what we had announced in June and are a testament to how dedicated our teams are to deliver for our customers while implementing these meaningful changes. Looking ahead, our focus remains on maximizing shareholder value by continuing to progress the fiber strategic review and delivering operational and financial results across our portfolio of tower, small cell, and fiber solutions assets. With that, Dave, I'd like to open the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Ric Prentiss with Raymond James. Please go ahead."
},
{
"speaker": "Ric Prentiss",
"content": "Thanks. Good afternoon everybody."
},
{
"speaker": "Steven Moskowitz",
"content": "Hi, Ric."
},
{
"speaker": "Daniel Schlanger",
"content": "Hi, Ric."
},
{
"speaker": "Ric Prentiss",
"content": "Thanks. Glad to hear your team made it through Helene and Milton okay. Obviously tough storms. Florida-based firm Raymond James, we did, too so we always are thankful for those of us in the Gulf Coast that we made it okay. So glad to hear your team is good. Questions. Thanks for all the detail on the small cell, 7,000 cut for the mostly greenfield stuff. So it sounds like there's no early termination fee for you guys to cancel it, like there would be if a carrier canceled it because the carriers are going to get some savings, too, where it's like they don't have to pay as much upfront capital reimbursement for building the nodes. Is that kind of the right way to think about why the carriers agreed to this reduction?"
},
{
"speaker": "Daniel Schlanger",
"content": "It's somewhat difficult for us to get in the head of the carriers and tell you why they did something. But I believe that we wouldn't have been able to mutually agree to a cancellation if it didn't help them and it didn't help us in a way that we both saw value. We did not pay any early termination fees. I can definitely - I can agree to that and say that, that's true. But what I would take away from this is there's going to - in this case, what we're looking at is in certain areas, the overall cost of getting these nodes built was higher than anybody would have expected, which impacted both our returns, and I would anticipate it impacted their economics as well, which led them to get the conclusion we got to, which was it was better in all of our interest not to continue with these specific nodes. Or they were in places where they've just been taking so long because of the zoning and permitting issues and other issues we were running into that it just didn't make sense to try to pursue these anymore. And I think that, that was the same concept that our customers had as we had. And we just mutually agreed that these were not good things to continue to try do."
},
{
"speaker": "Ric Prentiss",
"content": "Makes sense. And it looks like combined, between the $800 million of avoided CapEx, and I guess that $125 million to $150 million is a lot of probably CapEx that went to work in progress, these nodes might have looked like they were costing like over $130,000 per node. Is that a way of thinking about it if they have been built?"
},
{
"speaker": "Daniel Schlanger",
"content": "The math that you did is right, yes. And what I would say is, like we mentioned, these were in some pretty high-cost areas so the fact - I can't - we've had a really hard time trying to get to an average cost per node. That's a difficult concept across the country. But I would say these are on the high end of the - what we've experienced to build because they were in high-cost areas. And it led to conclusion for both us and our customers that these were okay to cancel is because they were such high cost."
},
{
"speaker": "Ric Prentiss",
"content": "Makes sense. Second question for me is on the strategic review. I know there's not a lot you can talk to there yet. But can you help us understand? Steven, you've been on board, gosh, six months. Seems like forever, I guess, but just six months. What are the long poles in the process to getting the strategic review over the finish line? And also, have there been any like major or any conditions that have changed as you guys have looked at the process as it's been almost a year probably in that?"
},
{
"speaker": "Steven Moskowitz",
"content": "Certainly. I mean, there's obviously a number of things that have changed over the last year. I mean, first and foremost is, we got a lot of good information from the operational review, and that helped set us up to make some key decisions in the spring and the summer to help drive more profitability to those businesses all along as we were engaged with conversations with potential suitors. There's also inflation that started to be reduced a bit. Interest rates have started to subside a little bit. I mentioned the change in our capital strategy. So there were a number of different things that have occurred over the year. And all of that, to some degree, plays in our thought process as we're trying to evaluate the best possible outcome for our shareholders with making final decisions on this process."
},
{
"speaker": "Ric Prentiss",
"content": "Okay. Any other long poles to the tent as far as thinking when the review would be something we on outside we'll get to hear about?"
},
{
"speaker": "Steven Moskowitz",
"content": "I think there's a lot of poles that we're going through, Rick. This is a very complex situation and we're just trying to do our best to make sure, again, we make the best possible decision to create the best long-term outlook for our shareholders. I mean, that's the key for all of us. So I really can't provide any type of timing. But we'd like to get this done as everybody in our company would like to get this done as soon as we can."
},
{
"speaker": "Ric Prentiss",
"content": "Makes sense. I'm glad, again, the team is all well through these natural disasters and appreciate everything they do to keep our networks working. Thanks, guys."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, thanks. And you, too."
},
{
"speaker": "Operator",
"content": "The next question comes from Simon Flannery with Morgan Stanley. Please go ahead."
},
{
"speaker": "Simon Flannery",
"content": "Great. Thank you very much. Good evening. I was interested in the carrier activity levels. It looked like the services business had picked up some from the first half of the year, and obviously, DISH had got their extension from the FCC. We saw Ericsson calling out some increased spend by AT&T. So, how are you thinking about the level of activity this year and then just conversations about continuing to densify and do more on that side? And then just a housekeeping item. I think, Dan, you said 11,000 to 13,000 new nodes this year. Is that a good run rate from here with that 40,000 backlog or is that impacted by the 7,000 cancellations? Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. So, I'll address the first part of your first question. I'll address your second question, and I'll kick it to Steven over for more of the activity levels. You're right, the services level gross margin did pick up in the third quarter. A lot of that was kind of timing-related, pulling in some things from the fourth quarter into the third quarter. We did not change the range of what we thought our services gross margin will be for the year. And what I would say is that happens in that business, so we expect kind of a run rate similar to what we've seen in the past. And I'll let - again, I'll let Steven talk to activity levels in a second. I just want to - the housekeeping items of the 11,000 to 13,000. We still believe that 11,000 to 13,000 is an appropriate goal and outlook for 2024. Can't really speak to what the right run rate will be going into 2025, but we'll give guidance in three months and clarify that when we do so for 2025."
},
{
"speaker": "Steven Moskowitz",
"content": "Great. Hi Simon. So, a little bit of color, I guess, on demand. I mean, this year, from our perspective, it's playing out, I mean, pretty much as we expected. With active kind of moderate application and leasing volume and it's this type of steady-state activity that is more consistent with what we saw at the second half of last year. Today, we're in the beginning, actually, of our stages of budgeting for next year, so our commercial teams are out speaking with their counterparts at the carriers. They're gaining insight about what their capital budgets may look like, in which geographies they may be spending more or less on, the cadence of their 5G overlays. So, all that together, by the end of January when we provide guidance, we should be pretty in relatively good shape to provide a range that we have confidence in as we work through 2025. And again, we believe that since most of the carriers still have lots of work to do to complete their 5G overlay cycle with their C-band spectrum, and as I mentioned in my opening remarks, consumers continue to drive significant demand for greater megabits and gigabits, for that matter, of data at faster speeds, it only means more pressure being put on the networks, which gives us continued confidence about the ongoing need for carriers to invest on wireless infrastructure and types of assets that we have to offer."
},
{
"speaker": "Simon Flannery",
"content": "And when do you think you can get the benefits from the digitizing the tower portfolio? It sounds like an interesting opportunity, but is that a medium term or can you see some of that next year?"
},
{
"speaker": "Steven Moskowitz",
"content": "I mean, I think there's going to be some quick hits developed out of it, but it's more - I think what I've tried to convey to folks is it's going to take time. Any type of business transformation takes a period of quarters or even years for that matter. I mean, we're hoping that by mid-next year, we'll be in a better position to be able to capture the best possible share that we get in the marketplace."
},
{
"speaker": "Simon Flannery",
"content": "Great. Appreciate it. Thank you."
},
{
"speaker": "Operator",
"content": "And the next question comes from Michael Rollins with Citi. Please go ahead."
},
{
"speaker": "Michael Rollins",
"content": "Hi. Thanks for taking the question. Just a couple. First, just in terms of small cells. Now you've had a chance to review the portfolio in more detail with the customers. With the remaining greenfields that are left in that backlog, what should be the expected initial return for those small cells? And can you share a little bit more detail on the marginal returns that you get for the colocation nodes? And then just secondly, as you had conversations with these carriers and you walked through some of the optimization of this backlog, as you get a better sense from these customers of when they may want to look at executing another tranche of small cell nodes in terms of their densification needs? Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Mike, on the first point on returns, what we said about the revision to our return threshold is that it's higher than it was. It used to be 6% to 7% and is now higher. And so we're not going to talk about exactly what that is, but you can assume that the greenfield nodes that we have remaining in our backlog meet our new threshold levels of higher than 6% to 7%. And then on colocation returns, generally speaking, we see, on an incremental basis, in the neighborhood of 20% incremental returns on those businesses. And it can be higher than that, but that's a good way to think about it. So those are the types of returns that we're looking at for our backlog. In the conversations with our customers that we've had over the course of the last several months, we are really focused on trying to get through this process and did not get a lot of - it didn't give us any more significant insight into the future potential for bookings. But as Steven has been talking about this whole time, the amount of data demand in the U.S. is growing so fast that we still believe that that the thesis underlying the small cell business makes sense, at some point, densification will be required. At some point, towers are not sufficient for that densification. And the next technology that we'll utilize is small cells, and we believe that over time, those small cells will come to us as a natural provider of a lower-cost solution because we can share those economics among multiple carriers. The difficulty has always been for us in trying to pinpoint the timing of when things like that happen. That's been a difficulty in the tower business of pinpointing when changes in activity levels will happen. I believe that's going to be a difficulty for us in the small cell business. But at some point, we believe that there will be significant demand for small cells over time."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I guess, Mike, I would just add that the carriers are focused, first and foremost, on their C-band overlays. And we're hearing projections that they'll be completed with those probably by the end of 2026, beginning of 2027. And we have a very significant backlog of nodes to build so we're very, very busy. It doesn't mean we wouldn't look forward to having a nice new contract, but the fact is we want to execute these first and do them flawlessly and continue build the trust and respect from these customers. And so our feeling is a year or so from now, we should be well positioned again to be able to go in and negotiate new agreements that fill that backlog for us going into '27, '28, '29."
},
{
"speaker": "Michael Rollins",
"content": "Thanks very much."
},
{
"speaker": "Operator",
"content": "The next question comes from David Barden with Bank of America. Please go ahead."
},
{
"speaker": "David Barden",
"content": "Sorry, guys. Thank you for taking the questions. I apologize. Telecom guys are always the ones on mute, and I'm sure you appreciate that. So the - I guess my first question is, Steven, you said something at the beginning about how MLAs are going to be a competitive differentiator for what you're prepared to do. And I think you said it was going to be a share-taking or win share event. I was wondering if you could elaborate a little bit on your perspective. Because this has been a philosophical question for the industry for a long time ever since back in the day when AT&T did their holistic with AT&T and is it a good thing because it stabilizes the outlook or is it a bad thing because it limits your upside opportunities? I was wondering if you could elaborate a little bit on maybe what you are bringing to the table in this thought process. I think that would be super helpful. And then I guess just - and I'm sorry to have to hammer on it, but it seems strange that a year after you've been into the strategic review and months after you finished your operating review, that you went proactively to carry your counterparts and eliminated a meaningful part of your backlog that presumably any counterparty who was engaged in this conversation could have gone ahead and done on their own. And I'm wondering like how you guys came to the determination that this was a thing that Crown should undertake at this juncture. And what does it tell us about where we are in the process? Thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Well, I mean, let me start with the question regarding the small cells. I mean, coming in here, I had a number of key priorities and one was a strategic review, one was looking at our capital allocation strategy, one was revenue growth, and one was business transformation, so to speak. So the combination of strategic review, that's - and in determining how we want to spend our capital, from my perspective, was pretty important. So they kind of fit together. And as we evaluated the opportunities with these carrier customers, the discussions that were - that came together, as Dan alluded to, really became kind of best outcomes for both parties. So could we have shifted that responsibility to a potential suitor? Possibly, but we didn't know what the timing was going to be. We didn't know what the outcome was going to be. And so - and we felt that we needed to be the fiduciary here. We needed to make sure that we were making disciplined decisions in how we spend capital. And a lot of these nodes, as Dan spoke to, were going to be exceptionally expensive propositions, and some of these nodes were in process for the last two or three years. So if we could come to a conclusion with our customers in any situation that creates best outcomes for both parties, then we're going to seize that opportunity. And that's what we felt was most important was to seize that opportunity, and again, realizing that many of these sites were in development for years. They were going to take a matter of time to complete in the future and they were going to be very expensive. We felt the right thing to do was to negotiate something, which we were able to accomplish and we're pretty satisfied by it. As it relates to MLAs, I mean, we've been able to achieve good growth and create significant shareholder value by negotiating these comprehensive agreements. And we've already articulated that, we believe that we're able to realize more guaranteed growth over a multi-year period of time in a way that we think maximizes the value of our assets while providing a pretty good degree of certainty as carriers stop and start their wireless network spending. And that's what typically happens, right? And we've talked about that with the 5G experience. So - and from there - and from a customer's perspective, to try to continue to ingratiate yourself with these customers, these agreements take a lot of the haggling out of the equation for individual lease type of negotiations. And it makes it easier for them to conclude the transaction. It saves them processing time and money. And it gets them on air faster. So we've looked at it as being, in many respects, a win-win situation. And just realize it doesn't mean that negotiation stops when you have a holistic agreement signed. Because a holistic agreement usually has a certain amount of terms and conditions within that agreement, and it's for a period of time. So as the carriers' demands keep changing, whether it's technology, whether it's adding equipment in towers or in compounds or hardening sites, there's certain things that are included in those agreements, and there's certain things that aren't included in those agreements. So we have the stable contracted revenue, and we have also uncontracted opportunities in the future that we work hard to try to seize."
},
{
"speaker": "David Barden",
"content": "Thank you, Steven for that. I appreciate those comments. If I could ask one quick follow-up, which would be you guys have been very careful to kind of couch the strategic review in terms of the strategic review of the fiber business. I just want to make sure that I'm not being too myopic, and if we zoom out and say, it's been an awful long time, is there - is the strategic review just about the fiber business, or is there some maybe even larger strategic considerations going on?"
},
{
"speaker": "Steven Moskowitz",
"content": "No, no, we've been very clear about our intentions as it relates to this, whether it's before I got here or after I got here. I mean, we own some of the best-in-class fiber networks in the U.S., and it's key for us to determine whether Crown strategy is aligned with those opportunities, right? And we're just - we've been taking the time, we've been obviously engaged with different parties who are interested in these assets, and it all comes down from our perspective to generating the most value for the shareholders, whether it's receiving some cash proceeds and redeploying capital, moving towards a tower-only company, keeping the businesses, if we feel they can create the most value that way. So it takes time. Maybe it's taken more time than you guys have patience for, but obviously, we'd like to wrap this up also, and hopefully this will enable people to make a decision in time, in time."
},
{
"speaker": "David Barden",
"content": "I appreciate the comments. Good luck with all of it. Thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "And the next question comes from Nick Del Deo with MoffettNathanson. Please go ahead."
},
{
"speaker": "Nick Del Deo",
"content": "Hi, good afternoon, guys. Thanks for taking my questions. Stephen, you described the number of efforts to digitize or streamline your operations, to save money and improve the customer experience. Is it your sense that Crown Castle was behind your peers in these areas, and this is going to kind of allow you to catch up? Or do you think this is more about being better than the peer group on these fronts after you've wrapped up the initiatives?"
},
{
"speaker": "Steven Moskowitz",
"content": "So listen, the goal of the company is to be best-in-class in what we do. And this company went through significant growth through 2010 up to 2020, buying significant numbers of assets and building a significant number of assets. And in that growth mode, as I've talked about before, that whenever you're growing to that level, it's difficult to focus not only in growth initiatives but also on kind of the internal infrastructure initiatives of the company. So there has been work done and the company is operating well, but there's opportunities to improve and enhance. And so that's what I'm talking about is transforming what we have. There has been some element of digitizing the assets, but the drone program that I mentioned started last year. I mean, it didn't start last month. It's been a work in progress. And I think to one of the earlier questions, when are we going to see the fruits of the labor? And as I said, there's going to be some opportunities for us to use that data. We're using it already to help generate more activity and more knowledge within our organization, which helps as we communicate with customers. So it's just - it's an evolution. And obviously, I was brought in for a reason, and part of the reason is to make modifications and changes that I think will be healthy and good for this company moving forward. That said, the company has always had and continues to have a very strong reputation as being very customer-oriented and very service-oriented. So to your question about kind of catch up or get ahead, I think we are doing a little bit of catch-up in certain areas, but we have every opportunity to really become best-in-class in the U.S., and that's the goal."
},
{
"speaker": "Nick Del Deo",
"content": "Okay, that's great context. Thank you. Yes, I guess the other thing I wanted to ask about were the node cancellations. I guess during the discussions, were you able to surmise at all what the customers might be planning to do as an alternative, whether just go to other vendors or try to get on macro sites or maybe not do anything at all? It just seems like an interesting situation where the customers seem to have kind of thrown up their hands in a tough area in which to work. I'm curious if you have any clues as to how they plan to address it."
},
{
"speaker": "Daniel Schlanger",
"content": "Again, it's hard for us to opine on what our customers are doing at that level of detail. But what I would say is, generally speaking, the first thing our customers want to look at, as you know, Nick, is try to maximize the tower availability in any given area because it is the cheapest way to deploy a spectrum over large geographies and population areas. And I think if I were to make a guess on your question is that they believe that with the amount of C-band and mid-band spectrum they have, they can cover these areas with towers in the short-term. But as we've talked about, at some point that, that is no longer an available option. But at this point, in a lot of these markets we're talking about, which were very high-cost or very long-term projects that just weren't coming to fruition, I think they determined that they could add more to the overall macro network to take advantage - to take care of the demand in these areas."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes, I would just also add, these agreements were signed with these customers before the C-band spectrum was auctioned. So the fact of the matter is these cancellations, in totality of our contracts, these cancellations represent just 6% of our total small cell build program. And many of us have been in this industry for a long, long time and have done lots of build-to-suit agreements over the years. Typically, for every 100 search rings you get, 20 to 25 you have canceled and you're left building 60 or 70. So the fact that there hasn't been any type of large cancellation of groups of projects or nodes since these contracts were signed is actually amazing to me. So I look at it as a small portion of what the carriers are doing overall. And to Dan's point, they're actively trying to find other ways to solve their network densification or coverage issues."
},
{
"speaker": "Nick Del Deo",
"content": "That's great color. Thank you, guys."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. Thanks for the question."
},
{
"speaker": "Operator",
"content": "And the next question comes from Jim Schneider with Goldman Sachs."
},
{
"speaker": "James Schneider",
"content": "Good afternoon. Thanks for taking my question. I guess if you set aside the 7,000 node cancellations and look forward to what your carriers or customers are telling you about their demand for small cells over the next several years, is there anything that makes you think that the structural case for small cells is in any way unchanged? And specifically with respect to the increased return profile you sort of put on this business now, anything that makes you believe you can achieve your sort of longer-term small cell growth targets at that higher investment return rate?"
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I mean, I'll start here, Dan. I mean, in terms of future growth, again, we believe this technology has good upside as the carriers, again, as I said, complete their mid-band deployments and consumers and businesses continue to be very data-hungry. So we just - we see the overall network structure as getting more densified, more distributed with the lowest latency networks you can find. And so to fill those types of hotspots and locations where macros are not suitable, we see this technology as being a perfect opportunity for the carriers. And so there aren't that many companies that play in this arena on an independent basis. The carriers play in this arena themselves at times. And as we look into the future, we feel that if we set forth reasonable expectations in terms of how we underwrite this type of business, we'll be able to achieve that, particularly if it's a combination of colocations and anchor tenants. And that's obviously, as you guys know, what it's all about for us, it's colocation, right? We're building in order to get colocations in the future. And if you think about this portfolio, there's been 65,000, 70,000 nodes put on air and the backlog of 40,000, the preponderance is colocation. So it's actually playing out. It's playing out a little longer than everybody thought. It's actually playing out to the point where the overall ROIC on this set of assets down the road is going to be admirable into some of the expectations that we're talking about."
},
{
"speaker": "James Schneider",
"content": "That's helpful. Thank you. And then maybe just as a follow-up on a different topic. Some of your peers in the enterprise fiber space have announced some deals tied to interconnection of data centers. So I'm wondering, is that any kind of opportunity you feel you would want to address or participate in? And does that kind of change your view on the expectations for the future growth in your fiber business and maybe your expectations around a price in terms of a potential asset build?"
},
{
"speaker": "Daniel Schlanger",
"content": "I think generally, the - as Steven was talking about in some of the prepared remarks, the increase in demand over networks is positive for our business because we have assets in very good markets that we believe will have good demand over time. Some of the specifics about what you're talking about, I do not believe that our footprint or strategy. So the idea of connecting large AI-focused data centers are being built in more rural locations because land costs are cheap and then connected into the market, into the market, big markets where people are via fiber, we're not interested in building that type of fiber because we don't see that as supporting our overall strategy of having fiber solutions and small cells together where we think the densest network demand will come. And we don't see it as much a shared infrastructure model as a build-for-suit infrastructure model. And that's just not what we do. So part of your - part of the answer to your question is no, we do not see the same type of outcome for us as we've seen in other companies' announcements recently. Not to say those are bad deals to do or bad businesses, it's just not for us. But we do see a tremendous opportunity ahead of us to connect data centers in metro markets that that already exist that we think are going to be extremely valuable because we have a footprint is very difficult to replicate in dense metro markets. We have lots of fiber under lots of streets already. And so connecting into where we can connect each data center to another data center and making a ring, we think we are well positioned for that type of demand. And we think that type of demand will be necessary to - or will be part of the growth in traffic going forward because part of the way that we think the networks will expand is for each individual user not to go to one data center but to try to be on-ramped into all sorts of different data centers and on-ramped into the network and into different AI locations. Whatever is the most efficient way to move the data is - or most efficient way to compute data is where the people are going to try to find. And we're going to be - we'll allow for that optimization to happen more readily because of where our assets are. So we think there's tremendous opportunity for us from the AI workloads that are coming, just very different than building into data centers built directly for AI in very low-cost areas. And what we see that meaning is whether we believe we are the right owners of this business or whether we think we come to the conclusion that we are moving on and somebody else is a better owner, that demand increases the value of our assets and we're excited about that."
},
{
"speaker": "James Schneider",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Richard Choe with JPMorgan. Please go ahead."
},
{
"speaker": "Richard Choe",
"content": "Hi. I had a follow-up on the tower business. In terms of gaining more share, do you expect that to come from national players or more regional players? And then regarding the small cell cancellations, of that $800 million that would have hit in 2025 and 2026, how should we look at that small cell CapEx? Was that CapEx going to be added on to the existing run rate? Or is that - potentially some of it was already in the run rate and could be brought down?"
},
{
"speaker": "Steven Moskowitz",
"content": "Want to start with start with that and I'll go back?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yes, I'll start with the CapEx question on the small cells. Yes, Richard, it's hard for me to say what would be in or out of run rate because we haven't given long-term guidance of what we think the capital would be. So, all I can say is that whatever capital we thought we were going to spend in 2025 and 2026 is lower now than it would have been otherwise. And in trying to relate it to what we've done historically, it's just - it's hard to do because both the magnitude, the overall number of nodes that we're constructing and the colocation and anchor build mix has been different over time. But you can assume that in our past build, we have built a lot of anchor builds. We've talked about that. And therefore, the capital intensity of the business was higher historically than we believe it will be going forward, both because we've cut off this $800 million and because the majority of our backlog now, over 70%, is colocation as opposed to anchor build. So, like I said, it's hard to relate to what the run rate would be, but compared to what we've spent to-date, we will be more capital efficient going forward."
},
{
"speaker": "Steven Moskowitz",
"content": "Hi Richard, in terms of market share, I would say two things; one, we're trying to get to the position where we continually improve, continually up the ante on customer service and have the large nationwide carriers look to us as being a preferred supplier and so that's pretty critical to us. And we think, again, part of these comprehensive agreements and part of what we're doing operationally with improvement will probably enable us to get there at some point in the near future. The other area that we need to focus on more is in the vertical area, which is those regional and smaller customers, whether it's government entities, whether it's WISPs, different types of broadcasters. So, we've had an effort there. We have to do a better job. So, I think between a combination of those two things, it should help us be able to maximize share in a little bit better way than we've been doing now."
},
{
"speaker": "Richard Choe",
"content": "Thank you for the color."
},
{
"speaker": "Daniel Schlanger",
"content": "And Dave, I think we have time for one more question."
},
{
"speaker": "Operator",
"content": "The next question comes from Batya Levi with UBS. Please go ahead."
},
{
"speaker": "Batya Levi",
"content": "Great. Thank you. A couple of follow-ups. First, on the 7,000 small cell cancellation. Can you talk about if that's more concentrated in one region? And does that leave you with some maybe fiber assets that will not be utilized now if they could be monetized? And the second question on tower business, how should we think about churn excluding announced churn? I think you have some higher renewals coming up in the next two years beyond the top three. Are you seeing any change in the competitive environment maybe from private tower companies and kind of like any change in the renewal pricing? Thank you."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. Batya, on the 7,000 nodes, there's no one reason I would point to that was concentrated in. It was a lot - there were specific markets, but there weren't specific markets in one region. So, I would not say that we had one place that is now no longer building small cells. It's more many places but concentrated in those places. And while we have some assets that we built, the reason that we had to take a write-off as part of this process was a lot of the CapEx that had been spent was not on hard assets but on the preparation of a lot of these, like we've said, we've had a hard time getting to actually building stuff and it was costing way too much. So we hadn't made it very far into a lot of the actual build for these things. So there is not a tremendous amount of fiber that is left over that we had built. And to the extent that we did build fiber in these markets, they're generally good markets that we see demand both from fiber solutions and small cells going forward. So I would not call them stranded or underutilized or unutilized assets going forward. We believe we can use some of those assets to deliver services to our customers going forward."
},
{
"speaker": "Steven Moskowitz",
"content": "About churn?"
},
{
"speaker": "Daniel Schlanger",
"content": "On the small - on the tower churn, what we've said for a long time is we see 1% to 2% churn in the tower business. We've been on the very low-end of that when you - we haven't had much tower churn from Sprint to-date. But when you exclude the $200 million in 2025, we still believe we'll be on the low-end of that range. And we have not seen a significant difference in the competitive profile of our business. And it's because of how good the business is. It's very difficult to make a change in a tower company when you already have that thing up on a tower. It costs money to bring it down, it costs money to build new one. So what we have found is very limited amounts of churn because the underlying business model has been very positive for us and for our peers as well."
},
{
"speaker": "Steven Moskowitz",
"content": "And I think it specifically calls out our asset base, which is urban and suburban. So it's just very difficult to try to replicate any type of site in the suburbs of Greenwich, Connecticut or outskirts of Washington, D.C., or Raleigh, North Carolina. So in these major cities where we have most of our footprint, we feel like we have a real good moat and are well protected against churn."
},
{
"speaker": "Batya Levi",
"content": "Got it. Thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cci | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day and welcome to the Crown Castle Second Quarter 2024 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Kris Hinson, Vice President of Corporate Finance and Treasurer. Please go ahead."
},
{
"speaker": "Kris Hinson",
"content": "Thank you, Betsy, and good afternoon everyone. Thank you for joining us today as we discuss our Second Quarter 2024 Results. With me on the call this afternoon are Steven Moskowitz, Crown Castle's Chief Executive Officer, and Dan Schlanger, Crown Castle's Chief Financial Officer. To aid the discussion, we have posted supplemental materials in the Investor section of our website at crowncastle.com that will be referenced throughout the call. This conference call will contain forward-looking statements which are subject to certain risks, uncertainties, and assumptions, and actual results may vary materially from those expected. Information about potential factors which could affect our results is available in the press release and the risk factor sections of the company's SEC filings. Our statements are made as of today, July 17th, 2024, and we assume no obligation to update any forward-looking statements. In addition today's call includes discussion of certain non-GAAP financial measures. Tables reconciling these non-GAAP financial measures are available in the supplemental information package in the Investor section of the company's website at crowncastle.com. With that, let me turn the call over to Steven."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, Chris. Good afternoon, everyone. We appreciate you joining us for this call and as you can see from our second quarter results, we delivered solid operating and financial performance in all three of our businesses and reiterated our full year 2024 outlook. We're confident in our outlook based on having 95% of our expected tower revenue growth for this year contracted either as part of our holistic master license agreements with our major customers or with revenues from regional and local wireless customers, and also having implemented changes to our fiber segment, which will position us to generate more profitable business and increase our operating efficiencies. In the tower business, we anticipate organic revenue growth of 4.5% this year, and believe that as we look out over the next few years, our growth rate will be higher based on three factors. First, the holistic master license agreements we have with our largest customers provide us a stable and consistent level of growth over time. Second, industry forecasts estimate that long-term US wireless data demand growth will continue to drive the need for significant future communications infrastructure investments. And we are aware that major carriers still have lots of work to do to expand their networks in the 5G build cycle. And finally, we believe that as more tangible steps are taken by our company to be a best-in-class supplier of low-cost shared infrastructure solutions, we'll be better positioned to compete for a higher share of revenues as our customers continue to invest in their networks. Moving to our fiber and small cell businesses, we've completed many of the changes to our operating plans that we announced in June and have started to see the benefits of those changes through more profitable growth and greater operating efficiencies. As part of the operational review of our fiber segment, which we conducted earlier this year, we affirm that greater opportunity exists to provide additional customer solutions to enterprise fiber connections and small cell locations that are on or near our existing high quality fiber footprint, which allows us to add revenue without the requirement to invest as much capital as we've done in the past. Implement these changes in our small cell business, our commercial and deployment teams have been working collaboratively with our customers on a mix of outcomes, many of which improves our project economics, while also addressing our customers' evolving priorities around network densification and capital allocation. As part of this change in our operating plan, we plan to build fewer anchor nodes in the short run. However, given our large pipeline and our customers' long-term densification needs in geographies where we have really robust assets in place. We continue to expect there is sufficient demand to grow small-cell revenues by double digits over the next several years. Turning to our fiber solutions business, we believe we can improve returns by focusing our sales efforts on or near-net opportunities that reduce discretionary capital expenditures going forward. And to support these changes, we've already adjusted our go-to-market commercial plan. We've changed our sales incentive award system and increased our required rates of project returns, resulting in anticipated shorter payback periods on invested capital. So like in our small cell business, we analyzed the markets around our fiber assets to quantify the opportunities to utilize our existing fiber. We believe we have ample opportunities to improve capital efficiency, while achieving long-term organic revenue growth in fiber solutions of 3% per year. As we announced in June, we believe our more focused effort to target on-net and near-net demand in both small cells and fiber solutions will drive a more efficient use of capital and will also generate approximately $100 million of annualized run rate cost savings. Importantly, we implemented most of these changes by the end of the second quarter, which keeps us on track to generate approximately $60 million of expected cost savings and reduce capital expenditures by about $300 million for this year. As we continue to deliver solid results and make operational changes, we remain focused on the fiber strategic review, which is active and ongoing. The management team and I continue working with the fiber review committee, the board of directors, and external consultants to evaluate strategic alternatives to determine how to maximize shareholder value. Now, we can't share much more about the process and the timing. What we can share is that we remain actively engaged with multiple third-parties who continue to show a lot of interest in our fiber solutions and small cell businesses. And we'll provide updates as the process unfolds. I'd like to conclude my comments by saying that over the past few weeks, I've been fortunate to have engaged in conversations with more than 50% of our company's employees through either in-person conversations and also video conference calls. The goal of my meetings with everybody was to be present and discuss the rationale behind our recent operational changes, answer questions that are on people's minds about the fiber segment, and start to set expectations for everybody in the company going forward. My takeaways from these discussions was that two major themes exist in the minds of Crown Castle employees. First, they care and have great pride. They are very proud of being part of Crown Castle and they want our company to be seen as excellent in the minds of the constituents we serve including shareholders and customers and communities. And second, most recognize that to be excellent, we need to continue to make changes in how we operate. And they are engaged and energized about their ability to participate in and lead the process and develop new ways of doing things to help differentiate us, as a leader in the sector. So I'd like to thank all the employees I met for being as open and transparent with me as they were, and to those employees I've yet to meet, but will at a time come soon. And to all of our employees, a big thanks for continuing to drive our business and deliver results over the past several months. I know there's been a lot of change, and it's reassuring that this team has been able to stay focused on delivering for customers during this period. Having said all that, I would ask all employees and our investors to keep in mind the change management is a process and it takes time. And I appreciate your understanding as we continue to develop new goals that will improve our chances of taking higher shares of new revenue opportunities, convert a greater share of new revenue down to EBITDA, increase investment returns on the growth capital we deploy, bolster our balance sheet to generate more optionality for us in the future and ultimately increase shareholder value. So with that, let me turn it over to Dan to walk through the quarter results."
},
{
"speaker": "Daniel Schlanger",
"content": "Thanks, Steven, and good afternoon, everyone. We delivered second quarter results in-line with expectations and remain on track for our full year outlook after implementing the operational changes we announced in June. Looking at the second quarter results on Page 4 of our earnings presentation. The underlying business continued to perform well in the quarter, highlighted by 4.7% consolidated organic growth, excluding the impact of Sprint Cancellations. The 4.7% organic growth in the second quarter consisted of 4.4% growth from towers, 11% from small cells, and 3.2% from fiber solutions. We are encouraged by these levels of growth at this time with our tower business generating growth in-line with our current expectations, the uptick in small cell activity resulting in higher growth compared to the last couple years, and our fiber solutions business delivering growth above our 3% expectation, despite the changes we made to our operating plan. This growth underscores the stability and attractiveness of our business, as we are well positioned to capitalize on the growing demand for data in the US. As anticipated, the solid organic growth delivered in the quarter was more than offset by several one-time and non-cash items, including a $106 million reduction to site rental revenues related to the Sprint Cancellations, a combined $105 million reduction in straight line revenues and prepaid rent amortization, both of which are non-cash items, a $22 million decrease in service margin contribution, due to the combination of lower tower activity and the decision we made to exit the construction and installation business, which we implemented in the second half of last year, and $20 million of advisory fees primarily related to our recent proxy contest. Turning to Page 5, we are reiterating the full-year outlook we released in June, which reflects a year-over-year decrease in site rental revenues, adjusted EBITDA, and AFFO, primarily due to the one-time and non-cash items I just mentioned. Our expected organic growth -- contribution to full-year site rental billings remains unchanged, with organic growth of 2% or 5% excluding the impact of Sprint Cancellations. The 5% consolidated organic growth excluding the impact of Sprint Cancellations consists of 4.5% from towers compared to 5% in 2023, 15% from small cells, as we expect 11,000 to 13,000 new billable nodes in 2024 compared to 8,000 nodes in 2023, and 2% from Fiber Solutions. As we announced in June, the small-cell organic growth of 15% includes a $25 million increase in non-recurring revenues, primarily related to early termination payments. Excluding this impact, small-cell organic growth is expected to be 10% this year. Moving to Page 7, we expect to deliver $105 million of AFFO growth at the midpoint, excluding the impact of the Sprint Cancellations and non-cash decrease in amortization of prepaid rent. Included in this AFFO growth is a $10 million increase in cost, which includes normal operating cost increases, as well as $25 million of advisory fees related to our recent proxy contest, all of which is expected to be offset by an approximately $60 million decrease in costs related to the reduction in staffing levels and office closures we announced in June. Turning to the balance sheet, we ended the second quarter with leverage at 5.9 times EBITDA or 5.7 times excluding the impact of the non-recurring advisory fees. Looking ahead to the third quarter, we expect our leverage metrics to improve as we believe our second quarter EBITDA will be the low point for the year and we benefit from our operating cost reductions. Since transitioning to investment grade in 2015, we have strengthened our balance sheet by extending our weighted average maturity from five years to seven years, decreasing the percentage of secured debt from 47% to 6%, and increasing the percentage of fixed rate debt from 68% to 89%. In addition, we ended the quarter with approximately $5.5 billion of availability under our revolving credit facility and only $2 billion of debt maturities through 2025, providing us with ample liquidity to fund our business. We believe the steps we have taken to strengthen our balance sheet, provide us with financial stability and flexibility as we evaluate strategic paths forward. As we announced in June, we decreased our outlook for discretionary CapEx, as a result of the modified investment parameters we recently implemented, and now expect $1.2 billion to $1.3 billion of gross discretionary CapEx, or $900 million to $1 billion after taking into account $355 million of prepaid rent we expect to receive. In summary, the business is performing well, delivering organic growth, and keeping us on track for our full year outlook after implementing the operational changes we announced in June. With the operating review complete, our focus is on maximizing shareholder value by continuing to progress the fiber strategic review and delivering operational and financial results across our portfolio of tower, small cell, and fiber solutions assets. Before starting Q&A, I'd like to note that we are changing the timing of when we provide guidance for the upcoming year. Going forward, we will provide forward-year guidance with fourth quarter earnings as opposed to our past practice of providing guidance in our third quarter release. This means you should expect to receive our full year 2025 guide with earnings in January. With that, Betsy, I'd like to open the call for questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Simon Flannery with Morgan Stanley. Please go ahead."
},
{
"speaker": "Simon Flannery",
"content": "Great, thank you very much. Good afternoon. Steven, thanks for all the color on the CapEx and OpEx review there. I wanted to get more color on was -- what is the new run rate of CapEx, presumably since this was sort of a mid-year review, some of the spending was already done. You may have more spending contracted in the second half of the year. So any color you can provide us at what sort of you think the more usual rate given this sort of higher hurdle rate and new more focused approach will be going forward. And then maybe Dan one for you, you talked about the leverage coming down to [5.7 times] (ph) on adjusted basis. What are you targeting in terms of leverage over the next couple of years here? And there's Bloomberg's reporting that there may be a Verizon portfolio out there. How are you thinking about M&A in the context of that? Thank you."
},
{
"speaker": "Daniel Schlanger",
"content": "Hey, Simon. It's Dan. I'm going to take the first two and leave the M&A point for Steven to hit. But the run rate of CapEx, as we had been talking about, we're focusing our CapEx on lower capital intensity projects, so that we go towards on-net and near-net opportunities, which means that over time we believe that the overall level of CapEx, the amount of revenue we generate, will come down. But ultimately, CapEx is going to be driven by how much opportunity we have in the business. So we can't really give a full run rate of what we think is going to happen until we understand what that activity looks like and we're able to give guidance in 2025 But I think one of the things you mentioned and you're right about is that this was a midyear move and we were able to save $300 million is what we expect for the year. So we would anticipate that somewhere in that neighborhood or potentially more going forward, but we're going to have to get to 2025 before we can really give specifics on that point. In terms of leverage, Our goal is to be at 5 times leverage. And obviously, we're elevated from that point now, but we believe as we continue to grow our EBITDA and not grow capital nearly as much because of the capital savings we just talked about. We think we will be able to organically bring that leverage down over time towards that 5 times goal."
},
{
"speaker": "Simon Flannery",
"content": "Thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Hey, Simon, it's Steven. In terms of M&A, you know, we're aware of different assets that are either in the market or coming to market in the US. And, if it's a truly compelling proposition for us, which we would consider compelling being highly strategic and cost effective, so we have confidence in delivering future shareholder value, then if it has those types of characteristics, we definitely have interest. But overall right now, M&A is not necessarily the priority for us."
},
{
"speaker": "Simon Flannery",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Rollins with Citi. Please go ahead."
},
{
"speaker": "Michael Rollins",
"content": "Thanks and good afternoon. I was curious Steven, on some of the comments that you made about the tower business. You talked about three things that you thought could drive a higher organic annual growth rate. I'm curious if you can give us an update within that context of what you're seeing in terms of carrier activity and are there any early signals that you're seeing as you look at the visibility that you have in this business and what could come in 2025. And then you also mentioned more tangible steps the company is taking to be a best-in-class provider. I'm curious if you could share some of those steps and how you think that will translate into better share and results going forward."
},
{
"speaker": "Steven Moskowitz",
"content": "Yeah, okay, Michael. You know, it's tough to talk about next year and beyond. It's a little bit early from our vantage point, but what we see in the market today and conversations that we're having with our customers, it just gives us optimism that what we've forecasted for revenue growth is directionally correct. We also obviously have benefit of stability and visibility in our revenue from our MLAs. So we don't really see demand shifting directions in one way or another from our major carriers. Right now, to some degree, we look at things as steady state, as carriers work on their mid-band 5G rollouts. So that's pretty much how we are thinking about this year. And again, going into next year, ideally there is more opportunity for growth. But we'll be working through our budgets between now and then this year from that vantage point. As it relates to tangible things, the priorities right now for us are the strategic review of our fiber business, very critical. Spending cash, what we would say is wisely or differently, you know, with some changes that have already occurred in our fiber business as we've outwardly discussed with everybody. Cost management for us, which is key, and our leadership team is evaluating kind of other areas of the business to see how we can consider improving operating and EBITDA margins over time. And then business transformation. I think business transformation is probably the biggest thing that we need to work on. I mean, this company has grown significantly over the last decade. And when you're growing like crazy, you tend to be focused more on driving revenue and getting every opportunity you can for lease up. And now that things are a little bit more in a steady state, I think the key for us is to, do some transformation. And when I think about that, it is really evaluating the people, making sure we have the right people in the right roles. It's the business processes, so identifying root causes of inefficiencies for us and [figuring out] (ph) plans to fix them so things are more repeatable and reliable, and efficient. And improving our systems, which a lot of people have been starting to do with improved workflows in this company. We have some new asset management tools, CRM and on the enterprise side. So kind of wrapping that all up, if we're able to over the next year, year-and-a-half, you know, really improve the processes that we have, whether it's the application to on-air cycle time, making sure we have just better data and data governance around our assets. All those types of things are going to help keep us really focused and that'll lead to providing better customer service to maximize organic growth in the future."
},
{
"speaker": "Michael Rollins",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "The next question comes from David Barden with Bank of America. Please go ahead."
},
{
"speaker": "David Barden",
"content": "Hey, guys. Thanks so much for taking the questions. A nice straightforward quarter. I guess my first question would be, Dan we – if we go backwards and we start thinking about the small cell return thresholds, right? It was always whatever the CapEx is [times 6%] (ph) and then if we get a second tenant that goes into the double digits, and if we get a third tenant it goes north of there. Could you kind of come back to that and kind of give us what the new language around return threshold expectations is for the company now that we've kind of undertaken the operational review? And then I guess the second question would be just in terms of the service revenue kind of run rate in the quarter. I think Steve, to your point, that this might be kind of run rate, you know, from a tower activity level. Is this the new run rate for kind of services for the foreseeable future before we start guiding to 2025? Thank you."
},
{
"speaker": "Daniel Schlanger",
"content": "Sure. Thank you. Let me answer the first one, which is what are our return thresholds as we look at the small-cell business? You pointed them out right. Historically, we targeted 6% to 7% on the anchor build. All I can say now is that our target is higher than that, and we are going to work through the market and figure out exactly what that's going to look like. But what it does by going to a higher level of anchor build economics is it allows us upon lease up to get even a higher return on the lease up, so that we de-risk the business substantially, with our cost of capital being higher than it was when we first targeted 6% to 7%. We think that we can start making on the anchor build a return that accommodates that higher cost of capital and allows us to make money over time by leasing up those assets. But they are not yet in a position of quantifying exactly what that number is going to be or is at this point. On the service revenue question that you asked, yes the second quarter run rate is what I would put in for kind of generally what we think will happen over the course of the rest of this year. And then as you pointed out, we'll give additional guidance for 2025, when we update our guidance in January."
},
{
"speaker": "David Barden",
"content": "Appreciated. Thank you, Dan."
},
{
"speaker": "Operator",
"content": "The next question comes from Ric Prentiss with Raymond James. Please go ahead."
},
{
"speaker": "Ric Prentiss",
"content": "Yeah. Thanks everybody. Hey, I want to start with the change in given guidance, slipping it to the 4Q call from the 3Q call. I know we had chatted about it in NAREIT, Dan, but kind of help us understand what kind of led to that change. I know your peers do it from the 4Q call."
},
{
"speaker": "Daniel Schlanger",
"content": "Sure. That is part of what led us to it. I think that what we had noticed is that when we were giving our guidance in October, we were a full five months ahead of our peers. And what we had also noticed was whatever trend we started to talk about, we were kind of blazing a trail well before anybody else could talk about them. And so we would get an outsized amount of the questions and an outsized amount of the consternation ultimately about what we were saying about the subsequent year for a pretty long time. And by the time that our peers were giving guidance in February, that news had settled a bit and it didn't impact them as much. And so what we've noticed is, it's been hard to be the trailblazer on that front. One of the things that has led us down the path of giving guidance so early is that our business is relatively predictable. And so we like the idea that giving guidance in October expressed that predictability. We didn't miss very often even though we were giving guidance in October. We still believe our business is predictable. We still believe we could give guidance in October and be good with it. But we think giving ourselves another three months and being closer to our peers, makes it easier for us to maintain a good message to the market and for investors to understand what's going on. And gives us a little bit more time to incorporate any additional information in that last quarter that will help us give the best guidance we possibly can."
},
{
"speaker": "Steven Moskowitz",
"content": "Hey Ric, it's Steven. I'd add to that. This company has started the budget process at the beginning of August. Most companies I've been with in August, September, October, we are driving home to try to finish out the year, as strongly as we can. So I also felt compelled to ask the team to reconsider, start the budget process a little bit later. And if we need to move guidance out, since it gives us a little bit more opportunity to really understand the market before we completely formulize what we have for our outlook."
},
{
"speaker": "Ric Prentiss",
"content": "That makes sense. And the carrier budget cycle seems to really come to a head, bottoms up, tops down Halloween into the fourth quarter. So I think it makes sense from your customer standpoint, too."
},
{
"speaker": "Steven Moskowitz",
"content": "That's exactly right."
},
{
"speaker": "Daniel Schlanger",
"content": "And it takes away -- one other thing, Rick, I would just mention. It takes away one of the issues that we were having, which was we would provide guidance based on what we thought that the fourth quarter was going to be and then it would be a jumping-off point. Now we actually will know what that is, so that we don't have that other -- that extra change to try to reconcile back to."
},
{
"speaker": "Ric Prentiss",
"content": "Makes sense to me. I'm going to talk to the strategic review delicately but I think this will work. Last quarter, we talked about fiber, small cells, and would it make sense from a seller standpoint or the buyer standpoint to separate fiber solutions from small cells? Is it possible to update us as kind of what are the pros and cons from a very 30,000 foot level to say, what about -- is there a strategic review outcome is including both of them together? Or what if it's something that splits them apart? Is that a fair question? I think it is."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes, it's a totally fair question. I think what we've said is that we are open to any alternative that maximizes shareholder value. And if that alternative is that somebody is willing to value the fiber solutions business apart from us higher than what we think we're getting credit for what we believe it's worth internally, then we would like to sell it separately. If that valuation metric goes only in combination with small cells, then we would do something with a combined business. So that's really how we are thinking about it. I can't tell you how a potential buyer would look at the pros and cons of whether they want it together or separate. That's up to them to try to figure out. We know that there have been good overlaps between towers, small cells, and fiber solutions. That's why we have them together, but we are open to somebody coming in and valuing each, however they think they see value and comparing that to what our own internal look is and making the best decision for shareholders."
},
{
"speaker": "Ric Prentiss",
"content": "Okay. Last one for me, Steven, unique position we think you're in. We continue to see private multiples well above public multiples. Can you give us your opinion on -- are you seeing that? Why are we seeing it, and why has it persisted so long if it is there?"
},
{
"speaker": "Steven Moskowitz",
"content": "That's a great question. Yes. I mean, it's a bit of a mystery. I mean, obviously, you have a lot of private investors who are very excited about this business, about the business model and about the future growth prospects. And they're investing capital and they feel that whatever high multiples of investing capital at, that at some point down the road. They'll be able to sell the business and get a good return on their invested capital or recapitalize the business somehow or partner with somebody but they see a very good exit. And I think there is, from our perspective of dislocation. We just -- we're – again we're not being opportunistic in looking at some deals that are out there that are very non-accretive to this company. So we'll see what happens over time. And we are hoping, Ric, that the dislocation changes and it does give us an opportunity. So as our balance sheet strengthens over the next number of years, and we do have more flexibility and optionality to grow inorganically, that there's opportunities. And that may be multiples at that juncture will have come down a little bit, and it's something that we would be seeking to engage in conversations with some of these privates."
},
{
"speaker": "Ric Prentiss",
"content": "Great, appreciate the color. Thanks guys."
},
{
"speaker": "Daniel Schlanger",
"content": "Thanks Ric."
},
{
"speaker": "Operator",
"content": "The next question comes from Jim Schneider with Goldman Sachs. Please go ahead."
},
{
"speaker": "Jim Schneider",
"content": "Good afternoon and thanks for taking my question. Relative to the operational update and a lower number of small cell deliveries you expect to make in 2024, can you clarify whether that reflects a reduction in the amount of small cell activity that carriers intend to do overall this year? And do you believe there is any change in their intention to do more self-perform work on small cells?"
},
{
"speaker": "Steven Moskowitz",
"content": "Yes, I'll take that. Again we made the shift, since returns on our invested capital has not yet materialized, right, to the level we had hoped for as we talked about. But we have a lot of conviction that if we continue to execute well, we are going to be able to maximize business in the future as long as it's more on or around our fiber backbone. And again, we are looking at this as the carriers have their demands in terms of network changes and expansion with their different types of solutions and it is based on many factors. And so for now, the carriers remain focused on deploying mid-band spectrum. I mean that's kind of their top priority. And from our perspective, our priority is to drive better returns on capital deployed. So we are in the process now of working with these customers on solutions, and we feel that we are going to be able to align their needs with ours in the short run right, going through kind of the balance of this year and into next year. But as it relates to future demand, this business is kind of ever changing, and it is a bit lumpy in terms of how we see things quarter-to-quarter. But generally speaking, the type of data demand growth that we see in the future, and that's estimated, we just -- we remain very optimistic that data growth is going to drive more densification, and it will drive more demand for small cells over time, which will lead to the type of double-digit revenue growth that we forecast into the future."
},
{
"speaker": "Jim Schneider",
"content": "That's helpful. Thank you. And then Steven, relative to your comments on the potential opportunity for market share gains, is there a particular segment of your business where you think you have the greatest confidence in achieving that over the next two years?"
},
{
"speaker": "Steven Moskowitz",
"content": "We have these holistic agreements with our major customers where we have one that's going to be coming up for kind of a new negotiation over the next year. So we are hopeful that, that leads to kind of sanctifying our relationship even further and kind of taking our relationship or partnership up to a next level of excellence with that customer, which hopefully will enable them to consider us as being a real preferred supplier. So that's one element of it. There's a whole host of kind of mid and smaller regional customers out there that we've been focused on. And I think with a greater effort, a greater sales effort and different rewards for our sales teams, we should be able to be kind of convincingly garnering a higher share of business than we have in the past. So I think the combination of those two things should give us the chance to be able to generate more of our unfair share of business than we are taking now."
},
{
"speaker": "Jim Schneider",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "The next question comes from Nick Del Deo with MoffettNathanson. Please go ahead."
},
{
"speaker": "Nick Del Deo",
"content": "Hi, thanks for taking my questions. And I hope you guys and your team have been managing through the effects of the hurricane okay. Steven, you just touched on this a little bit in your prior answer, but I was hoping you could expand a bit more broadly on your high-level philosophies as it relates to MLAs, so we can kind of understand the puts and takes of what you think about or want to see when you're contemplating those sorts of arrangements."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I mean, Nick, obviously we've been able to achieve good growth and create significant shareholder value by negotiating these types of comprehensive MLAs. And the key for me is to be able to find ways where we are really kind of getting to a yes-yes situation or a win-win situation between both parties, where we are able to realize kind of more guaranteed growth over a multi-year period of time, in a way that maximizes the value of our assets, while giving the carriers really a much better degree of certainty, as it relates to how they budget. And also enables them to get on to our sites more quickly, more efficiently, which then lowers their overall cost of operations. So the goal here is to have them be really beneficial to both our customers in providing that framework to leverage our assets and also for us in order to be able to drive more revenue. But obviously, there is key elements of that include pricing and packaging and volume and annual escalations in addition to the types of needs that the carriers feel that they need over time in terms of entitlements on these assets. So there is a number of things that come to play, which I know you know a lot of those, but that's kind of how I think about it broadly."
},
{
"speaker": "Nick Del Deo",
"content": "Okay, that's helpful. Thank you for sharing that. I guess one other question on fiber solutions. I guess can you guys drill down a little bit on the changes to your sales tactics or sales incentives or the sales tools you are going to be using to enable you to sell more on or near-net versus what you've been doing historically?"
},
{
"speaker": "Steven Moskowitz",
"content": "Well again, from an enterprise perspective or fiber solutions, the shift is in sales and marketing primarily, basically going kind of from a wide-angle lens to more of a zoom lens, I guess, I would say. And we’ve been dealing a lot with retail type of clients, and we're trying to move a bit away from retail clients that are more transactional, that create a little bit more churn, that aren't as financially sound. And we are trying to move to customers and increase time spent with the larger customers out there that are in telecom, financials, what we call GEM, which is Government, Education, and Medical. And those folks tend to remain loyal for longer contractual periods of time which help, and they also have more financial wherewithal to contribute more capital to any type of new project. So the goal really is to kind of shift more into that, what we call complex sale area. And between the review that our teams did over the last number of months and some input from an adviser who's very steeped in this industry, they both felt collectively that there is a lot of headroom or opportunity to be able to kind of shift a bit from retail to more complex selling. And we've put some pretty good sales incentives in place. And we have some automated systems that also help us in terms of kind of defining where there is upside in our footprint."
},
{
"speaker": "Nick Del Deo",
"content": "Okay, that’s great. Thank you Steven."
},
{
"speaker": "Operator",
"content": "The next question comes from Richard Choe with JPMorgan. Please go ahead."
},
{
"speaker": "Richard Choe",
"content": "Hi, I have one question regarding the strategic review. I mean, should we be thinking about an outcome kind of by the next earnings call, end of the year, or maybe longer than that? And then following up on the tower question, longer term, is the tower business still a 5% business? Or could that actually be a little bit higher, given maybe the changes that you are focusing on? Thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. As it relates to the strategic review, it is difficult to put a time frame on it, right? We're in the mix now. We're heavily engaged with multiple counterparties, potential counterparties. And we'll see how it plays out. We'd like it to be accelerated so we can make a decision, right? It would be good for our company, it would be good for our people. It'd be good for our shareholders depending on what outcome we decide on. So just I guess, stay tuned, stay with us on this, and we'll be able to hopefully report something out as the year flows through. As it relates to the tower business in terms of kind of the outlook, we are not sure how -- if over 5% is something that's so readily available. Ideally for us, it could be. We've talked about cycles with the Gs and we feel we are kind of in mid-cycle right now, a bit of a trough. And ideally by the mid-to-end of next year, maybe we see a tick-up by the carriers in their capital spend. I think they are going to be spending $32 billion or $33 billion this year overall. Not all of that, of course, on our networks. But if they ratchet back a bit or say ratchet forward a bit, particularly maybe as interest rates settle a bit, which could be helpful to them, then by middle of next year, ideally we see a little bit greater demand and kind of finishing off between '26 and '27, of the 5G expansion. So if that happens, then that could increase growth incrementally. And then if we are able to get a bit of a higher share of growth, those things collectively puts us, we believe kind of in that 5% or maybe 5%-plus range."
},
{
"speaker": "Richard Choe",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Ari Klein with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Ari Klein",
"content": "Thank you. Maybe just going back to small cells. Given the shift in strategy, I think you've previously talked about 50,000 nodes in backlog. How many of those are impacted, I guess, by the shifts that you are implementing?"
},
{
"speaker": "Daniel Schlanger",
"content": "As of right now, we don't have a change. We still have the 50,000 nodes in backlog. We're working through all of those in the discussions with our customers. And nothing at this point has changed that would change that 50,000. As we come to some sort of decisions with our customers and figure out what we want to do, should there be changes, we will obviously update that number, but it hadn't happened yet."
},
{
"speaker": "Ari Klein",
"content": "Thanks. And then maybe you talked a little bit about increased flexibility which includes the balance sheet and maybe bringing leverage lower. Could that at some point, include shifting the dividend strategy and how you think about that?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. I think given the fact that we're in the middle of the strategic review which would include the thought around capital allocation, dividend policy, everything else ultimately. We are really not in a great place to talk about what's going forward until we have more of a conclusion on what businesses we have and where we are going to be in the future."
},
{
"speaker": "Ari Klein",
"content": "Got it. All right. Thanks for the color."
},
{
"speaker": "Operator",
"content": "The next question comes from Matt Niknam with Deutsche Bank. Please go ahead."
},
{
"speaker": "Matt Niknam",
"content": "Hi guys. Thanks for taking the question. Just two on fiber as well, it seems to be the theme of the call. One, obviously, there is a sharpened focus on more profitable on or near-net build. So Dan, I want to go back to a point that was brought up before. I know we reduced discretionary CapEx for the fiber business $300 million this year. This is a business that typically has from what I remember, an 18-month to 36-month book-to-bill, so there is pretty decent visibility. And so I'm wondering as we sit here today how that maybe informs what 2025 can look like, just given sort of that longer book-to-bill window. And then secondly on fiber solutions, the core leasing number this quarter, $39 million, I believe that was the highest since 1Q '22. So just looking for any updates you can share there and anything notable you'd call out driving that strength. Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. Matt, I just want to make sure. The first question you asked was based on -- was directed at small cells, right not fiber solutions?"
},
{
"speaker": "Matt Niknam",
"content": "Yes, more so just around discretionary spend for fiber in general."
},
{
"speaker": "Daniel Schlanger",
"content": "Okay, fiber in general. Because when we were talking about an 18-month to 36-month book-to-bill, that's more like a small cell type of book-to-bill cycle. Fiber solutions is much faster. So we have reduced the discretionary CapEx. We do believe that -- that reduction will ultimately impact the amount of nodes that we are going to build and the revenue that we can generate. And part of how we are going to go through the discussions with our customers and how those will end up will impact 2025, and we'll be able to talk about it, like I said, in January when we give guidance. On the fiber solutions side of reduction, we do have reductions in the CapEx that has to do with some fiber business. And that's because what we talked about is we are not really targeting building out to new locations. We are targeting locations that are already on our existing fiber. So both of those are happening at the same time, all of which may impact 2025. But as we pointed out, as we look out at our business in the fiber solutions side, we believe there is plenty of opportunity around our existing fiber plant in great markets throughout the top 30 markets in the US, which is most of where our fiber assets reside now, that we think we can get back to a 3% growth in fiber solutions going forward even with a more limited focus to on- and near-net opportunities as opposed to expansion opportunities. And as you pointed out in your second point of your question on the core leasing activity in fiber solutions, it was a very good quarter for us. And it gives us some encouragement that the changes that we are making are available to still generate that 3% growth over time. And as you pointed out, that's some of the best growth or core leasing activity we've seen in that business in quite some time. And what I would say is, it really is the focus of the sales team having gone out and made the right types of decisions with the right types of customers to sell the right types of products. And as Steven was talking about earlier, put the right incentives in place to make all of that happen. And our sales team and sales leadership have done a phenomenal job of taking that input and attacking the market. And we are seeing that there's still -- like I said, we're encouraged by how much opportunity we are unearthing that's near our already existing assets."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I guess, I'd like to also just add, in a recent meeting with our teams on the enterprise fiber side in New York, some of the sales teams were asking a question about greenfield builds. And the answer to that was it is not like it's binary, right? It is not a yes or no scenario. And the example that the individual brought up was if I'm able to get a deal done with a very well-known hedge fund who wants 15 floors of fiber built in Hudson Yards. And I think there is opportunity for colocation, and we can prove in that the returns from day one are going to be X and the payback is going to be within the realm of what we're looking at, is that something that I can compete on? And the answer was yes. So we are not counting out not doing greenfields at all. It is just from our perspective, it just has to be profitable."
},
{
"speaker": "Matt Niknam",
"content": "If I could just follow up on the first question. I know there was a reduction of about $300 million that was announced, and I think that was reaffirmed in today's release for discretionary spend in totality for fiber. That is six months of this year, so is it fair to extrapolate that and say next year could look more like an $800 million number? Or is that too much of a generalization and we should just sit tight till January to get additional color?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. Unfortunately, you are not going to love the answer. It's going to be, you're going to need to sit tight till January because like I tried to say earlier, the amount of CapEx that we ultimately spend is going to be based on the amount of activity we see from our customers. Whatever that CapEx is, is a lower capital intensity than it would have been historically for us. But it still could be that there is lots of activity we can go out and get. To Steven's point, that would be very profitable. And so we don't want to give any guidance that says we will definitely have this amount of capital reduction going into next year. Plus we haven't given a forecast for 2025, so it's hard to give a reduction to a forecast that doesn't exist. So unfortunately, Matt I'm sorry, you are going to have to just sit tight and wait until January."
},
{
"speaker": "Matt Niknam",
"content": "I had to ask. Appreciate it. Thank you both."
},
{
"speaker": "Steven Moskowitz",
"content": "No problem."
},
{
"speaker": "Operator",
"content": "The next question comes from Batya Levi with UBS. Please go ahead."
},
{
"speaker": "Batya Levi",
"content": "Great. Thank you. A couple of follow-ups. First on the small cell side, can you provide more color on how we should think about the pacing from here? Should we assume the 3,000 to 5,000 delayed build will be just tackled down to maybe the 10,000 annual deployments you were targeting next year? And then one more follow-up on the fiber CapEx reduction if you don't mind. The $300 million, can you give us a split on what the small cell versus fiber mix of that is?"
},
{
"speaker": "Daniel Schlanger",
"content": "Sure, Batya. On the first point again, we don't have really a plan for 2025 that we've talked about publicly around the small cell nodes that we would deploy. But the push-out of the 3,000 to 5,000 nodes from 2024. We do believe some of those will hit in 2025 because it is a deferral of those nodes going into a future period, a lot of which will happen in 2025. So we do think we have a pretty good sense or a good starting point for 2025 and think that the small cell business will continue to grow as we've talked about, that we think we can grow that business in the double digits over the next several years. And because our backlog is what it is, because we are able to continue to build for our customers, we feel comfortable with being able to grow double digits. On the $300 million reduction in CapEx, the majority of that reduction is in small cells as opposed to fiber solutions."
},
{
"speaker": "Batya Levi",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Eric Luebchow with Wells Fargo. Please go ahead."
},
{
"speaker": "Eric Luebchow",
"content": "Great, thank you for taking the question. On the small cell backlog and what you expect to deliver the next couple of years, any change to the mix of colocations versus anchor tenant nodes? How should we think about that shifting as a result of the strategic review or the operational review that you announced last month?"
},
{
"speaker": "Steven Moskowitz",
"content": "Hi, Eric. It's Steven. The fact that we are going to be shifting down on the anchor nodes means that a higher percentage of our nodes going forward will be colocations. And I think we've already communicated that of the 50,000 backlog a big chunk of those, the majority of those are colocations. So when you look at our overall mix, you are going to see a higher percentage of colos versus anchors."
},
{
"speaker": "Eric Luebchow",
"content": "Okay, great. And then just a higher level question on tower activity. So perhaps with the exception of DISH, is the majority of your activity today still amendment related from carriers upgrading mid-band spectrum? Or have you seen any activity out there related to new colocations to densify tower grids in any of your markets, particularly the more urban ones? And if you haven't seen that in a big way, any kind of visibility on when that tower densification phase may pick up in the next couple of years? Thanks."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I mean, most of our activity is amendments. There is a few colocations in the mix but it is not a large percentage. Obviously, some of the colocations we are getting are coming from, as I said before, kind of the smaller regional players out there, not necessarily the Big 3 or DISH. And we expect that same type of cadence to happen over the next number of quarters."
},
{
"speaker": "Eric Luebchow",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Walter Piecyk with LightShed. Please go ahead."
},
{
"speaker": "Walter Piecyk",
"content": "Thanks. Just I was hoping you could remind me of the components of believe it or not, I'm asking about SG&A at $200 million, $204 million not much of a reduction from last year, especially given the reduction we saw in first quarter. Maybe there is just some non-cash things that moved back and forth. But can you just kind of talk about the components in there and what areas are targeted for reductions going forward?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. Well, I’m happy to talk about the components that are in there? Majority of our G&A, as you would imagine are people that are working on the back office functions that we have, whether those are accounting or finance things of that nature, legal and IT. And what we've been able to do in that business, we've been able to offset all of the labor inflation that we've seen over the course of the last several years by the operating plan we have. And we are and have targeted the G&A and believe that we will have reductions over time, which is part of the $60 million reduction that we talked about and that we will realize in 2024. And you'll have to just allow me, I don't have the number off the top of my head of what quarter-over-quarter."
},
{
"speaker": "Walter Piecyk",
"content": "That's fine. I'm just looking -- I mean, last year you had -- it kind of came up in the second quarter. But then I looked at prior years, and there doesn't seem to be seasonality there. So when you talk about $60 million, is it – that is all for the fourth quarter level and then that's just going to keep going down? Or maybe there was some proxy fees in there in the quarter but I guess there wasn't -- I mean, that was a big number last year."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes, there were $20 million of proxy fees --."
},
{
"speaker": "Walter Piecyk",
"content": "But that wasn't there last year in the second quarter which also was up, but whatever. I just -- it seems like obviously an important component but you don't think there is anything abnormal there? And so when are we going to see these reductions kick in? Obviously, the proxy fees drop out in the third quarter, so you'll get whatever that number is an immediate drop, and then we'll see some additional organic improvements in Q3 or are these all back-end loaded?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. So as you pointed out, I think as we see the proxy fees come out, we will be at a lower run rate than we saw in 2023 because we also did a restructuring in 2023, where in Q2, we reduced our G&A pretty substantially as well. And we believe we see the impact of the money we saved was largely done very recently at the end of Q2. So you will see the impact in Q3 and beyond. So you'll see both of those things go on. So I think the answer to your question is basically yes, it is back-end loaded to see the reductions. And if you look at the numbers in 2023, you see a similar outcome which even not looking -- not focusing on Q2 but going from Q1 to Q4, there was a substantial reduction. But it started in Q3 because we had a very similar timing for the restructuring we did last year to this year. So I do think you'll see a reduction in G&A. And the spike in the second quarter was very much because of the proxy-related fees."
},
{
"speaker": "Walter Piecyk",
"content": "Okay. So I mean look, at the end of the day, next year assuming there is no more proxy fights and then you've got the reduction in whatever you announced in terms of guidance, you should get some much better efficiencies in 2025, hopefully, right?"
},
{
"speaker": "Daniel Schlanger",
"content": "That is the plan. And as we've talked about a few times today, we announced the restructuring, the changes we were going to make in June. We have completed those changes for the most part and believe that we will see the savings that we are talking about roll through our income statement over the course of the last half of this year."
},
{
"speaker": "Walter Piecyk",
"content": "Got it. All right, thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Brandon Nispel with KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Brandon Nispel",
"content": "Yeah. Hi, thanks for taking the questions. A lot have been answered already. But you guys have talked about, in the past the guidance 5% tower growth through '27, and that 75% of that is contracted. So I guess a simple question is how are lease applications trending today in terms of your confidence in achieving the remaining sort of 25% to hit that 5% growth rate? Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Yes. I would -- what I would say there is that the 5% growth rate is based off of, as Steven talked about earlier, the MLAs we have in place and then additional growth we see going forward. The application volumes are much more akin or much more linked to what we see as near-term growth in our tower business. And what we've talked about is that we've maintained our 4.5% guidance for 2024 because we see activity levels that are very much in-line with what we expected when we gave guidance last year. So it is all very much in-line with what we would have expected. And we gave that 5% longer-term guide knowing what was going on in 2024, so it is all in line with what we would have expected to get to that longer-term growth."
},
{
"speaker": "Brandon Nispel",
"content": "Great. Thanks."
},
{
"speaker": "Operator",
"content": "Our last question today comes from Brendan Lynch with Barclays. Please go ahead."
},
{
"speaker": "Brendan Lynch",
"content": "Great. Thanks for taking my question. How should we interpret the changes in operations in the fiber and small cell businesses while the sales process is still ongoing? It sounds like you're engaged with multiple counterparties currently. And it seems like maybe it would be a little bit premature to make such changes that somebody else is going to be managing these assets somewhat imminently."
},
{
"speaker": "Steven Moskowitz",
"content": "Yes. I mean, I guess we look at it, the process really was two different processes under one, where strategic obviously is trying to figure out what makes the most sense for the fiber division as it relates to shareholder value in the future. And then from an operations perspective is what can we do to continually improve our business. And we are trying to have that continuous improvement mindset going forward with this company in all elements of our businesses. So we just felt there was opportunity. We wanted to take it. We felt it was something that was going to be good for our business, good for the division, and good for the profitability of our business as we move forward, which in essence, creates more shareholder value. So just -- we want to take the opportunity now and implement these changes because it is kind of separate apart from how we think about the strategic part of a potential sale."
},
{
"speaker": "Brendan Lynch",
"content": "Okay, thank you."
},
{
"speaker": "Steven Moskowitz",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session and concludes the conference call. Thank you for attending today's presentation. You may now disconnect."
}
] |
cci | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to the Crown Castle First Quarter 2024 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to hand the call to Kris Hinson, Vice President, Corporate Finance and Treasurer. Please go ahead."
},
{
"speaker": "Kris Hinson",
"content": "Thank you, M.J., and good afternoon, everyone. Thank you for joining us today as we discuss our first quarter 2024 results. With me on the call are Rob Bartolo, Crown Castle's Board Chair; Steve Moskowitz, Crown Castle's recently appointed President and Chief Executive Officer; Tony Melone, Crown Castle's former Interim President and Chief Executive Officer; and Dan Schlanger, Crown Castle's Chief Financial Officer. To aid the discussion, we have posted supplemental materials in the Investors section of our website at crowncastle.com that will be referenced throughout the call this afternoon. This conference call will contain forward-looking statements, which are subject to certain risks, uncertainties, and assumptions and actual results may vary materially from those expected. Information about potential factors which could affect our results is available in the press release and the risk factors section of the company's SEC filings. Our statements are made as of today, April 17, 2024, and we assume no obligation to update any forward-looking statements. In addition, today's call includes discussions of certain non-GAAP financial measures. Tables reconciling these non-GAAP financial measures are available in the supplemental information package in the Investors section of the company's website at crowncastle.com. With that, let me turn the call over to Rob."
},
{
"speaker": "Robert Bartolo",
"content": "Thanks, Kris, and good morning, everyone. Thank you for joining us. I would like to start by welcoming our new CEO, Steven Moskowitz. As you know, the CEO search committee along with the full board has been actively engaged in a robust process to find our next leader. We worked with Russell Reynolds and evaluated a number of talented and highly qualified candidates. Ideally, we were looking for someone with strong operating experience in the tower industry, a track record of strategic capital allocation and value creation, as well as prior CEO experience. This process has resulted in the unanimous view of both the CEO search committee and the full board that Steven is the ideal person to lead Crown Castle going forward. A 25-year industry veteran, Steven is a proven executive with deep tower operating experience. Steven spent 12 years at American Tower, including the last seven years as EVP and President of the U.S. tower business. During his tenure, American Tower's U.S. operations became the largest and most profitable U.S. wireless infrastructure company, tripling in size to more than 20,000 sell sites. After American Tower, Steven served as the CEO of NextG Networks, a provider of fiber-based small cell solutions. At NextG, Steven produced market-leading returns on invested capital, while increasing the asset base to approximately 10,000 nodes. Most recently, Steven served as CEO of Centennial Towers, where he created a leading provider of build-to-suit cell sites in Brazil, Colombia, and Mexico by focusing on prudent capital allocation and operational excellence. As I've gotten to know Steven, it's clear that his experience and capabilities in the areas of operational efficiency, process improvement, capital allocation, and his proven ability to build strong leadership teams will serve our customers, shareholders, and employees extremely well. We are excited to welcome Steven and believe his leadership will enable Crown Castle to effectively execute on its strategic and operating plans and grow value for all shareholders. I would also like to thank Tony Melone for serving as our Interim CEO for the past three months. With the help of Tony's leadership, the company remains on track to meet its 2024 financial and operating goals and is well prepared for a seamless transition to Steven as the company's next CEO. I'm going to turn the call over to Steven in a few minutes to introduce himself and say a few words. But as you can imagine, after starting in the job late last week, he won't be in a position to take your questions at this time. But before I turn the call over to Steven, I would like to provide an interim update on our Fiber Review process. As you know, in January, the Board created a committee to direct a strategic and operating review of the company's fiber business with the goal of enhancing and unlocking shareholder value. The board engaged financial advisors, Morgan Stanley and Bank of America, as well as strategic and operating advisors, Altman Solon, as well as another leading management consulting firm to assess our businesses, core capabilities, competitive positioning, and organizational structure and also to perform market analysis and operational benchmarking. The goal of these assessments was to determine how to optimize the company's enterprise fiber and small cell businesses and determine the fit, value, and synergies both inside and outside of Crown Castle. As it relates to the overarching conclusion, this review confirmed that we have premier assets in attractive markets throughout the U.S. The next step was to determine the optimal path to maximizing the value of these assets, both within and/or outside of Crown Castle. To help assess the potential value creation opportunities, we have recently engaged with multiple parties, who have expressed interest in a potential transaction involving all or part of our fiber business. These discussions are ongoing. While we will not comment further on these discussions during the call, we are excited to have Steven on board to help us think through our strategic alternatives. We believe his extensive experience in the digital infrastructure sector will be extremely beneficial throughout this process. Regarding our operational review, we have concluded our work with our external consultants. The main conclusion is that they believe there are opportunities for operational improvement in both our enterprise fiber and small-cell businesses regardless of the outcome of our strategic review. We have begun sharing these insights with Steven, who will work with the board and the executive team to develop a revised operating plan that he will share with investors when appropriate. I speak on behalf of the board by saying how pleased we are to have concluded our CEO search with the appointment of such a talented and proven tower executive as well as progressing substantially on our Fiber Review. We are laser focused as a board and moving rapidly yet methodically on these initiatives that we laid out in late December. To reiterate what I said earlier, we believe Steven is the person best suited to lead Crown Castle through the next stages of our Fiber Review, as well as position the company for long-term success and value creation. We look forward to providing further updates as appropriate. Before I turn the call over to Steven, I would like to say, thank you to the talented employees at Crown Castle for continuing to serve our customers and deliver on the financial results we guided to for 2024. I'm impressed by your dedication and capability to stay focused even during these times of uncertainty. With that, let me turn it over to Steven."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, Rob. I appreciate the kind introduction and hello, everybody. I know there's some people on the call that I know from the past, others that don't know me yet, and I look forward to getting to know all of you in the months ahead. But I want to start off conveying how excited I am about the opportunity to lead Crown Castle and really what lies ahead for this company. As you may have seen from my background, I've been at this for a long time. And during my time, I've learned that my leadership success really has been a function of a relatively simple formula. It's been developing and clearly articulating a strategy that the management team and employees can align with and also execute from the onset, having a great team of managers, who are trustworthy and driven and solutions oriented and get things done. Also maintaining a culture that is customer service driven and based on values of hard work and thoroughness, thoughtfulness, and also having some fun. Also giving employees the necessary resources and tools to make their jobs easier and operate more efficiently, very, very important. And doing these things in a way that focuses on long-term value creation for our shareholders, most critical. Now I think we should be able to apply this type of formula at Crown Castle and also apply the benefit I have of coming really from the other side as a competitor of this company for many, many years. And it really provides me with knowledge and a fresh perspective and it's really a big part of the reason I'm here is that I believe that this company has many good things to offer, but also has the opportunity to be best-in-class in this industry. I'm also here because I am optimistic about the long-term future of the needs for communications infrastructure and also because I believe the U.S. market is just the best place to do business in the world and have had some experiences in other markets outside the U.S. I've also admired Crown Castle's assets and customer service focus in the past and instinctively, I believe this company is ripe for significant upside. So all that said as incoming CEO, the company's strategic review is a top priority for me. I've already been digging in the last couple of days, start analyzing what's been done by the Fiber Review Committee and also be collaborating with the board to finalize and execute a strategy, of course, that maximizes shareholder value. Beyond that, even as Rob mentioned, it's kind of too early for further comments on the approach that we're going to end up taking with fiber and small cells. But there are other imperatives that I'll be focused on working with the teams at Crown Castle such as enhancing customer relationships, making sure we manage cash prudently, and finding ways to operate more efficiently. So we definitely convert more new revenues to cash flows. And without a doubt, this is going to be a process that will take some time. But I know together with the employee base, we will create solutions to refresh and reengineer the company in many different aspects of the business operations, finding both some quick hits along the way for some kind of short-term success and longer-term changes that will make it easier for the employees to do their jobs and be more effective at serving our customers, which really will meaningfully enhance our performance. It's going to improve our operating margins and we'll be in a better position to capture unfair share of new leasing business and new site development as our customers ramp back up spending on network expansion. So anyway, that's kind of it for now from me. Before I hand it over to Dan to walk you through our first quarter results, let me first thank Tony, he has been unbelievable, his unyielding commitment to Crown Castle and a great partner as an Interim CEO. And I also appreciate him helping me to get acclimated over the next month to ensure that we have a smooth transition. I'd also like to say thanks to Rob and the board for their faith in me as incoming CEO. And of course, the employees here of Crown Castle, who are continuing to perform at a high level. So with that, I look forward to providing more details about our strategic initiatives as they unfold and I look forward to taking your questions when I host our second quarter earnings call. So Dan, I'll hand over to you."
},
{
"speaker": "Daniel Schlanger",
"content": "Thanks, and welcome, Steven. It's great to have you here as part of Crown Castle team and look forward to working with you. We delivered first quarter results in line with expectations and remain on track for our full year outlook as we continue to focus on executing for our customers and shareholders. Our first quarter results demonstrated our customers' consistent and growing demand for our shared infrastructure assets, leading to us generating 5% organic growth, excluding the impact of Sprint Cancellations. The 5% growth in the first quarter consisted of 4.6% growth from towers, 16% growth from small cells, which includes $5 million of higher than expected non-recurring revenue received in the period, and 2% growth from fiber solutions. As we had anticipated, the solid organic growth delivered in the quarter was offset by the following three items, leading to a year-over-year decrease in site rental revenues, adjusted EBITDA, and AFFO. First, a $50 million reduction in the site rental revenues related to the Sprint Cancellations. Second, a combined $54 million reduction into non-cash items, straight-line revenue, and prepaid rent amortization. And lastly, a $26 million decrease in services margin contribution due to the combination of lower tower activity and the decision we had made and implemented last year to discontinue offering construction and installation services. Turning to Page 5 of our earnings materials. Our full year outlook remains unchanged and reflects a year-over-year decrease in site rental revenues, adjusted EBITDA, and AFFO due to the non-cash and one-time items I just mentioned. On Page 6, our expected organic contribution to full year site rental billings remains unchanged with consolidated organic growth of 2% or 5% exclusive of the impact from Sprint Cancellations. The 5% consolidated organic growth consists of 4.5% growth from towers compared to 5% in 2023, 13% growth from small cells as we expect 16,000 new billable nodes in 2024 compared to 6% growth in 8,000 nodes in 2023 and 3% growth from fibers solutions compared to flat in 2023. Moving to Page 7. We continue to expect to deliver $65 million of AFFO growth at the midpoint, excluding the impact of the Sprint Cancellations and non-cash decrease in amortization of prepaid rent. Turning to the balance sheet. Since transitioning to investment grade in 2015, we have strengthened our balance sheet by extending our weighted average maturity from five to seven years, decreasing the percentage of secured debt from 47% to 6%, and increasing the percentage of fixed rate debt from 68% to 90%. In addition, we ended the quarter with approximately $6 billion of availability under our revolving credit facility and only $2 billion of debt maturities occurring through 2025, providing us with ample liquidity to fund our business. The steps we have taken to strengthen our balance sheet provide us with financial stability and flexibility as we evaluate strategic paths forward. Lastly, our 2024 outlook for discretionary capital remains unchanged at $1.5 billion to $1.6 billion or $1.1 billion to $1.2 billion net of $430 million of prepaid rent received. To wrap up, we continue to deliver good underlying growth across each of our businesses in the first quarter. At the same time, we made substantial progress on the strategic and operating review of our fiber business and successfully concluded our CEO search. I'm excited to welcome Steven to Crown Castle and look forward to working together with him and the board to enhance value for all shareholders. With that, M.J., I'd like to open the line for questions."
},
{
"speaker": "Operator",
"content": "Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Michael Rollins with Citi. Please go ahead."
},
{
"speaker": "Michael Rollins",
"content": "Thanks, and good afternoon. Rob, great to have you on the call and Steven, congratulations on joining Crown Castle. I have two questions. One, just a clarification. Can you clarify the engagement that you mentioned with multiple parties? You referred to the fiber segment, I believe. Does that potentially include both fiber solutions and small cells or do those engagements refer only to the fiber solutions segment? And then second, just taking a step back, can you share a bit more of what you learned from shareholders over the last few months and the fiber strategic review that can help investors think about the direction that the board and management team want to take this company in over the next few years with respect to strategy and asset mix? Thanks."
},
{
"speaker": "Robert Bartolo",
"content": "Hi, Mike. Yeah. Nice to talk to you again. It's been a while. Let me take your first question. I believe it was, does the engagement with the fiber business contain the whole fiber business or just the enterprise portion of the fiber business? And what I would say to you is, there's different parties that are interested in different parts. I would say, as a board, as a company, we are open to whatever type of a transaction would maximize shareholder value. So we're looking at different structures, different formats. So to answer your question, either the whole thing or what I would call the enterprise fiber business are both in play. Now the second -- remind me, the second part of your question, Mike?"
},
{
"speaker": "Michael Rollins",
"content": "Yeah. Just taking a step back after conversations you have with the shareholders and then going through the fiber strategic review so far, just what you've learned and how you're thinking about kind of optimizing strategy and go forward asset mix over a multiple-year period of time?"
},
{
"speaker": "Robert Bartolo",
"content": "Yeah. That's a little more difficult to answer because there are some different views from different shareholders. I think in general, we received positive support from shareholders in terms of us conducting the strategic review of the fiber business. It's too early to really say, this is the definitive direction we're going to go in, so we have to complete that work. And Steven is going to be a big help in completing that work. So I would say the opinions have varied somewhat on shareholders, but they're all excited that we are taking these steps to unlock shareholder value."
},
{
"speaker": "Michael Rollins",
"content": "And just maybe lastly, timing. Is there any timing expectations for the next update or a goal in terms of when Crown wants to complete this part of the process?"
},
{
"speaker": "Robert Bartolo",
"content": "Yeah, Mike. As you can see from our CEO search where we're working hard and we're dedicated to performing for the shareholders. So in a manner that is rapid, but is also thorough. So at this point in time, I can't give you a date and I wouldn't want to put a limit on the time it's going to take. But just know that we've made substantial progress to get to this point in time and only about three or four months of work. So we're happy with the pace that it's going, but I don't have an end date for you."
},
{
"speaker": "Michael Rollins",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Jonathan Atkin with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Jonathan Atkin",
"content": "Hi. Good afternoon and great to connect again. Maybe just a quick follow-up to the last question and that revolves around openness. You talked about maximizing shareholder value. Could that possibly include selling partial stake in fiber solutions and/or small cells? So that's maybe the follow-on question. And then my question would be just as we think about kind of the cadence for how second half momentum might shape up in the core tower business as well as in fiber solutions and small cells, anything you're seeing operationally around how to think about the next three quarters of the year and are we going to be seeing any kind of a different run rate going forward? Thanks."
},
{
"speaker": "Robert Bartolo",
"content": "Yeah. Hi, Jonathan. I'll take your first question. In terms of the form of a potential transaction, we're open to any form that we think does maximize shareholder value. So I think you're kind of referring to a JV structure where you would -- we would sell some portion of either the entire business or one of the two segments of the business. So I'm not going to rule anything out. Those type of transactions are on the menu. And at this point, I can't give you any more guidance as to what we would favor because we're still working through that. But yeah, we're not ruling anything out in the maximization of shareholder value."
},
{
"speaker": "Tony Melone",
"content": "Jonathan, it's Tony. Regarding the second question, as Dan mentioned, we grew tower revenue 4.6% and the annual guide is 4.5%. And while traditionally seasonality suggests that the second half activity generally is higher than the first. So far, what we've seen suggests that there's nothing that we see that would cause us to see something fall outside the range that we've already guided to, which if you recall was $105 million to $115 million for the year. So we still see ourselves in that range."
},
{
"speaker": "Jonathan Atkin",
"content": "And if I could ask one more about cost cutting because there's been some announcements in the past around office consolidation and just where do we land in that process and anything further to expect around cost optimization?"
},
{
"speaker": "Daniel Schlanger",
"content": "Yeah, Jon. It's Dan. We, as you know, in July or August last year announced a consolidation of offices as well as a reduction in mostly our tower force. We have realized the benefits of all of those cost savings and they're coming through in our income statement this year and have been incorporated into our guide, but are coming true. So that was greater than $100 million of cost savings. With additional cost savings, we're always looking to try to find ways to optimize the business. And I would believe that Steven coming in will help us think through if there are other things we might be able to do, but there's -- there are no plans at this point that we would point to."
},
{
"speaker": "Jonathan Atkin",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Ric Prentiss with Raymond James. Please go ahead."
},
{
"speaker": "Ric Prentiss",
"content": "Thanks. Rob, good to hear you and Steven, welcome back and we agree that U.S. tower business could be maybe the best business ever."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, Ric."
},
{
"speaker": "Ric Prentiss",
"content": "Yeah. One question, philosophical. When you think about the dividend kind of path at Crown Castle, dividends flat from '23 to '24. I think previous language had been if we could grow it again beyond '25. How should we think about the puts and takes about philosophically how the board -- it's a board decision, not asking to make the decision today. But philosophically, how do you want to fund the dividend, how do you want to grow the dividend? What do you want cash payout to kind of be as you think about the strategic review? Is there anything you can help us kind of wrap around philosophically, how you're thinking about what the dividend might have -- how it might be structured into the future?"
},
{
"speaker": "Robert Bartolo",
"content": "Hi, Ric. Thanks for the question. The dividend is extremely important to the board and the company. We recognize that our investors, many of which that's a significant component of return for the company as a REIT. We believe our balance sheet is strong and that our earnings and our balance sheet well support the dividend. So we're going to have to -- as we go through and the strategic review and everything else, we're going to have to go through that. But I want to just reiterate our support for the dividend and it's a key part of our capital and our philosophy as a board."
},
{
"speaker": "Ric Prentiss",
"content": "Okay. And then you guys have touched on a couple of times for previous questions with Mike and Jonathan on the fiber small cell piece. How easy is it to separate the small cell business from the fiber solutions business? Just thinking through kind of how Crown's genesis is getting into small cells and then expansion beyond that. But how easy is that to physically kind of pull those apart?"
},
{
"speaker": "Robert Bartolo",
"content": "Yeah. So, Ric, there's many fiber companies and there's many small cell companies that operate without a fiber company, enterprise fiber companies such as ours. So part of the review, one of the learnings is that those businesses can be separated out. And so that increases our alternatives and informs our view as we progress through the strategic review."
},
{
"speaker": "Ric Prentiss",
"content": "Okay. Makes sense. Again, good luck, Steven. And good to hear all you guys on the call today. Thanks."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, Ric."
},
{
"speaker": "Robert Bartolo",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Simon Flannery with Morgan Stanley. Please go ahead."
},
{
"speaker": "Simon Flannery",
"content": "Great. Thank you very much and congrats, Steven on the new role. Dan, you had said before that you expected first half to be the low point in FFO per share. Just wanted to get an update on that. Obviously, you're reiterating guidance today. And then, I wonder if you could just give us an update on just carrier or customer activity across the three segments and in particular just where we are on the carriers moving on to more of an densification phase for 5G and wrapping up the upgrades to mid-band 5G on the sites they haven't upgraded yet? Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Yeah, Simon. I'll take the first one. Yes. We still believe the first half will be the low point for AFFO per share and believe we will grow the AFFO per share through the course of the remainder or the second half of 2024."
},
{
"speaker": "Simon Flannery",
"content": "Thank you."
},
{
"speaker": "Tony Melone",
"content": "Hello, Simon, it's Tony."
},
{
"speaker": "Simon Flannery",
"content": "Hi, Tony. How are you?"
},
{
"speaker": "Tony Melone",
"content": "Good. Regarding activity levels, as I said earlier, we're extremely pleased with results for the first quarter, but as I said, there's nothing that we see right now that takes us outside of our guidance range that we previously provided. What I will say, on the -- I'll reiterate what I said last quarter regarding the carriers. To deliver on the promise of 5G throughout their footprint will require a significant amount of continued densification. Hard for me to predict over what period of time, but there's clearly still a lot of work I believe that they will do to densify their 5G network over years to come, and I think provides a great opportunity for Crown and our tower portfolio."
},
{
"speaker": "Simon Flannery",
"content": "Great. And just maybe a quick follow up on the small cells, you talked about the 16,000 nodes up from 8,000. Can you just give us an update on what your sort of year-to-date pacing has been, that's a big jump sequentially?"
},
{
"speaker": "Tony Melone",
"content": "Yeah, Simon. As you know, we typically provide increments in 5,000 ranges. And so we don't have a further update on that for this quarter. What I can tell you is that the 16,000 sites that we expect, we continue to feel -- have line of sight on for 2024. And as you might expect in what you saw in previous years that is typically back end loaded."
},
{
"speaker": "Simon Flannery",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Nick Del Deo with MoffettNathanson. Please go ahead."
},
{
"speaker": "Nick Del Deo",
"content": "Hi. Thanks for taking my questions. And I want to echo others comments and congratulate Steven on the new role. I guess returning to the cost efficiency topic, Rob, you noted in your prepared remarks that there seem to be opportunities to run the fiber segment more efficiently. You didn't make any comments about the efficiency with which the tower business is run. Should we take that to mean that you believe the tower business is run as efficiently as one can reasonably expect or has that just not been an area of focus yet?"
},
{
"speaker": "Robert Bartolo",
"content": "Well, here's what I would say, the operational review is primarily focused on the fiber segment. So we didn't have a deep dive into the tower cost structure. As Steven's remarks indicated, there are areas for operational efficiency, and he's an expert at extracting those on the tower side as well. So, like I said, it was more focused on the fiber segment, but stay tuned on the tower segment as well."
},
{
"speaker": "Steven Moskowitz",
"content": "Yeah, I guess..."
},
{
"speaker": "Nick Del Deo",
"content": "Okay."
},
{
"speaker": "Steven Moskowitz",
"content": "Hey, Nick. This is Steven. Yeah. I just add that, again, I have some ideas, but I just don't -- it's too early to say anything concrete. My style is typically to first brainstorm with the employees, with the teams, and kind of learn from them, from their perspective what's gone well and what they think needs attention. And then after that, I'll add my thoughts and opinions, and we'll work together in coming up with an improvement plan. And that plan needs to be executed well, have a timeframe, we had a reasonable cost, and this type of operational efficiency movement. I think a lot of people here are eager for some change that will help improve our customer service and improve their abilities to get their jobs done. So I'm pretty excited about it. But again, nothing to communicate at this point. So I guess stay tuned."
},
{
"speaker": "Nick Del Deo",
"content": "Okay. That's helpful. Thanks for sharing all those details. And maybe in a similar vein, last quarter, I think Tony talked about implementing a change in how the segments are run. I think it was basically giving the COO's full P&L responsibility, which is an approach he liked. I guess it's early, but wondering if you're seeing any benefits from that yet, and if that sort of structure is generally consistent with how you like to run the business, Steven?"
},
{
"speaker": "Steven Moskowitz",
"content": "What, I've been an observer. So give me a little bit of time to kind of learn about the different roles, kind of who does what and how things are being implemented. And as I said in my opening remarks, the key focus for me is to have great people. We're all aligned on a relatively simple strategy, so we'll be working on that. But in the meantime, yes, the team has done a nice job coming out of first quarter, and there's momentum. So it's good to see."
},
{
"speaker": "Tony Melone",
"content": "Yeah, Nick. And I'll add to that. It's hard to know exactly what contributed to our results, but I will say the fact that we're able to deliver results, solid results for the quarter, across all lines of business, despite the changes that were going on in the business, myself coming in, etc., gives me comfort that the added focus was helpful. But as I said to Steven, all these changes were made in mind that new CEO certainly is going to come in and provide their own influence on how the business should be run, and the team is adaptable."
},
{
"speaker": "Nick Del Deo",
"content": "Okay. Great. Well, thank you, everyone."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from David Barden with Bank of America. Please go ahead."
},
{
"speaker": "David Barden",
"content": "Hey, guys. Thanks so much for taking the question. I guess I asked this question last quarter, which was -- which would come first, the CEO or the strategy? And obviously, Steven, you are coming first, so welcome. And Rob, it's good to hear from you again. So, Steven, I guess, what kind of agency do you believe you have in constructing the strategy that is ultimately going to be what you're going to own on a go forward basis? And then, I guess, second, more of a detailed questions, Dan. It looks like a non-big three renewal helped the straight line revenue EBITDA this quarter. Could you elaborate a little bit on what that was? Thanks."
},
{
"speaker": "Steven Moskowitz",
"content": "Hey, David. It's Steven. I couldn't hear part of your question, but I think you were asking how I'm thinking about my involvement in what the future strategy will be of the company."
},
{
"speaker": "David Barden",
"content": "Yes."
},
{
"speaker": "Steven Moskowitz",
"content": "I mean, part of the reason why I came here was because I spent a lot of time with Rob, spent a lot of time with the different board members and Tony, obviously, and felt very comfortable that there was good chemistry between the team and myself, the team of board members and myself. And for me, chemistry is critical. I've had it for many, many years in many different roles, and it's allowed me to build trust, hopefully quickly with my bosses, I guess, and then implement and be empowered to implement in a way that I feel will best set the company up for future success. So I feel I'm going to be very involved, and I think maybe there's a little bit of frustration with, hey, the fiber review is to some degree, there's a lot of work that's been done and Moskowitz (ph) is coming in now and maybe there's a little bit of delay, but from my perspective, it's critical for me to really have a lot of exposure to what's been done to provide as an influencer for the strategy and then agreeing with Rob and the board on the best way to move forward. I'm not sure if that answers your question. I hope it does."
},
{
"speaker": "David Barden",
"content": "That's helpful. Thank you, Steve."
},
{
"speaker": "Daniel Schlanger",
"content": "Hey, Dave. I'm struggling with how to answer your question because I'm not exactly sure what you're looking at to conclude what you concluded. There was nothing that I would point to that is a new contract or an extension or anything that would significantly impact straight line and there wasn't a big jump in straight line. So I'm struggling with how I can address whatever you're thinking through."
},
{
"speaker": "David Barden",
"content": "Sorry. Yeah. I was just looking at the supplemental disclosure where the contract renewable contract revenues in 1Q last quarter was going to be about $230 million, now it's about $180 million. And it didn't show up again in the later schedule. It looked like something had gotten pushed out or renewed. I'm sorry if I got it wrong."
},
{
"speaker": "Daniel Schlanger",
"content": "No. There was nothing that was pushed out or renewed. And I can't answer the question directly here, but I'm happy to follow up with you or anybody else who has the same question, but there was nothing that got renewed in the quarter."
},
{
"speaker": "David Barden",
"content": "Okay. Great. Thanks, Dan."
},
{
"speaker": "Daniel Schlanger",
"content": "Yeah."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Richard Choe with J.P. Morgan. Please go ahead."
},
{
"speaker": "Richard Choe",
"content": "Hi. I just wanted to follow up. In the Fiber Review, there's the sale, full or partial, but then there's also the efficiency review. How should we think about the two processes going on simultaneously?"
},
{
"speaker": "Robert Bartolo",
"content": "Yeah. So I would say on the sale of all or part, that's a strategic priority where, as I said earlier, we're engaged with third-parties, so that process is ongoing. And then on the operational review, maybe I'll pass it to Tony."
},
{
"speaker": "Tony Melone",
"content": "Yeah. Essentially, Richard, the work on the operational side with third parties has concluded. We've done the analysis with them and we've shared that work. Internally, we've analyzed the work and processed it, etc. And now we've passed all that work we've done to Steven, and he's going to work with the management team, as we said earlier, to take that input and obviously add his own insight and apply that to the business."
},
{
"speaker": "Richard Choe",
"content": "Great. And then with the services business, are you seeing any changes with the, I guess, ongoing services business?"
},
{
"speaker": "Robert Bartolo",
"content": "No. As we talked about, we think that the services, the contribution to margin that we have to service in the first quarter, when we talked about it last quarter, are generally going to be consistent across the quarters. So there's nothing that would have changed our view of that consistency at this point."
},
{
"speaker": "Richard Choe",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Matt Niknam with Deutsche Bank. Please go ahead."
},
{
"speaker": "Matt Niknam",
"content": "Hey, guys. Thanks so much for taking the question. Just two quick ones, if I could. First, on the fiber business, is the strategic review affected pace of bookings any sort of customer behavior over the last several months at all, whether on the fiber solutions around the small cell side? That's number one. And then secondly, just any color you can provide in terms of pacing of application volumes, carrier activity on the tower side, and whether there was any meaningful change or pickup across the four carriers intra quarter? Thanks."
},
{
"speaker": "Daniel Schlanger",
"content": "Thank you, Matt. So on the booking side, the answer to your question is, that we have good line of sight as we talked about on the bookings for both small cells as well as fiber solution to give us comfort in the guides we provided both the 16,000 small cells for the year as well as the 3% growth for the year, so feel very comfortable with that. And so on your second question, in terms of pacing. No, there hasn't been any evidence -- any material change in terms of pacing within the quarter that would be of significance to comment on."
},
{
"speaker": "Matt Niknam",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Batya Levi with UBS. Please go ahead."
},
{
"speaker": "Batya Levi",
"content": "Great. Thank you. A couple follow-ups. First, on the tower activity. Can you provide us an update on what percent of the towers have been upgraded with 5G equipment now? And if you're seeing any change in the carrier activity to support fixed wireless? And a follow-up on the discretionary CapEx side, can you talk about how much of that is already committed to? Can we expect that you might pull back a bit as the strategic review is ongoing? Thank you."
},
{
"speaker": "Tony Melone",
"content": "Regarding 5G, I think the last time we commented on 5G, we don't regularly update on that number. I think it was 50% and we'll provide an update at some point in the future. But we have no update for you today on that."
},
{
"speaker": "Robert Bartolo",
"content": "Carrier activity on fixed wireless."
},
{
"speaker": "Tony Melone",
"content": "Yeah. Carrier activity on fixed wireless, really it's hard for us to – the activity. our activity, it's hard for us to determine whether it's being driven by fixed wireless or their general mobility services. And quite frankly, it's hard for them to determine that themselves. Just the nature of the cell site, their capacity needs as dictated by both and which one triggers that relief requirement is difficult to predict. So it's almost impossible for me to give you a feel for what's driving that and how much of it is fixed wireless."
},
{
"speaker": "Daniel Schlanger",
"content": "On discretionary capital and how much is committed. We do, as you know, have long term commitments based on the contracts that we've signed with our customers. Those commitments we intend to honor. We'll continue to build the small cells we need to build, we'll continue to build the fiber for our fiber solutions business. And as you saw, we have not changed guidance for 2024. So we still anticipate that we'll spend that and can't really comment on what the strategic review might do, for all the reasons that have been said before. So, as of -- so, we continue to think that we will spend the money and generate the growth that we articulated in our outlook."
},
{
"speaker": "Batya Levi",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Brendan Lynch with Barclays. Please go ahead."
},
{
"speaker": "Brendan Lynch",
"content": "Great. Thank you for taking my question and congrats, Steven, on the new role. Maybe just another one, on the strategic review. Obviously, you're considering what to do with the fiber and small cell business, but is there a component of the strategic review that is also considering how to manage the remaining business if you were to sell off those assets, whether that be to expand the tower business into new markets or enter a new vertical of some sort?"
},
{
"speaker": "Robert Bartolo",
"content": "Yeah. This is Rob. Thanks for the question, Brendan. The strategic review right now is focused just on the fiber business. So to answer your question directly, we're not focused at this point in time on what would happen after the strategic review, and the future course and strategy of the company in terms of capital allocation in those -- in that nature. I think Steven is going to be a huge part of that, along with the board. So yeah, the strategic review is just focused on the fiber business right now."
},
{
"speaker": "Brendan Lynch",
"content": "Okay. Thank you. That's helpful. And maybe one follow up, with the higher for longer rate environment, do you anticipate that this will affect carrier spending this year or next, or are they primarily responding to network needs when considering their deployment pace?"
},
{
"speaker": "Tony Melone",
"content": "Brendan, this is Tony. I would -- based on my experience there, there's always potential for some movement along the edges, but principally, they're responding to capacity needs, quality of service needs, etc. So I would say, the vast majority of their decision making in year is based on that."
},
{
"speaker": "Brendan Lynch",
"content": "Okay. Very good. Thank you for taking my questions."
},
{
"speaker": "Operator",
"content": "Thank you very much. The last question this evening is from Brandon Nispel with KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Brandon Nispel",
"content": "Hey. Thanks for getting me in and taking the questions. I was hoping to go back to the tower business. You obviously called out, your first quarter results were right in line with guidance. But I think, big picture, your level of leasing is well below historical levels that you've seen, and much closer to the trough than any sort of peak. So I was hoping you could talk about the confidence you have in terms of reacceleration. It didn't sound like that was in the guidance for this year, but something to get back to your 5% long term growth guidance? And I'll leave it at that. Thanks."
},
{
"speaker": "Tony Melone",
"content": "Yes, Brandon. Thanks. It's Tony again. I think I just reiterate what I had said earlier when I said last quarter. I know what's needed to cover 5G at the speeds that are promised, again, with fixed wireless and that activity, and just overall growth in data demand in that business, that requires either more spectrum or more densification. And as you know, in the past few years, the carriers have been focused on utilizing spectrum and deploying 5G. And I believe at some point in the future, densification efforts will pick up, but it's very hard to predict exactly when that timing will start. But as Steven said, I believe in the U.S. market. I believe in our shared infrastructure model. And so, I'm optimistic that those types of growth levels will be back at some point."
},
{
"speaker": "Steven Moskowitz",
"content": "Hey, Brendan. It's Steven. Yeah. I just say that there's always phases of builds, right, all the G’s that we've seen over the years, Phase 1 is pretty much massive building over two, three years. And then, there's kind of a pause, right? They still spend capital, they're still filling holes in their network and doing overlays, etc. And that takes typically, could take a year, could take a year and a half. In this market maybe it's taking a little bit longer, but then Phase 3 kicks in, and then there's a reacceleration. And so I think what we're saying is we're kind of in that Phase 2. And I think the good news for me, at least, is I'm coming in new here. But my goal is, again, to work with the team to make sure that we're exceptionally prepared so when Phase 3 comes, which we're anticipating, hopefully at some point in 2025 that we're able to really maximize our unfair share of business going forward."
},
{
"speaker": "Brandon Nispel",
"content": "Thanks for taking the question."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes our question-and-answer session. I would now like to turn the call back over to Tony Melone for closing remarks."
},
{
"speaker": "Tony Melone",
"content": "Thank you, M.J. I'd like to take this opportunity to express my appreciation to the Crown Castle team throughout the country. Over the past three months, I've had the opportunity to spend time with many of you, and I've been impressed by your dedication to our customers and shareholders. You have made my time at Crown Castle something I will look back on fondly. And I thank you for all you do. And I'd also like to say that, like Rob, I'm really excited to have Steven here. When I worked at Verizon, I had the benefit of being one of Steven's largest customers. And I got to see his professionalism, customer focus, and strong operational acumen first-hand. I believe Steven's skills, experience and proven track record of improving financial performance will help the great team we have across the company, take advantage of the growing demand for communications infrastructure. I look forward to working with Steven over the next month and staying actively engaged on the board. Thank you and have a good evening."
},
{
"speaker": "Steven Moskowitz",
"content": "Thanks, everybody."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you very much for your participation. You may now disconnect your lines."
}
] |
ccl | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Carnival Corporation and PLC Fourth Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. If anyone should require operator assistance, you may be placed into the question queue at any time by pressing star one on your telephone keypad. We ask that you please limit yourselves to one question, one follow-up, then return to the queue. As a reminder, this conference is being recorded. It's now my pleasure to turn the call over to Beth Roberts, Senior Vice President, Investor Relations. Go ahead, Beth."
},
{
"speaker": "Beth Roberts",
"content": "Thank you. Good morning, and welcome to our fourth quarter 2024 earnings conference call. I'm joined today by our CEO, Josh Weinstein, our Chief Financial Officer, David Bernstein, and our chair, Mickey Harrison. Before we begin, please note that some of our remarks on this call will be forward-looking. Therefore, I will refer you to the forward-looking statement in today's press release. All references to ticket prices, net per diems, net yields, and adjusted cruise costs without fuel will be in constant currency unless otherwise stated. References to per diems and yields will be on a net basis. Our comments may also reference cruise costs without fuel, EBITDA, net income, free cash flow, and ROIC, all of which will be on an adjusted basis unless otherwise stated. All these references are non-GAAP financial measures defined in our earnings press release. A reconciliation to the most directly comparable U.S. GAAP financial measures and other associated disclosures are also contained in our earnings press release and in our investor presentation. Please visit our corporate website where our earnings press release and investor presentation can be found. With that, I'd like to turn the call over to Josh."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Beth. We had a strong finish to an incredibly strong year. And right off the bat, I'd like to thank the efforts of our hardworking and dedicated team, the best in all of travel and leisure. They have delivered results that consistently outperformed even my own high expectations. Our global portfolio is clearly firing on all cylinders, and I am very proud of what we've been able to accomplish together. We delivered another stellar quarter to close out a phenomenal year. In fact, this was our seventh consecutive quarter achieving record revenues alongside favorable forward indicators like record booking trends and record customer deposits, indicating a continuation of the strong momentum we've been experiencing for the last two years. Fourth quarter net income improved by over $250 million year-over-year, coming in over $125 million better than expected. The outperformance was up and down the P&L and driven by strong closing demand across the portfolio, which pushed yields, per diems, EBITDA, and operating income all to new highs this year. Full-year revenues hit an all-time high of $25 billion and produced all-time high cash from operations of almost $6 billion. Robust demand delivered a full-year 2024 yield increase of 11%, with the majority of the increase attributable to higher prices. Yields finished the year nearly 250 basis points better than our original guidance, driven by a strong demand environment that we elevated throughout the year. Encouragingly, this was broad-based. For 2024, prices were up in all of our major brands and trades between mid-single-digit to mid-teen percentages. And on top of this, onboard spending levels actually accelerated sequentially each quarter throughout the year. Additionally, unit cost came in 100 basis points better than our original guidance for the year as we identified and executed upon additional cost savings initiatives and saw the benefit of an easing inflationary environment. All of this translated to an additional $700 million pickup to the bottom line compared to our December guidance and step-change improvements in our two financial metrics that form part of our 2026 sea change targets: EBITDA per ALBD and ROIC. After just one year down with two to go, we're already over 80% of the way toward achieving both of these targets, calling for a 50% increase in EBITDA per ALBD from our 2023 starting point and an ROIC of 12%, both of which would be the highest the company has seen in almost 20 years. And with ROIC ending 2024 at 11%, comfortably above our cost of capital, we're already delivering long-term value for our shareholders as we lay the foundation we'll build upon in 2025 and beyond."
},
{
"speaker": "Josh Weinstein",
"content": "At the outset, and with about two-thirds of the year already on the books, 2025 is shaping up to be another banner year, with yield growth exceeding 4%, far outpacing historical growth rates and again exceeding unit cost growth, delivering more than $400 million incrementally to the bottom line. In fact, booking trends even accelerated during the quarter. Despite less inventory for sale as compared to the same time last year, 2025 booking volumes over the quarter were actually higher year-on-year at higher prices for each quarter, including the period leading up to the election. Booking volumes for 2026 also continue to break records, reflecting sustained demand even for further out sailings. The ongoing strength in demand reinforced our record-breaking book position. Both price and occupancy are higher for each of the four quarters of 2025, and we managed to increase both our price and occupancy advantage for our 2025 book position thanks to our outstanding efforts this past quarter. I can actually now report that our North American and European segments are each at their longest advanced booking windows on record. All core deployments are also better booked at higher prices than the record levels we achieved at the same time last year. So with a good amount less inventory to sell for 2025, I cannot stress enough to our customers and trade partners that if you want to sail with us this year, book now while there's still space available. And keep in mind, our 2024 results and booked position for future sailings are being driven by improved operational execution across our brands and are essentially on a same-ship basis. Now don't get me wrong. New ships are great. In fact, we welcomed three amazing new ships in 2024. Carnival Jubilee, the third of five XL class vessels for Carnival Cruise Line, is proudly sailing out of the great state of Texas. Some Princess Cruises' next-generation flagship was just awarded Conde Nast Travelers 2024 megaship of the year, beating out all other megaships that entered service this year. And last but not least, came the spectacular Queen Anne, Cunard's first ship in fourteen years and a beautiful addition to Queen Victoria, Queen Elizabeth, and the venerable Queen Mary 2. While new ships do command a nice premium, the vast majority of our yield growth was driven by fundamental demand improvements for the existing ships across our portfolio of world-class brands. Even excluding our new builds, 2024's yields were still up almost 10% over 2023. That's because we're achieving demand growth well above our modest supply pipeline through ground-up efforts to improve execution across the commercial space. We've been investing in both talent and tools, honing in on each of our brands' unique target markets, crafting marketing campaigns that speak directly to them. We're successfully enticing new cruise guests away from land-based alternatives. In fact, both new-to-cruise and repeat guests were each up double-digit percentages this past year. At the same time, our marketing efforts are continuing to deliver growth in web visits, natural and paid search that far outpaced our limited capacity growth, keeping the pipeline of new demand. Simultaneously, with augmenting our performance from top-of-funnel consideration to closing the deal and generating the bookings, we've been sharpening our yield management techniques to optimize our booking curve. Hire and drive ticket prices and onboard spending. While all of these efforts are already in flight and clearly working, we have even more in store to continue the momentum. We're launching new marketing campaigns across all our brands. Princess, Cunard, and Seaborn have already debuted spectacular new creatives this month. In Princess's case, its fresh take on its incomparable love boat theme featuring Hannah Waddingum of Ted Lasso fame already helped to produce record booking volumes for the Black Friday through Cyber Monday period. And stay tuned for new campaigns from Aida, Carnival, Costa, Holland America, and P&O Cruises in the UK, all launching shortly to coincide with wave season, our peak booking period. We're aggressively working to increase awareness and consideration for cruise travel globally. We're also actively working on an enhanced destination strategy to provide guests with yet another reason to take a cruise vacation with us, and that is sure to help us continue to excel. While we retain by far the largest footprint in the Caribbean with six owned and operated destinations that captured six and a half million guest visits in 2024, we believe we had a meaningful opportunity to expand and capitalize on this strategic advantage. These destinations are amongst our highest-rated guest experiences today, and we have plans to lean into these assets even further. While historically, the marketing of our own assets has really focused on the ships, we have untapped potential to create demand for these amazing destination experiences."
},
{
"speaker": "Josh Weinstein",
"content": "I have never been more excited about these prospects. As we begin to unfold this multiyear strategy with the opening of Celebration Key in just about six months, this will be by far our largest and most carnival-centric destination in our portfolio with five awesome portals built for fun, from family-friendly to exclusive beach club experiences. Not only will Celebration Key be the closest destination in our portfolio, saving fuel costs and reducing greenhouse gas emissions, the only way you can get to Celebration Key is on one of our cruises. Moreover, we just recently announced a change that signals more about the shift in our destination asset strategy. Half Moon Key, the highly rated and award-winning exclusive Bahamian destination known for beautiful beaches and crisp clear waters, is being renamed Relax Away Half Moon Key to better reflect the experience guests can expect as they are immersed in this tropical paradise. Enhancements, lunch venues, a variety of bars, and other features created with intentionality to reinforce this destination's natural beauty and pristine appeal. Ready in summer of 2026, a newly constructed pier on the north side will allow two ships to dock, including Carnival's XL class ships that will be able to visit the private island for the first time. We'll be positioning these jewels of the Caribbean with consumers in a way that will encourage guests to actively seek out these specific destinations offered exclusively by our brands, and many of Carnival Cruise Lines itineraries will feature both Relax Away Half Moon Key and Celebration Key, providing guests with complimentary experiences enjoying both the idyllic and the ultimate beach days. We believe developing and promoting these unique assets will help us cast the net wider and capture even more new-to-cruise demand. We're already in flight with preparation for branding and marketing campaigns for these amazing destinations with more to come in the future. As it is, for 2025, we expect to hit our 2026 EBITDA per ALBD target a full year early while raising ROIC to just shy of our 12% 2026 target. So considering all the progress we've made, without this in place, it's clear we have a tremendous amount of headroom remaining to create more demand, cultivate more guest loyalty, and capture more pricing for the incredible ship and shoreside experiences we provide our guests. At the same time, we're making meaningful progress on the sustainability front. We achieved about a 17.5% reduction in greenhouse gas emissions intensity versus 2019, on track to achieve our target of 20% by the end of 2026, a goal that was previously pulled forward by four years. Improvement hasn't just been in emission intensity levels. Despite the fact that we're over 9% larger than we were in 2019, we have actually lowered our absolute greenhouse gas emissions by almost 10% over this time. And, of course, we're also making huge strides on rebuilding our financial fortress. In under two years, we've paid down over $8 billion of debt off our peak and significantly reduced interest expense, which coupled with our improving EBITDA has improved our leverage metrics tremendously. Our current 2025 guidance will put us at 3.8 times net debt to EBITDA, closing in on our expectation to reach investment-grade leverage metrics in 2026. Again, thank you so much to each of our team members who have delivered a step-change improvement in 2024 and set us up for a fantastic 2025 and beyond. And as has always been the case and always will be, thank you so much to our travel agent partners who have contributed immensely to this success. We also appreciate the support we've received from our loyal guests, investors, destination partners, and other stakeholders. Let's not forget, these efforts were really all about the main thing, delivering unforgettable happiness to over thirteen and a half million people in 2024 by providing them with extraordinary cruise vacations while honoring the integrity of every ocean we sail, place we visit, and life we touch. With that, I'll turn the call over to David."
},
{
"speaker": "David Bernstein",
"content": "Thank you, Josh. I'll start today with a summary of our 2024 fourth quarter results. Next, I will provide an update on our refinancing and deleveraging efforts. Then I'll finish up with some color on our 2025 full-year December guidance. Let's turn to the summary of our fourth quarter results. Net income exceeded September guidance by $126 million as we outperformed once again. The outperformance was essentially driven by three things. First, favorability in revenue worth $77 million as yields came in up 6.7% compared to the prior year. This was 1.7 points better than September guidance driven by close-in strength in ticket prices as well as strong onboard spending. Second, cruise costs without fuel per available lower berth date or ALBD came in up 7.4% compared to the prior year. This was six-tenths of a point better than September guidance, which was worth $13 million. And third, favorability in interest expense, other income and expense, and tax expense, all of which were partially offset by higher fuel prices, netted to a $38 million improvement. Per diems for the fourth quarter improved over 5% versus the prior year, which I would remind you were up over 10% last year, with improvements on both sides of the Atlantic driven by higher ticket prices and improved onboard spending. Strong demand allowed us to once again report records, delivering fourth-quarter record revenues, record yields, record per diems, record adjusted EBITDA, and record customer deposits. Next, I will provide an update on our refinancing and deleveraging efforts. Our full-year 2024 yield improvement of 11% was over three times our 3.5% cost increase. This drove improved margins and cash flow, which resulted in our strong EBITDA of $6.1 billion and cash from operations of about $6 billion. All of this propelled us on our journey to pay down debt and proactively manage our debt profile. During 2024, we made debt payments of over $5 billion, which included opportunistically prepaying over $3 billion of debt, reducing secured debt, removing the secured second lien layer from our capital structure, and paying off some of our more expensive debt. We ended 2024 with $27.5 billion of debt, over $8 billion off the January 2023 peak. Our leverage metrics continued to improve in 2024 as our EBITDA continued to grow and our debt levels continued to shrink. We achieved a 4.3 times net debt to EBITDA ratio, nearly a two and a half turn improvement from 2023, positioning us three-fourths the way down the path to investment-grade leverage metrics in just one year. With the benefit of well-managed near-term maturity towers and improved leverage metrics, we expect to opportunistically capitalize on improved interest rates while proactively managing our maturity towers for 2027 and beyond with various refinancings. Now I'll finish up. On top of 2024's 11% yield growth, we are expecting to deliver strong 2025 yield improvement with our guidance forecasting an increase of over 60 cents per share when compared to 2024. The strong improvement in 2025 yields is a result of an increase in higher ticket prices, higher onboard spending, and to a lesser degree, higher occupancy, with all three components improving on both sides of the Atlantic. We are well-positioned to drive 2025 ticket pricing higher with significantly less inventory remaining to sell than the same time last year. Now turning to cost. Cruise costs without fuel per ALBD are expected to be up approximately 3.7%, costing 28 cents per share for 2025 versus 2024. We are looking forward to the introduction of our game-changing exclusive Bahamian destination Celebration Key in July 2025. We anticipate that Celebration Key will be a smash hit with our guests and provide an excellent return on our investment. However, operating expenses for the destination will impact our overall year-over-year cost comparisons by about half a point. In 2025, we are expecting 687 dry dock days, an increase of 17% versus 2024, which will also impact our overall year-over-year cost comparison by about three-quarters of a point. In 2024, there were several one-time items that we benefited from, impacting our overall year-over-year cost comparisons by about a quarter of a point. The remaining 2.2-point increase in cruise costs is driven by inflation and higher advertising expense, partially offset by efficiency initiatives and further leveraging our industry-leading scale. An increase in depreciation expense and lower interest income is partially offset by an improvement in interest expense from our refinancing and deleveraging efforts for a net impact of $0.04 per share. The net impact of fuel price and currency is expected to favorably impact 2025 by approximately $0.04 per share, with fuel prices favorable by approximately nine cents per share, while the change in foreign currency exchange rate goes the other way by five cents per share. Let's not forget that the European Union allowance or EUA regulation in 2025 increases to 70% of carbon emissions from 40% in 2024. As a result, we would expect the impact of higher EUA costs on our year-over-year fuel expense to be about $0.03 per share. In summary, putting all these factors together, our net income guidance for the full year 2025 is over $2.3 billion, an improvement of more than $400 million versus 2024 or 28 cents per share. Robust demand for our brands and continued operational execution is driving our strong financial results along with our increased confidence in achieving investment-grade leverage metrics during the next couple of years as we move further down the road rebuilding our financial fortress while continuing the process of transferring value from debt holders back to shareholders. Now operator, let's open the call for questions."
},
{
"speaker": "Operator",
"content": "Certainly. We'll now be conducting a question and answer session. First question today is coming from Matthew Boss from JPMorgan. Your line is now live."
},
{
"speaker": "Matthew Boss",
"content": "Great. Thanks. And congrats on another great quarter. Thank you very much, Matt. So, Josh, could you elaborate on the foundation that you've laid over the last two years which you think has positioned the company to capitalize on the current demand that you're seeing? And with 2025 shaping up to be another banner year, could you speak to initiatives across the organization to take share, optimize yields, and drive onboard spending in 2025 and beyond?"
},
{
"speaker": "Josh Weinstein",
"content": "Yep. Thanks for the question, Matt. I guess if we look back at the last two years, probably the biggest thing was just doing a bit of restructuring as we've talked about in the past and getting the right leaders in place, leading the brands, and those leaders are a fantastic group of people leading fantastic brands. On the commercial focus side, which we've been talking about for the last few years, right, it is scrutiny expectations around how we're improving in the revenue management space, in the marketing space, considerations at top-of-funnel stuff all the way down to closing the bookings. The amount of advertising that we've ramped up really just to get us closer to where the rest of the market is, I think it's helping to pay dividends. You know, everything from making sure our brands have great relationships with the trade to investing in our own capabilities. Probably the last thing about the foundation would be the portfolio management. You know, we've been actively managing the portfolio and allocating ships differently, moving vessels, winding up a brand in the case of P&O Australia. I think it's setting ourselves up to really put the assets where the highest returns are in the immediate term while we help all the brands who aren't yet where I think they should be get to those levels. So with respect to 2025 and what are the things that we got that are gonna continue our progress, you know, at a base level, it's a continuation of all those things in the commercial space and having those great brand leaders really lean in even further. You know, we're investing in our people. We're investing in our tools, our revenue management tools to make sure that we are utilizing the technology effectively to optimize the yields. The destination strategy that you already heard in the prepared remarks, I think that's gonna be a tailwind continues for a really long time, and we're really looking forward to that. As far as the OBR onboard spending, you know, we've got runway there. I mean, we've got a good amount of runway to continue the progress we've been making around pulling forward the spend as everybody knows opens up the second wallet and the more people spend before they get on the cruise, the more they spend on the cruise. So our brands are, again, working hard to continue that, and we're nowhere near what the cap could be on those types of efforts. So I'm pretty enthusiastic as you could probably tell."
},
{
"speaker": "Matthew Boss",
"content": "I can tell. I can tell. And then David, maybe just quick. If you could just break down net cruise cost ex-fuel components and that 3.7% for this year. But I think more so, how best to think about maybe a reasonable spread between yields and cruise cost multiyear. If there's maybe a back-of-the-envelope rule of thumb multiyear."
},
{
"speaker": "David Bernstein",
"content": "Yeah. So I did my notes talk about the 3.7% because just briefly, the expenses relating to Celebration Key were a half a point. Increase in dry dock days was three-quarters of a point. I also said about a quarter of a point was the one-time items that we benefited from in 2024. And then the remaining 2.2 points really was a combination of inflation and higher advertising that Josh mentioned, partially offset by efficiency initiatives and other leveraging, you know, our scale throughout the company. So those are really the four key components, and it's up to 3.7%. As far as the difference, you know, I don't think there's any rule of thumb here. I really do believe we can, you know, continue as you saw, in 2024, it was three times, but that was a recovery story. Our guidance has a half a point difference between the yield improvement and a cost improvement. Keep in mind that a point to yield is worth, you know, almost double what a point of cost is. So there is leverage there in and of itself. But we will work hard to continue to maintain our cost consciousness. And as Josh talked about, you know, all the things we're investing in in advertising and revenue management should help drive yields higher over time as well as the continued improvement in margins."
},
{
"speaker": "Matthew Boss",
"content": "Great color. Best of luck."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Ben Chaiken from Azero Securities. Your line is now live."
},
{
"speaker": "Ben Chaiken",
"content": "Hey. Thanks for taking my questions. Celebration Key looks pretty exciting opening up later this summer. Do you think you are in the customer awareness of this product? Like, do you think it's well understood, appreciated, by customers? Or is it still or is that marketing kind of, like, and then and awareness still ramping and then thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. Thanks, Ben. I definitely still ramping. I mean, it doesn't exist yet. So we are definitely building momentum. We're building excitement. We're getting the response that we expected with respect to how the bookings are shaping up, which is good to see. But it's still early days. I think the really exciting part is once we're in there really operating and having guests enjoy these experiences and optimizing what we do and how we do it, it takes off from there because right now it's make-believe. So we gotta let everything get in place, and then I think it'll help tremendously."
},
{
"speaker": "Ben Chaiken",
"content": "Got it. Understood. And then in the release and call transcript, you referenced an enhanced destination strategy. Can we open this up a little bit? Does this refer to Celebration Key? Is this a little bit of a teaser to additional opportunities to provide guests with differentiated, you know, Carnival-owned operated destinations? I know you mentioned the Pier at Half Moon Cay, I believe. Just trying to understand the magnitude and direction of the strategy. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah. So let's take a step back from any one particular destination. I think what I've seen for a long time now for several years, and I think some are doing better than others, and better than us, is turning their own destinations into something that not only guests but non-cruisers look at and decide that's gonna help tilt my vacation decision to take a cruise. Because the destination itself looks amazing, is an amazing experience, I can only do it on a cruise. And we have not historically, I think, done a good enough job in raising the level of awareness of the amazing destinations that we have and that are in the pipeline. So when it comes to Celebration Key, we're getting a head start because we're doing it before the location exists. When you think about the change to Relax Away for Half Moon Cay, it is beautiful. It is one of the most stunning destinations in the world. And yet, if you're not a cruiser, you don't know anything about it. You're not looking for it. And we're gonna change that dynamic. And with Relax Away, what we're trying to convey to people who don't cruise is really the vibe of the experience that they can get. And the great thing about it is we're leaning into that natural beauty, which is going to be different from Celebration Key. Celebration Key, as we said, that is the ultimate beach day. Right? Relax Away is all about the idyllic. It's being in a tropical paradise, and we're gonna be able to marry those two things together. So people on the same cruise will be able to get both experiences that are very, very different and exclusive to us. And so we're gonna raise our game there. There's more things that we can do without heavy investment with some of the destinations that we own to make that part of that more exclusive collection. So early days, but we're pretty excited about it."
},
{
"speaker": "Ben Chaiken",
"content": "Helpful. Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Steve Wieczynski from Stifel. Your line is now live."
},
{
"speaker": "Steve Wieczynski",
"content": "Yeah. Hey, guys. Good morning. Happy holidays to all you guys. So Josh or David, if we think about the yield guidance for 2025, just based on the fact that you're two-thirds booked already for next year, it seems like you have strong pricing momentum across pretty much all your geographies. I know you'll hate that I'll say this, but it seems like the approximate 4% yield guidance might end up being conservative when we have this same call a year from now. So I guess the question is, can you give us color around the makeup of that yield forecast? And maybe, Dustin, it seems like you could be taking a conservative view around whether it's onboard trends, whether it's the close-in pricing opportunity. And if I ask that question the other way, I mean, if we think about your initial yield guidance last year, which I think was 8.5% and it ended up closer to about 11%, what did you guys underestimate for 2024? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Hey, Steve. Well, first of all, we were a little worried you weren't first in the queue, so we were gonna literally call 911 to make sure you were okay. So glad to hear your voice. All good. Good. Good. Good. You know, look, our goal is to give guidance based on what we know. And it's certainly something that we want to meet and obviously work hard to exceed. Last year, I meant what I said in my prepared remarks. I think it was a fantastic year by the whole team. That outperformance was, I would argue, pretty special. And, you know, also argue that 250 basis points of yield on top of a base of 8.5% proportionally is not 2.5% on top of 4.2%. So we have a very good handle, I think, on where we are today. Much more so than last year even because we're already back up in full occupancy percentage more or less that we always get. If you remember, the first half of the year, we still catch up, which is like five points of our improvement in yields last year. Was occupancy. I think we're in a more stable place than we were. You know, well, the onboard spends have been fantastic. There's no doubt about it, and we're working hard to continue that trend. And when you look at the 4.2%, you know, there's a little bit for occupancy, but it's all price. Right? Outside of a little bit of occupancy, it's price, and it is a combination of the ticket side and the onboard spot continuing. And we'll work hard to optimize as much as we can. I promise you, our goal is the same as yours. Is get as much revenue as we can."
},
{
"speaker": "Steve Wieczynski",
"content": "Okay. That's good color. And then, Josh, if we look at slide seventeen, you know about SeaChange. You noted your EBITDA per ALBD, you know, it's gonna be hopefully achieved in 2025. You know, but if we look at your ROIC targets, we look at the even carbon reduction target, I mean, it's almost like you're gonna hit those potentially hit those as well next year. So you know, I guess the question is, do you start to think about laying out another set of long-range financial targets, you know, at some point? To us, it seems like those sea change targets really were important pillars and gave the investment community something to really rally behind. So I'm trying to get a little bit more color on how you're thinking about the long-term opportunities here."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah. No. Look. When we get there, I can tell you that whether we do it on the same day or whether we wait a quarter to catch our breath, I can promise you I like the concept of longer-term targets that we set for ourselves and we set for our investors so you can understand what we think our trajectory should be. And I can motivate my team internally to rally around what I think we should be expecting of ourselves. So, yes, you can expect that to happen when we get there. And look, I'd love nothing more than to get to where we say we're gonna be in 2026 sea change targets early. You know, we need about a hundred million bucks of operating income to get to the ROIC. Carbon will be harder. We have a pretty good understanding of where we are, but getting to 19% is pretty good, and we'll see what happens."
},
{
"speaker": "Steve Wieczynski",
"content": "Okay. Gotcha. And real quick housekeeping-wise, David, is there anything we should think about in terms of the cadence of costs? Obviously, we've got the first quarter NCC guide, but anything else through the rest of the year we should about?"
},
{
"speaker": "David Bernstein",
"content": "So as you can imagine, it is tough in terms of seasonalization because between quarters. But, you know, the guidance I would give you is that in the second quarter, we do expect higher dry dock days. So I wouldn't be surprised if the second and third quarters were, call it, one point five to two points above the full-year average in the fourth quarter as lower. That's about the best initial guidance I can give you. But we too will probably see some changes because, you know, this guidance presumes we've made every decision on all advertising and everything else between the quarters. So just take it as a forecast."
},
{
"speaker": "Steve Wieczynski",
"content": "Okay. Thanks, guys. Happy holidays."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Robin Farley from UBS. Your line is now live."
},
{
"speaker": "Robin Farley",
"content": "Great. Thank you. Obviously, fantastic guidance here. And better than expected. I did want to ask about two things just to get a feel for whether these things are in your guidance or how much they're in your guidance and whether this would be additional upside. First is, you know, Celebration Key, you mentioned obviously expected to be very successful and a driver, but you're not really able to see at this point what it would add really to ticket price or onboard spend. So I'm just wondering if you could help us understand how much and really how little you may have in your yield guidance today for Celebration Key. I know in your cruise cost guidance, it's that fifty basis point. How much is it in your yield guidance at the moment? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah. Thanks, Robin. So it is in our guidance, but I'll give you some magnitude of just what touches Celebration Key this year. And it's only 5% of our total sailings in 2025. So it's not that much. When we get to 2026, and we're on kind of a full-year run rate basis, you're talking about 15% plus. So it will be more meaningful for the company overall. Nonetheless, I'm not gonna say what it is, but we're happy to say that we look at our bookings in the fourth quarter for Carnival, we are seeing the premium that we expected to see. Just get this."
},
{
"speaker": "Robin Farley",
"content": "Okay. Great. Thank you. And then also in your EPS guidance, I think that you have three billion in debt that's callable next year. I hope I'm getting this number right, but it's and I assume that you're not factoring in the lower interest cost from some of that very expensive debt. If that were redone at maybe what some other things this year have been done at, could that be, you know, twenty or twenty-five cents of sort of upside in annual interest expense savings? Is that kind of the ballpark to think about potential upside?"
},
{
"speaker": "David Bernstein",
"content": "So twenty to twenty-five cents. Twenty cents would be two hundred and eighty million dollars because it's zero point one four dollars per penny. So just keep that in mind. I'm not sure what you were thinking of. I will say that there is opportunity on the refinancings. We do expect to address those two double-digit interest rate debts that you're referring to. The most callable, as you said, in the first half of the year. There will be some additional savings. We will look at that throughout the year. We did include just a bit of interest savings in our forecast, but, you know, because we're not sure what the market will bring in terms of interest rates to us. So there is hopefully, we'll have a number of successful transactions this year, which will provide some upside for it should say, some lower interest expense."
},
{
"speaker": "Robin Farley",
"content": "Okay. Great. Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from James Hardiman from Citi. Your line is now live."
},
{
"speaker": "James Hardiman",
"content": "Hey. Good morning. So I wanted to ask maybe a big picture question. Obviously, not a whole lot of capacity being added here, and so much of the growth story is organic, obviously. And so I guess my first question is, how much of that organic turnaround do you think it's a function of sort of factors taking place in the industry versus, I don't know, self-help? Right? You listed obviously a whole bunch of things that you're doing brand by brand. I'm ultimately trying to figure out sort of the sustainability of this organic growth that we're seeing right now."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah. Hey, James. How you doing? Man, I wish I could tell you, you know, what the scientific answer to your question is about the industry overall versus us. I think the industry being more mainstream along with us is certainly a fantastic thing for everybody. And I don't want to discount that. But I meant what I said about same ship sales. You know, we got almost 10% yields on the same ship. And if you look at our history, our historic growth rate on revenue was significantly lower than our cruise competitor set. When you look I don't know what they're gonna do next year, but when you look at this year, we're right in the mix and or at the top. So I feel very good that our trajectory is changing for us versus what we had been accustomed to, and it means we've got a pretty good amount of headroom as we look forward because people should be paying more for our experiences. Not only vis a vis our cruise competitors, but I'm talking about vis a vis the experience gap, you know, that exists on what we do versus what land offers. What we call the price to experience ratio is just remarkably skewed. And we should be getting a lot more versus what land competitors do. And I think it's probably a pretty good sign that I'm right about that and the potential when you think about Disney. It basically says we're gonna underinvest in things we have in the past, but we're gonna double down on cruise. They see the value of that as well. So I think we're in good company, and we've got a lot of self-help along the way."
},
{
"speaker": "James Hardiman",
"content": "Got it. And then guess along those same lines, although in a lot of ways, I'm asking previous questions in a different way, but you finished 2024 with per diems up north of 5%. The guidance for the year, I guess, yield guidance is 4 to know, there's some occupancy in there. And then, you know, first quarter is 4.6. So we're going five plus to 4.6 something lower. I guess from our perspective, right, Celebration Key, which comes on in the back half, should actually help with some acceleration. I guess, is there anything quantifiable that we should be thinking about that would weigh on per diems as we work our way through the year? You know, maybe an itinerary, geographical mix issue or is this just, you know, you get some version of this question every quarter. Right? Is this just sort of conservatism the further out you look?"
},
{
"speaker": "Josh Weinstein",
"content": "I get my same answers that we've been giving. Right? We're trying to be as transparent as we can be with everyone on the call and everyone who's not on the call. You know, we haven't been through Wave yet. We will although it's been a remarkable ride two years, it feels like Wave hasn't stopped since, you know, summer of 2022. But we haven't been there yet, and so we'll see what that brings us. And we'll talk again in March."
},
{
"speaker": "James Hardiman",
"content": "Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Patrick Scholes from Truist. Your line is now live. Patrick, perhaps your phone is on mute."
},
{
"speaker": "Patrick Scholes",
"content": "Hi. Good morning. Can you hear me?"
},
{
"speaker": "Operator",
"content": "Yes. Yes. Yes."
},
{
"speaker": "Patrick Scholes",
"content": "Great. Great. Thank you. I'd like to ask a little bit about Mexico for my first question, you know, some news out there lately regarding additional passenger charges on that. Josh, do you think this is a done deal? Or is there any chance that that may not go through at this point? And then specifically for your folks, for your ships, you know, what percentage of your itineraries do make a stop at a port in Mexico? That's my first question. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Yep. So right off the bat, no. I do not think it is a done deal. You know, we've spent dealing with this with the folks in Mexico for the last few weeks. We were not consulted. No one was consulted when this was passed. It's pretty clear to me. I have a lot of respect for the president and what she's doing. But she was misinformed, not informed, and no one was thinking through the ramifications of what they were suggesting. And there's a reason why cruise is in transit historically. As opposed to people who fly into Mexico and stay there for several days. So it's already been pushed off to July first. We're not satisfied with that. We want to have good dialogue with the government and explain all the benefits that we bring to Mexico, which are significant, and it doesn't take much to tweak itineraries to effectively erase what the proposed tax is on the industry. And so I feel we are engaged in those conversations. We hope to have more after the New Year, but it's definitely not settled. And we have nothing in the forecast for these changes for the tax, just so everybody knows. Nothing for the year. As far as what the impact would be, for 2025, you know, assuming it did go into place and we made no changes, starting in July of 2025 with less than 5% of our itineraries for the year for the rest of the year."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. Thank you. Certainly, a fluid situation. And then a follow-up question is on the year-over-year growth rate in your passenger ticket revenues versus year-over-year growth rate in your commissions, transportation, and other. The past several quarters, those growth rates sort of moved in line or lockstep. This most recent quarter, you did have a noticeable increase in passenger ticket revenue percentages higher than the commissions paid out. You know, are you starting to see more book direct or anything to read in? Right. Thank you."
},
{
"speaker": "David Bernstein",
"content": "Patrick, we should talk after the call. I thought it was a pretty close I thought it was a tenth of a percent or something. It's very close. Oh, okay. Revenue. Okay. I come up a little bit different. We'll talk about that after the call. But anything else to consider?"
},
{
"speaker": "Patrick Scholes",
"content": "Nothing else to consider. I mean, that's the numbers you know do vary a little bit from quarter to quarter because of currency and the amount of ARC mix that we have. But nothing significant otherwise."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. Thank you for the clarification."
},
{
"speaker": "Operator",
"content": "Thank you. Next question today is coming from David Katz from Jefferies. Your line is now live."
},
{
"speaker": "David Katz",
"content": "Hi, afternoon. Thank you for taking my question. Covered a lot already. I wanted to get a sense for the cost side of the equation. Right? And know, the variability within there, right? The degree to which know, and what would have to happen for you to turn out a little bit better on the cost increases that you may have built into your guidance. And then I have a quick follow-up."
},
{
"speaker": "David Bernstein",
"content": "Yeah. So if we're talking about the full year, you know, and the 3.7%, you know, the thing that is likely to change over time is most likely to be the efficiencies we find in the magnitude of those efficiencies. We are constantly working hard. We have lots of ideas out there. It is always very difficult to figure out the exact timing. And we did build quite a bit into our guidance and into our forecast. We continue to work hard to improve on those. And so last year, we were able to exceed what our expectations were. And we'll work hard to try to do better this year, but it's very hard on the timing of all these items. Plus, you know, we built in inflation something a little bit less than 3%. And trying to get that number perfect. I mean, if you know absolutely in every category what inflation will be in 2025, let me know because we did the best we could. But I'm sure some of those pieces are gonna be off. As I always say, there's only one thing I know about every forecast, it's wrong. I just don't know by how much and in what direction."
},
{
"speaker": "David Katz",
"content": "Well said. I wanted to follow up just on the leverage side of things. When I look back historically, at you know, where the company has operated, you know, obviously, making good progress today, but you know, should we be thinking about the two times or better, you know, as a long-term aspirational target? Is that still achievable?"
},
{
"speaker": "Josh Weinstein",
"content": "Well, that's for a proud former treasurer of the company. It's not a target we have for ourselves right now. Know, our target right now is to investment-grade metrics, which is three and a half times. How strong we wanna rebuild that fortress, that's still up for a decision, you know, do we need to be an A-minus rated company again bordering on A, which is, you know, some of the situations we found ourselves in, I could argue no, we don't need to. Do we wanna be a solid investment grade? Absolutely. So as we get closer to that metric, know, we're obviously gonna be having conversations with our board to really set out what we think the right balance is between that balance sheet strength, investing in ourselves, investing in our shareholder returns via dividends or buybacks will remain to be seen. What the formal being when. But that all goes into the mix, but I'd say nobody should be thinking about a two-time as a target we're setting for ourselves."
},
{
"speaker": "David Katz",
"content": "Thank you very much. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Next question today is coming from Jaime Katz from Morningstar. Your line is now live."
},
{
"speaker": "Jaime Katz",
"content": "Hey, good morning. Thank you for taking my questions. First, I'm hoping that you guys can talk a little bit about wave season. I guess I'm trying to understand how to think about balancing filling the rest of 2025 with pulling forward more demand from 2026 and whether or not one is a better strategy than the other without giving too much competitive information away. You know, is there a way to, I guess, bundle even less than you are bundling now and, you know, maybe promote less in order to optimize pricing? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah. Thanks. So it's a little bit of a hard question to answer. You know, we are actively and have been actively selling 2025 and 2026 for some time as you might have picked up in the prepared remarks, we actually just had a record this past quarter for booking activity for the further year out, so 2026 in this case. So I think our brands are actually when it comes to revenue management optimizing the shape of the curve, they're doing a pretty solid job across the board, which doesn't mean there's not a lot of room for improvement, but a pretty solid job. So everyone's hitting wave in slightly different positions with respect to how much they're booked for 2025 and in what quarters. So I'd say it's a case-by-case decision about how they're gonna be tackling Wave. I would say everybody does promotions and wave. Everyone. It's how you get people interested in cruising during this critical period. But will remind you, we did promotions last year. In which? And we ended up with 11% yields. So the promotional tactics and tools that we use, they're healthy. And they're part of the process that we go through."
},
{
"speaker": "Jaime Katz",
"content": "And then the other question I have is a little bit of a longer-term strategic question. Right? We know what the costs are affiliated with Celebration Key this summer, but I suspect this isn't a one-and-done project. So is there some non-newbuild CapEx we should be thinking of, like, level that will be in these brand-building projects longer term that might be higher than it was in the past?"
},
{
"speaker": "Josh Weinstein",
"content": "That's a fair question. I think if you think about things that we've been investing in outside of the new build, Celebration Key, Appear at Half Moon Key, Aida Evolutions, which is their mid-shift refurbishment plan. And Aida is much to Carnival's chagrin, Aida is pretty much neck and neck with Carnival for the highest returning brand in our portfolio. We're making the right investments in non-new builds to continue the momentum that we have. As far as what the ultimate level is on a run-rate basis goes, you know, I don't have a number for you that I'd stick to that says over the next six years or seven years, this is what you should expect. But clearly, we're making these investments on the basis that they are gonna support the improved returns that we demand of ourselves. So about $600 million for Celebration Key as we've talked about. Another few hundred million for what we're doing at Relax Away, Half Moon Key. And Aida evolutions, you know, for any one particular ship that they're going through this process, you're talking about, you know, tens of millions, but we think it's tens of millions that really is gonna be a boost for a brand that is incredibly high returning. So I don't know, David, if you wanna add any more color?"
},
{
"speaker": "David Bernstein",
"content": "Yeah. The only thing I'd say is, I mean, you saw in the press release what our number was for 2025. In all likelihood, it's gonna be something similar to that going forward, but it's hard to say exactly what it will be every single year. Because there are so many bigger decisions that we'll be making over time which will make up that number."
},
{
"speaker": "Josh Weinstein",
"content": "One thing I would say about the destination side is Celebration Key and Happy New Year are a little bit unique in the scope and size of what we're doing. The other destinations we have in our footprint, they're amazing. And we will spend some money over time to do some things and make the experience better and better opportunity for us to generate returns. But I don't see other than maybe a continued expansion or celebration key as we've already been talking about through the end of this decade, I'm not sure I on the horizon anything that I'd flag for you right now is kind of out of the that we'd be talking about in six months or a year."
},
{
"speaker": "Jaime Katz",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Brandt Montour from Barclays. Your line is now live."
},
{
"speaker": "Brandt Montour",
"content": "Hey, good morning, everybody. Thanks for taking my question and congratulations on the results today. So the first question you're welcome. So the first question is on the booking curve. Josh, and I don't know if this is an easy one to answer. But when you try to take forecasting out of it and you just focus in on your booking curve today versus the way or versus how your bookings looked at the same time last year, does the pricing look any less robust than this time last year, perhaps tougher comps or anything else that you would highlight?"
},
{
"speaker": "Josh Weinstein",
"content": "Well, I mean, it's certainly tougher comps this year than it was last year. The brands are, you know, as I said, though, in the prepared remarks, we're basically at a higher occupancy at a higher price point and that's across all four quarters. So I think the brands are doing a good job of continuing the momentum and optimizing that curve. So it probably doesn't answer the question the way you'd like it to, but we'll see where that shakes out. We gave you our view of yields as of now and we'll update you as there's things to update."
},
{
"speaker": "Brandt Montour",
"content": "Okay. Great. Thanks. And then just a quick housekeeping. The Red Sea had something like a hundred and thirty million dollar impact last year. How much of that effectively do you get back in 2025 and sort of how should we think about the timing of it and the cadence and where it would kind of show up in the comps?"
},
{
"speaker": "Josh Weinstein",
"content": "Yep. So I think when it all shook out, it was probably a little less than a hundred million dollars, you know, at the end of the day as we did our analysis for 2024. I think the thing about year-over-year for 2025 that people need to keep in mind is it's not a huge springback. And the reason why is if you think about this time last year, we had already sold our world cruises. People were already on them before the Red Sea became a thing. We had to scramble. We did everything we had to do. It cost us ninety million dollars. This year, we're in a different place, which is we knowingly took Red Sea out of the equation, you know, back in February, March for 2025, which meant we had to sell cruises that weren't necessarily as attractive to sell because you can't go through the Red Sea. And so from a year-over it's a different kind of pain point that we had to deal with. And we dealt with, and it's in our numbers. But it means that, you know, what you'd love to see is kind of this bounce back and we're whole and we move forward. I don't think 2025 versus 2024 is really the year that we'll see that. The normalization is now and so 2026 versus 2025 will be on an apples-to-apples basis."
},
{
"speaker": "Brandt Montour",
"content": "Because the lower yields offsetting no disruption this year?"
},
{
"speaker": "Josh Weinstein",
"content": "More or less in high level. Yeah. I think that's fair."
},
{
"speaker": "Brandt Montour",
"content": "Alright. Congrats again, guys. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks very much, Brandt. Okay. So with that, I think we're overtime. So I'd say happy holidays and wish everybody on the call nothing but good health and happiness in 2025. Thanks much for joining."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. Thank you for your participation today."
}
] |
ccl | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Carnival Corporation Plc Third Quarter 2024 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Beth Roberts, Senior Vice President, Investor Relations. Thank you. You may begin."
},
{
"speaker": "Beth Roberts",
"content": "Thank you. Good morning, and welcome to our third quarter 2024 earnings conference call. I'm joined today by our CEO, Josh Weinstein, our Chief Financial Officer, David Bernstein; and our Chair, Micky Arison. Before we begin, please note that some of our remarks on this call will be forward-looking. Therefore, I will refer you to the forward-looking statement in today's press release. All references to ticket prices, net per diems, net yields and adjusted cruise costs without fuel will be in constant currency, unless otherwise stated. References to per diems and yields will be on a net basis. Our comments may also reference cruise costs without fuel, EBITDA, net income, free cash flow and ROIC, all of which will be on an adjusted basis, unless otherwise stated. All these references are non-GAAP financial measures defined in our earnings press release. A reconciliation to the most directly comparable U.S. GAAP financial measures and other associated disclosures are also contained in our earnings press release and in our investor presentation. Please visit our corporate website where our earnings press release and investor presentation can be found. With that, I'd like to turn the call over to Josh."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Beth. Before I begin, I'd like to express my support and heartfelt sympathy for all those impacted by Hurricane Helene this past week. Our thoughts and prayers are with you. With that, I'll turn to our prepared remarks. As September comes to an end and we closed out the year, I am happy to report that we are delivering well in excess of 2024 expectations. We've also built an even stronger base of business for 2025, and we're off to an unprecedented start to 2026. Our third quarter by all accounts was phenomenal, breaking multiple records and outperforming on every measure. Revenues hit an all-time high of almost $8 billion, a $1 billion more than last year's record levels. Record EBITDA exceeded $2.8 billion, up $600 million over last year and $160 million over guidance and we delivered over 60% more net income than the year prior, achieving double-digit ROIC as of the end of our third quarter. These improvements were driven by high-margin same-ship yield growth across all major brands, not driven by capacity growth. And it resulted in EBITDA and operating income on a unit basis of 20% and 26%, respectively to levels we've not seen in the last 15 years. Strong demand enabled us to increase our full year yield guidance for the third time this year. And consistent with our historical emphasis on efficiency, we also improved our cost guidance, which enabled us to drive more revenue to the bottom-line with around 99% of our 2024 ticket revenue already on the books were poised to deliver record EBITDA of $6 billion, almost $600 million above our prior peak and $400 million above the original guidance we set in December. ROIC is expected to end the year at 10.5%, 1.5 points better than our original December guidance and almost double last year's ending point. Looking forward, the momentum continues as we actively manage the demand curve. At this point in time, 2025 is a historical highs on both occupancy and price. All core deployments are at higher prices than the prior year. Every brand in our portfolio is well booked at higher pricing in 2025, demonstrating the ongoing benefit of our demand generation efforts throughout our optimized portfolio. Our base loading strategy is continuing to work well, allowing us to take price, thanks to having pulled ahead on occupancy. In fact, in the last three months, our 2025 booked positions price advantage versus last year has actually widened for the full year and for each quarter individually. And with nearly half of 2025 already booked, we feel confident in maintaining our trajectory. While early days, the benefit of our enhanced commercial performance is carrying nicely into 2026 as we just achieved record booking volumes in the last three months for sailings that for out. This incredibly strong book position for 2024, 2025 and 2026 drove record third quarter customer deposits towards $7 billion, and that's along with continued growth in pre-cruise purchases of onboard revenue. It's also gratifying to note the onboard spending levels were not only up strong again this quarter. Our year-over-year improvement in onboard per diems actually accelerated from the prior quarter. In essence, all demand indicators are continuing to move in the right direction. And we have so much more in the pipeline to sustain this momentum, including the North American Premier of the highly successful Sun Princess in just a few weeks. This will be followed by the introduction of her sister ship, Star Princess, the second next-generation Princess ship coming online in a year. We also continue to invest in the existing fleet with major modernization programs like AIDA evolution expected to deliver additional revenue uplift over the coming years. As you know, we're not just going to be buoyed by our ship. I can't wait for the introduction of our game-changing Bahamian destination Celebration Key. It's five portals built for fun were opened in July 2025, but it really ramps up in 2026 when Celebration Key serves as a premium call for 19 Carnival Cruise Line Ships and rest assured, we're already planning for our Phase 2 landside development to fully leverage the use of the four berths we're building. In 2026, there's also the midyear introduction of a two-berth pier at Half Moon Cay, are naturally beautiful and pristine Beach consistently rated among the top private islands in the Caribbean. These two destinations will be available to even our largest ships, further reducing fuel costs and our environmental footprint at the same time. Stay tuned as we'll be sharing more exciting reveals about Half Moon Cay in the next few months. We're also stepping up our marketing efforts in the fourth quarter, which David will touch on. Our elevated marketing investment has been working as we continue to drive demand well in excess of our capacity growth with year-to-date web visits up over 40% versus 2019; paid search, up more than 60%; and natural search up over 70%. Our brands are iterating on under creative marketing and constantly finding ways to attract more attention to the amazing product and execution we already deliver on board, and it is continuing to pay off as we chip away at the unwarranted price disparity to land-based vacations. All of these activities, along with strong support from our travel agent partners, have allowed us to once again take share from land-based peers as we attract even more new-to-cruise guests. In fact, both new-to-cruise and repeat guests were up double-digit percentages over last year. Now, turning to our balance sheet. We expect to continue on our path towards investment grade and have a clear line of sight for further debt paydown, having recently finalized our order book through 2028. We have just three ships spread over the next four years. That's one ship delivery in 2025, one in 2026, and one ship in each of 2027 and 2028. This limited order book should also position us well to continue to create demand in excess of capacity growth. Our continued focus on high-margin same-ship yield growth should deliver improving EBITDA off of this year's record levels. Of course, strong and growing free cash flow and further debt reductions provide a consistent formula for ongoing improvement in our leverage metrics and a continuation in the trajectory we have experienced already this year, resulting in a two-turn improvement in debt to EBITDA in just nine months. We have certainly come a long way in a relatively short amount of time. In just two years, we've already more than doubled our revenue and are going from negative EBITDA to an expected all-time high of $6 billion this year. This remarkable achievement is all thanks to our global team. They continue to outperform as we progress through 2024 and they are also setting us up for a successful 2025. It is their continued execution that has put us firmly on the path to achieving our SEA Change targets. And just as important, they once again powered our ability to deliver unforgettable happiness to nearly 4 million guests this past quarter by providing them with extraordinary cruise vacations, while honoring the integrity of every ocean we sail, place we visit, and life we touch. With that, I'll turn the call over to David."
},
{
"speaker": "David Bernstein",
"content": "Thank you, Josh. I'll start today with a summary of our 2024 third quarter results. Next, I will provide the highlights of our fourth quarter September guidance, some color on our improved full year guidance, along with a few other things to consider for 2025, then I'll finish up with an update on our refinancing and deleveraging efforts. Let's turn to the summary of our third quarter results. Net income exceeded June guidance by $170 million as we outperformed once again. The outperformance was essentially driven by two things; first, favorability in revenue were $40 million as yields came in up 8.7% compared to the prior year. This was 0.7 point better than June guidance, driven by close-in strength in ticket prices as well as onboard and other spending. Second, cruise costs without fuel for available lower berth day or ALBD, improved slightly compared to the prior year and were nearly 5 percentage points better than June guidance, which was worth over $125 million. The third quarter benefited from cost-saving opportunities, accelerated easing of inflationary pressures, benefits from one-time items and the timing of expenses between the quarters. Most of the third quarter cruise cost benefits will flow through as an improvement to our full year September guidance. Per diems for the third quarter improved at least 6% versus the prior year driven by higher ticket prices and improved onboard spending on both sides of the Atlantic. At same time, our European brands on the path back to higher occupancy levels saw outsized growth in occupancy of 5 percentage points as compared to the third quarter of 2023. For the third quarter, we reported record-setting operating results with strong demand, delivering record revenues, record yields, record per diems and record operating income. Now two things to highlight about our fourth quarter September guidance. The positive trends we saw in the third quarter are expected to continue in the fourth. The yield guidance growth for the fourth quarter is set at 5% over the prior year. The difference between the yield guidance for the fourth quarter and the third quarter yield improvement of 8.7% is the result of a tougher prior year comparison as fourth quarter 2023 per diems were up over 10% versus just 5% for the third quarter of 2023. Having said that, it is great to see that we anticipate continued strong yield growth in the fourth quarter and that it is driven primarily by price. Cruise costs without fuel per available lower berth day for the fourth quarter are expected to be up 8% like first quarter of 2024, which was up 7.3%. Both quarters are impacted by higher dry dock days and higher advertising expenses planned, and we did have about $25 million of anticipated third quarter costs shift to the fourth quarter. As I have said many times, relative to cruise cost per ALBD judge us on the full year and not the quarters as we often see certain cost items like dry dock expense, advertising and other items have different seasonalization between the quarters from year-to-year. 2024 is a great example of this, where cruise costs without fuel per ALBD were up 7.3% in the first quarter, essentially flat in the second quarter, improved slightly in the third quarter and are expected to be up approximately 8% in the fourth quarter. Turning to our improved full year September guidance. Net income for September guidance is set at $1.76 billion, a $210 million improvement over our June guidance. This improvement was driven by three things; first, an improvement in yields to 10.4% by flowing through the $40 million revenue benefit from the third quarter. Second, a one point improvement in cruise cost per ALBD to approximately 3.5% from flowing through $100 million of the $125 million cost benefit from the third quarter with $25 million re-seasonalize to the fourth quarter, as I previously mentioned. And third, a benefit from fuel pricing currency worth $70 million, the strong 10.4% improvement in 2024 yields is a result of the increase in all the component parts, higher ticket prices, higher onboard spending, and higher occupancy at historical levels, with all three components improving on both sides of the Atlantic. Now a few things for you to consider for 2025, we are forecasting a capacity increase of just 7%, compared to 2024. We are well positioned to drive 2025 pricing higher with less inventory remaining to sell than the same time last year. We are also looking forward to the introduction of our game-changing Bahamian destination, Celebration Key in July 2025. We anticipate that Celebration Key will be a smash hit with our guests and provided excellent return on our investment. However, we do expect that the operating expenses for the destination will impact our overall year-over-year cost comparisons by about half a point. In 2025, we are expecting 688 dry dock days, an increase of 17% versus 2024, which will also impact our overall year-over-year cost comparison by about 0.75. I will finish up with a summary of our refinancing and deleveraging efforts. With record third quarter EBITDA of $2.8 billion, our efforts to proactively manage our debt profile continue. Since June, we prepaid another $625 million of debt bringing our total prepayments to $7.3 billion since the beginning of 2023. Additionally, we successfully upsized the borrowing capacity on our revolving credit facility by nearly $500 million, bringing the total undrawn commitment to $3 billion back to its 2019 level. Furthermore, we will continue to look for more opportunistic re-financings overtime. Our leverage metrics will continue to improve in 2024, as our EBITDA continues to grow, and our debt levels improve. Using our September guidance EBITDA of $6 billion, we expect better than a two-turn improvement in net debt-to-EBITDA leverage compared to year-end 2023 and approaching 4.5 times and positioning us two-thirds of the way down the path to investment-grade metrics. Looking forward, we expect substantial free cash flow driven by our ongoing focus on operational execution and among the lowest newbuild order book in decades to deliver continued improvements in our leverage metrics and our balance sheet, moving us further down the road to rebuilding our financial fortress, while continuing the process of transferring value from debt holders back to shareholders. Now operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Matthew Boss with JPMorgan. Please proceed with your question."
},
{
"speaker": "Matthew Boss",
"content": "Great. Thanks. And congrats on another really nice quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Matt."
},
{
"speaker": "Matthew Boss",
"content": "So Josh, on the continued momentum, maybe could you elaborate on the stronger base of business for 2025 and the record start to 2026 that you cited? Maybe if you could touch on volume and pricing trends that you're currently seeing across regions and maybe specifically in Europe?"
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So I'm probably broad-based is the best way to talk about the strength and what we're seeing on 2025. The book position is higher for both North America and our European brands, and that's consistent across the quarters as well. So we're positioned very well. Our brands have been doing a great job of pulling forward the booking curve and now we get to take price, which is the goal. So it's very encouraging. We are we're about two-thirds booked when you look at next 12 months. So we're in a pretty enviable place. Matt, do you have a follow-up?"
},
{
"speaker": "Matthew Boss",
"content": "Yes, thanks. So maybe just a follow-up would be on the balance sheet. If you could speak to capital priorities from here, just given the free cash flow generation and some of the changes that you've made?"
},
{
"speaker": "David Bernstein",
"content": "So basically, our priority one, two and three is debt reduction, where you have the goal of becoming investment grade, and we do expect to see both the reduction in our debt levels as well as the improvement in our EBITDA, achieve investment-grade metrics as part of our SEA Change program towards the end of 2026. And so we've got plenty of time to think about other alternatives beyond that."
},
{
"speaker": "Matthew Boss",
"content": "Great. Congrats, again. Best of luck."
},
{
"speaker": "David Bernstein",
"content": "Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Steve Wieczynski with Stifel. Please proceed with your question."
},
{
"speaker": "Steve Wieczynski",
"content": "Yes, hi, guys. Good morning. And congratulations on the strong quarter and the outlook. So Josh or David, this might be some of a shortsighted question. And David, you touched on this a little bit in your prepared remarks. But if we kind of think about the fourth quarter yield guidance, it looks to us like it might be a little bit lower versus the implied guidance for the fourth quarter back in -- that you gave back in June. So just wondering if there's anything from a -- whether it's a pricing perspective or any geography or brand, it is showing any -- I don't want to use the word softness, but I guess I have to use that word or weakening in pricing during the fourth quarter? Or are you guys just taking a more conservative view around onboard spending over the next couple of months?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes. Hi, Steve, this is Josh. Actually, I'm not sure your math, but there was really no change from where we were in June guidance when it comes to the fourth quarter on the yield side. We always said -- when we came out with our guidance, frankly, in December, we were challenged a lot, particularly in the fourth quarter, and people didn't think we'd be able to actually reach breakeven year-over-year because the fourth quarter of 2023 was so strong. So now we're talking about 5%, and we feel good about that."
},
{
"speaker": "Steve Wieczynski",
"content": "Okay. Got you. And then, Josh, I want to ask about the 2025 and 2026 bookings, and you talked how you're already 50% booked for next year and in a pretty good position, it seems like already for 2026. So just wondering if you think about your booking window. Has it expanded too much? We're saying that differently? Are you nearing a point where you might start leaving -- you might be leaving money on the table if demand kind of stays status quo from here? And then following up on that question, just wondering if you've seen demand accelerate for bookings, maybe more in late 2025 and 2026 that are going to be touching celebration key?"
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So as -- the great point on the booking curve, the goal is not an ever-increasing booking curve. It's to maximize the revenue that we're going to generate by the time we sell. I would say this is a brand-by-brand, itinerary-by-itinerary buildup. And I would say that almost all of our brands are pretty much -- are higher year-over-year. There's one that's not, and that's an active decision to pull back because we want to make sure we're not leaving price on the table, exactly to your point. So despite the fact that overall, we're in a record position, we are looking at that, obviously, with a lot more clinical eye and making sure we're doing the right thing to optimize that revenue. When it comes to Celebration Key, clearly, there's a premium and it's going to benefit us, in particular, if the 2026 ongoing story when we get to ramp up to about 20 ships, which is going to be pretty fantastic. And the fact that we're doing all of this that we've been able to talk about with 2024 and even into the first half of 2025, it's got nothing to do with Celebration Key. This is just based on the natural demand and all the commercial activities that we're doing and delivering on board, and that's supporting real strong revenue increases."
},
{
"speaker": "Steve Wieczynski",
"content": "Got you. Thanks for that, Josh. Really appreciate it. Congrats, guys."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Robin Farley with UBS. Please proceed with your question."
},
{
"speaker": "Robin Farley",
"content": "Great. Thank you. I know it's too early to give guidance for 2025 but..."
},
{
"speaker": "Josh Weinstein",
"content": "You're going to ask anyway -- but you're going to ask anyway."
},
{
"speaker": "Robin Farley",
"content": "Let me just ask it this way, which I think is harmless. Given everything you're saying about the booked position for 2025 and even 2026 being at record levels, is it fair to say that you're off to a better start for 2025 than a typical year? So hopefully, that's an innocent way to ask it. And then I also did just want to clarify on the expense. David, I heard what you mentioned the $25 million of expense that that was sort of borrowed from -- will show up in Q4 that that kind of shifted $25 million. But was there a separate amount, and I apologize if I missed this, it was a onetime cost saves this year that we should think about coming back in 2025? I just wanted to catch what that amount was and even what it was for. If you would share that. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Okay. So I will actually very directly answer your question. So we are starting off even better for 2025 than we did for 2024, which is shaping up to be a record year. We are higher in occupancy, and we're higher in price and the brands doing a great job of really trying to optimize that booking curve and revenue generation. So that's not guidance, but it's a point in time, and that's where we are."
},
{
"speaker": "Robin Farley",
"content": "Okay. Thanks."
},
{
"speaker": "David Bernstein",
"content": "As far as the second question is concerned, yes, there were a couple of reasons why we reduced cost by the full point of the year. One included some onetime benefits, wasn't huge, probably about $20 million of the $100 million related to some pension credits and a few other little things for the year."
},
{
"speaker": "Robin Farley",
"content": "Okay, Great. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Robin."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ben Chaiken with Mizuho Securities. Please proceed with your question."
},
{
"speaker": "Ben Chaiken",
"content": "Hi. Good morning. On the cost side, EBITDA flow-through has been stronger than expected. It was almost 60%. Costs have been better generally for the majority of the year. Can you talk about some of the cost saves, margin opportunities you're finding? Is this simply better leveraging a fleet that is now leaner subsequent to some of the asset sales over the past few years? Or is it cost that you're actively pulling out of the business or both? Thanks."
},
{
"speaker": "David Bernstein",
"content": "No, it's not cost that we're pulling out of the business. I mean what we're seeing is hundreds of small items across the board, across many brands, things like crew travel savings, other port savings opportunities as well as a lot of sourcing savings, cost innovation better leveraging our scale across all the brands. And that probably represented about half of the $100 million cost savings that we roll through for the full year."
},
{
"speaker": "Ben Chaiken",
"content": "Got it. That's helpful. And then I guess for Josh, higher level, you folded P&O Australia into the Carnival brand this year. I know it was somewhat smaller scale, but do you think there's other opportunities to streamline the portfolio in a similar way going forward? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. I'd never say never take things off the table. I think this is one of those decisions that just made a lot of sense and something that we felt pretty passionately about executing quickly. We'll continue to review our portfolio brand-by-brand, ship-by-ship. But right now, we feel real good about how we're entering 2025."
},
{
"speaker": "Ben Chaiken",
"content": "Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of James Hardiman with Citi. Please proceed with your question."
},
{
"speaker": "James Hardiman",
"content": "Hi. Good morning. I wanted to dig into some of the cost commentary you gave us, David. So 3.5% growth for this year, that seems like it's getting better, obviously, with some cost saves and maybe better inflation. I think you called out about 0.5 point next year for Celebration Key and another 75 bps from dry-docks. I guess, are there any call-outs on the other side of that equation? I don't think our starting point should be in that 5% range if we were to just take the 3.5% this year and add those 2% callouts. Maybe talk us through sort of what the base level of inflation is as we think about 2025 and any other sort of positive factors that will help offset some of the negative ones for next year?"
},
{
"speaker": "David Bernstein",
"content": "Well, it's if you know exactly what inflation is going to be over the next 15 months, let me know, but we're still trying to figure that out. There is some level of inflation that continues in our business. We'll include that within our guidance when we provided in December Plus, we continue to work on cost-saving opportunities. As I said in the June call, even though we have the best cost metrics in the business. We still believe there are opportunities in our business to further leverage our scale and to work through those opportunities as we did in the second and the third quarter, and we'll continue to do so. And we'll include some of that in our guidance, which will offset some of inflation. So -- but stay tuned. The two things that I gave in my prepared remarks were relative to the dry-docks and the cost of Celebration Key are pretty well fixed at this point. And so we wanted to highlight those in the prepared remarks."
},
{
"speaker": "James Hardiman",
"content": "Got it. And then obviously, it sounds like everything is going pretty well from a demand perspective. Maybe speak to one of the questions that we keep getting is the potential for the widening conflict in the Middle East to negatively impact your business. I mean I -- to some degree, it would seem to help that much of that region was already vacated in 2024. I guess the hope was that, that would be a '25 tailwind. That now seems off the table. But just maybe speak to how, if at all, you expect that region to impact your business next year?"
},
{
"speaker": "Josh Weinstein",
"content": "So we weren't banking on it getting better and hope to god it doesn't get worse -- thoughts -- everybody in the Middle East region and hoping for peace. But our business isn't really contingent on it. It's not a major source market for us, and we're not going to the region. So unless it were to escalate to something significantly wider than the Middle East, our ships are mobile, and we're in source markets that are phenomenal for us with lots of potential."
},
{
"speaker": "James Hardiman",
"content": "Got it. Thanks, guys."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Patrick Scholes with Truist Securities. Please proceed with your question."
},
{
"speaker": "Patrick Scholes",
"content": "Hi guys. Good morning everyone. My first question, you talked about dry docks increasing next year. Can you give us a little more possible granularity on dry dock increases or decreases for perhaps some quarters by quarter for next year modeling purposes? Thank you."
},
{
"speaker": "David Bernstein",
"content": "So I don't have all that detailed handy, Patrick. But if you call Beth, I'm sure she can provide that to you."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. Beth, we will call you. Thank you. And then second, I see there's some news out about a new cruise pier at Half Moon Cay. Do you have any longer-term plans above and beyond just a pier for Half Moon Cay, such as water parks and the like down the road?"
},
{
"speaker": "Josh Weinstein",
"content": "So well, I'll give you a yes and a no. So, do we have more plans? Absolutely. Do we want a water park? Absolutely not. So the difference between Celebration Key and what we're building at -- and pardon me, the difference between Half Moon Cay and what we're building a Celebration Key is Celebration Key is really about 5 portals of fun and looking to be that entertainment center. What we have at Half Moon Cay is one of the most naturally beautiful white sand Beach, Crescent Shape islands in the Caribbean. And that's a true private destination and something that we want to enhance. And we will be talking about that more over the coming months. I won't steal Christine's thunder, but good things coming that are going to make that in a pretty amazing destination and of itself for a completely different reason."
},
{
"speaker": "Patrick Scholes",
"content": "Great. Sounds great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Brandt Montour with Barclays. Please proceed with your question."
},
{
"speaker": "Brandt Montour",
"content": "Good morning everybody. Thanks for taking my questions. So just starting off, we haven't really touched on SEA Change and your 3-year targets there. We kind of got a little bit of an update in the release. I guess the question is, Josh, with this new '24 full year guidance, obviously, we can calculate the progress you're making, and we can look at that number and sort of imply some KPIs yields cost to get to those targets. And it's implying a pretty narrow spread between those two. And would give us the sense that if we harken back to your – what you gave us in the Investor Day, what you were thinking for per diems that were sustainable and costs that were sustainable that we would think you could do better? So I guess if you could just – I know that, that was a long-winded way of asking the same question that you've already gotten twice. But if you could just give us a sense for how you think about the business in the current operating environment given all the positive commentary you've said today vis-à-vis those longer-term targets?"
},
{
"speaker": "Josh Weinstein",
"content": "Well, I think the teams around the world are doing a phenomenal job. And if you think about – in December, we were saying up 8.5 points on percent on yields, up 4.5% cost, which gets us to 9% ROIC. And now we're seeing up almost 10.5% on yield, only up 3.5% on cost. It gets us to 10.5% on ROIC. So clearly, we're outperforming the expectations. It gets us about 75% of the way there for two of the metrics, the EBITDA per ALBD and the ROIC after one year with 2 years remaining and carbon is progressing as expected. We're about 50% there after one year. So the teams aren't doing all those things to make targets. They're doing those things to make their guests happy and provide great business results and the outcome that's going to be hitting those targets. Do I want to hit them early? Yes, do I want to get further than that? Absolutely. But we'll take that in stride, and we'll probably talk more when we get to December guidance, and you could put that in context where we'll end in 2025 and then take it from there."
},
{
"speaker": "Brandt Montour",
"content": "Okay. Thanks for that. And then just a follow-up, maybe, Josh, if you could address the broader land-based leisure demand environment, what we're seeing elsewhere is not what cruise has seen, we see steady, slow somewhat softer normalization. We don't get any of that from you in your commentary today. I guess, we understand why it's happening, but if the rest of the world is narrowing a little bit toward narrowing your, let's say, your gap from the top. Do you see any of that affecting your consumers' behavior and willingness to spend and pricing sensitivity?"
},
{
"speaker": "Josh Weinstein",
"content": "We are still a remarkable value to land-based alternatives. And maybe land-base is softening because we're doing better. Who knows? You have to ask them that. I can't tell you their business. But we have a tremendous value. We are doing a better job of getting our word out better marketing, more eyes on the industry, more eyes on us. Our new-to-cruise this past quarter was up about 17% year-over-year. That's not an accident. That's because our brands are really focused on driving that demand profile. So I don't have a crystal ball, and I can't tell you what the world is going to look like a year from now, two years from now. But I can tell you if we keep focusing on commercial execution and doing the right things and doing them better, then there's a long runway because the one thing that's never been a question is can we execute on board and deliver a great experience. And that's always been the case. It's just a matter of how we convince people to come with us who have never have, and I think we're doing a good job on that."
},
{
"speaker": "Brandt Montour",
"content": "Great. Congrats on the quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you. I guess, I'd be remiss if I didn't shout out the travel agents because all they do is amplify our voice in a tremendous way. And so that success that we're seeing in building that demand profile is really hand-in-hand with their success, and we appreciate their efforts."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Conor Cunningham with Melius Research. Please proceed with your question."
},
{
"speaker": "Conor Cunningham",
"content": "Everyone, thank you. Maybe sticking with that -- the comments on new-to-cruise. Can you -- I mean, look at your 2025 bookings, are you seeing new-to-cruise and new-to-brand accelerate? And if you could just touch on just the younger demographic. I think I asked you that last quarter, but it just -- it seems like a pretty big megatrend for you over the long-term? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Well, sorry, I just got distracted -- as far as what the demand profile is for the future bookings, we don't really talk about that in advance, but we're happy to talk about it when we get to our results, and we can talk about what the breakdown is for the profile of folks who sailed. But suffice it to say, everything I'm saying is not ending in 2024 with respect to our efforts to keep optimizing and keep getting better at execution, keep driving that demand profile and casting that net as widely as we can. We have almost no capacity growth. So all of that increased demand is just going to result in who wants pay the most to get on our ships, and that's what we're driving for."
},
{
"speaker": "David Bernstein",
"content": "Yes."
},
{
"speaker": "Conor Cunningham",
"content": "Okay."
},
{
"speaker": "David Bernstein",
"content": "And as far as the average age is concerned, I think we touched on this last quarter. I mean if you look back at all of our brands over the last 10, 12 years or so, the average age for most of the brands really hasn't changed. Now of course, the repeat guest who sailed a decade ago or 10 years old, but the average age of our guests. So we are attracting a lot of new young people and some of our brands like Carnival Cruise Lines has an average age of like 41 years old. So that's a brand, obviously, millennials these days are, I think it's 43 or 44 years old or younger. And that does represent half the -- over half the population in the United States. But Carnival has got over half of its guests for millennials because the average age is 41 or younger."
},
{
"speaker": "Josh Weinstein",
"content": "But I would say -- I think I said this on either the last call or the call before, we love boomers, right? And we love Gen X. I mean, it is -- if you think about our portfolio approach, we have brands like Holland America, like Cunard where that is where they're trying to push that demand profile because it's folks a very good income, a very good retirement base and a lot of time to take cruises that can go 14 nights, 21 nights world cruises. So we love the fact that we're pushing harder into that millennial generation, and we're getting that interest and that demand profile. But we don't want that to the exclusion of really leaning into the other generations for what we have to offer."
},
{
"speaker": "Conor Cunningham",
"content": "Helpful. On Celebration Key, I know you've gotten a lot of questions on that. Just it is opening in mid of next year. Is it creating the halo effect that you would have expected? Like are people asking for -- or maybe they're asking a little bit different. I think you mentioned 19 ships are going to touch there. Like are those ones selling out quicker than you would have expected reverse relative to history in general? Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Unfortunately, because every carnival ship is going, there's no test case. But -- so yes, we are seeing a premium for it. We are seeing people that are seeking it out. And the good thing is it hasn't even opened yet. So we think the rubber is really going to hit the road once we can deliver the experience and really show people what it can do."
},
{
"speaker": "Conor Cunningham",
"content": "Appreciate. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of David Katz with Jefferies. Please proceed with your question."
},
{
"speaker": "David Katz",
"content": "Hi. Good morning, everyone. Thanks for taking my question."
},
{
"speaker": "Josh Weinstein",
"content": "Hi."
},
{
"speaker": "David Katz",
"content": "Hi. I appreciate all the details so far. And it's interesting when we look across our coverage, there are some smaller pockets of weakness that consumers have started to demonstrate here and there. And this is a broadly based positive quarter and I just wanted to double-click on the issue of are there any small pockets, any areas of consumer behavior that we should just keep an eye on as we go forward that are, again, embedded in what appears to be a pretty broad-based strong quarter and outlook?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes. No, I appreciate the question. I guess I'm happy that I just have to say no. What we're seeing is, in fact, broad-based. We're seeing that demand for all the brands pretty much across the portfolio. What we're seeing it in the booking trends that we've talked about, the onboard spending. The onboard spending levels were 7% up year-over-year. That's off the top of my head. Am I off by a point?"
},
{
"speaker": "David Bernstein",
"content": "Something like that more than this second quarter, so…"
},
{
"speaker": "Josh Weinstein",
"content": "6.7% -- onboard per diems were 6.7% year-over-year, which is an acceleration versus the increase that we saw in second quarter versus the prior year. So, all things that you look at is our -- is that demand profile changing or the state of the consumer changing. I can't speak to macroeconomics, because there's a lot going on in the world, but at least with what we have to offer people are happy to pay and to participate and we think that's a great thing. And we think that goes back to all the things that we've been talking about for the last two years about where we want to focus and make sure that we are doing a better and better job as time goes on."
},
{
"speaker": "David Katz",
"content": "Perfect. And if I can, just as my follow-up, are you able to observe or record any trade-down dynamics where part of the demand you're seeing is a consumer who's traded out of something else into a cruise vacation?"
},
{
"speaker": "Josh Weinstein",
"content": "No, nothing that we've seen that says that. I mean I think it's the opposite. It's -- we're doing a better job of convincing them. This is something they want to do, not because they're trading down from something, but that they want to experience what we have to offer."
},
{
"speaker": "David Katz",
"content": "Okay. And I apologize for the questions, my ratings speech mix up."
},
{
"speaker": "Josh Weinstein",
"content": "No, no. I think they were good. They were good questions. I think they're good questions."
},
{
"speaker": "David Katz",
"content": "Very fair. Congrats on the quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Jaime Katz with Morningstar. Please proceed with your question."
},
{
"speaker": "Jaime Katz",
"content": "Hi. Good morning. I'm curious if you have any update on, I guess, the Chinese consumer? Is it trending as you would like or Asia Pacific in general? Just because the data that's been coming out of the region has been a little bit lumpy, and it was obviously something that was pretty meaningful prior to the pandemic? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. Hi, Jaime. It wasn't very meaningful for us prior to the pandemic and the grand scheme of things. It was a few percentage points of our capacity that was really dedicated to China. We have, as I've been pretty open about, I'm ecstatic that it's reopened to international cruising. I wanted to be very successful for our competitors, but it's not something that we're pursuing at this time and have not. With respect to the region overall, when it comes to Japan, Taiwan and other regions, that's going well. People like cruising with us before, and they continue to enjoy it now."
},
{
"speaker": "Jaime Katz",
"content": "Yes. I was just curious if there was any movement with them with outbound travel more so than anything else. As far as occupancy in the European brands, is there a little bit of room left in that for upside? Or has the gap sort of closed on that?"
},
{
"speaker": "Josh Weinstein",
"content": "I mean overall, we're back to historical norms, which is a range. It's not a number. And I'd say all of our brands to varying degrees, have the ability to maybe addressed a little higher here and there. It's not going to be a big driver of our improvement as we look forward. It's really going to be from driving price, which is where we're focused. But there's always an opportunity to make some tweaks and find some more occupancy."
},
{
"speaker": "Jaime Katz",
"content": "And I don't think you guys had mentioned anything on any hurricane impact, but any insight to the cost of that disruption if you have it, would be helpful? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. I mean ours is -- it's insignificant compared to the impact that it's having on the region, which, first and foremost, we should take a second to just think about. But putting that aside, it's a few million dollars for us. It's not anything of significance."
},
{
"speaker": "Jaime Katz",
"content": "Excellent. Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Assia Georgieva with Infinity Research. Please proceed with your question."
},
{
"speaker": "Assia Georgieva",
"content": "Good morning guys. Congratulations on a great quarter. And I'll just delve into the few quick questions that I have. Occupancy is still not fully caught up relative to fiscal 2019. Isn't that by itself already a yield opportunity?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes, like I said, we operate in a range for occupancy, and we are within our range, but there's certainly the opportunity to push that a little bit more. It's just not going to be the biggest driver of how we can improve the revenue picture going forward."
},
{
"speaker": "Assia Georgieva",
"content": "And maybe a quick question for David. Fuel costs seem to be a little bit -- well, quite a bit higher relative to what we were estimating because we track for 180, 380 MGO. Could that possibly be related to shore power in the Baltics, Denmark, Germany ports that are offering shore power Sweden, et cetera. Is that part of the play there?"
},
{
"speaker": "David Bernstein",
"content": "No, because our shore power, when we buy it, is actually not included in the fuel expense, it's included in port expenses because we purchased it at the port. So, that would not have been an impact. So, I'm not sure what you're looking at and what you're tracking. But Beth can give you some websites to look at, which maybe will improve your tracking overall."
},
{
"speaker": "Assia Georgieva",
"content": "That would be great and Beth, I'm sorry, I'll bother you on this one. And basically, the -- my second question, given the acceleration in EBITDA generation and how far ahead you're with the SEA Change program? Is it possible at this point to order a sister ship for 2027, 2028 delivery, whether it's for a Princess brand or Carnival brand?"
},
{
"speaker": "Josh Weinstein",
"content": "No, I mean, our order book is set through 2028. We feel very good about that. And as you know, we did order what we call Project ACE, which is next generation for Carnival, what -- that doesn't start until 2029. So, the focus of all that EBITDA generation is really its cash flow and we're going to use the headroom with a reduced capital expenditures to pay down debt."
},
{
"speaker": "Assia Georgieva",
"content": "So, Josh, in terms of the debt tranches, we're going after the highest cost of debt, correct?"
},
{
"speaker": "Josh Weinstein",
"content": "Well, as long as it's got a good NPV if we want to pay it down. So there's a lot of factors -- yes, go ahead."
},
{
"speaker": "David Bernstein",
"content": "I was going to say it's really a combination of three things that we look at. One is the cost of the debt. And we do have two double-digit issuances out there. Both are callable in 2025. So that should help our overall -- when we -- we'll look at refinancing those in the early part of next year. We also look at the maturity towers. We're well set through 2026 on maturity towers. They're very well managed. But the towers in 2027 and 2028, we'll be looking at refinancing some of that as well as looking at secured versus unsecured debt, because our goal is to get to be completely unsecured, but we'll manage that over time as we move forward."
},
{
"speaker": "Assia Georgieva",
"content": "And David, that was basically my question, has cost versus secured towers. So it's a balancing act, I imagine?"
},
{
"speaker": "David Bernstein",
"content": "Correct."
},
{
"speaker": "Assia Georgieva",
"content": "All right. And lastly, if I may ask somebody is encroaching on your Galveston, Texas port and building a terminal there. What do you think about that? They already have a presence in Miami and are doing Port Canaveral, et cetera, an unnamed competitor, who do not have to report to us on ROIC or other metrics? How do you feel about sort of the -- what I call the encroachment?"
},
{
"speaker": "Josh Weinstein",
"content": "I don't think about it as an encroachment. We are 2% of the overall vacation market. And if it's the company, I think you're talking about, it's a small part of the overall cruise market growing, but small. And so there's -- the demand profile as long as we do our jobs with our world-class portfolio of brands will be just fine. I got to cut you off though, you did three questions, and the operator only said one. Sorry."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Dan Politzer with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Dan Politzer",
"content": "Hi, good morning everyone. Thanks for taking my question. Josh, I do want to follow-up on the fourth quarter yield comment. I know you mentioned that there really wasn't much if any -- actually, any change to your prior guide. But as we think about the third quarter came in better, David, cited better close-in demand and on board driving the beat. I mean is there any reason that wouldn't be in the cards for the fourth quarter? Or are there near-term demand hiccups or noise, whether it's a new cycle or election that could be maybe driving additional conservatism?"
},
{
"speaker": "Josh Weinstein",
"content": "Look, we try to give you our best estimate of what's going to happen. And do we always try to outperform? Absolutely. That's the goal. There's nothing in particular about the fourth quarter other than what other than what you said. I mean right, the next month. A lot of attention is going to be focused on something other than what's normal. It happens every four years. So we'll see kind of impact that has. But the business is still going strong, and we expect a lot of ourselves."
},
{
"speaker": "David Bernstein",
"content": "Yes. And also keep in mind, with 99% of the ticket revenue for the for the gear already on the books, there's not a lot left to sell, yes."
},
{
"speaker": "Dan Politzer",
"content": "Right. No, that makes sense. And then just for my follow-up. In a couple of weeks, you're hosting some investors at Board, Sun Princess. Any way to kind of think about maybe framework and maybe kind of the key topics we should focus on? It seems like there's a lot progress on SEA Change, your Celebration Key, maybe some of these cost opportunities or savings from easing inflation. But what are the kind of the key high-level focus points we should be thinking about? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Look, it's been -- it's been about 15 months since we got together for the first time to talk about what our priorities were and announced SEA Change. And think it's a good opportunity for us to just kind of level set on where we are and everything. And hopefully, as you see it, the way we see it, which is the progress that we're making across board. We also get an opportunity to showcase the Princess brand and specifically the Sun Princess, which is just a true game changer for Princess. And I'd say for the premium market, she's a remarkable ship and the team on board does a remarkable job. And you also get an opportunity, not just to hear from me, but he and David, but you'll be able to hear from the President of that brand and to actually meet the presidents of pretty much all of our brands who will be there with us. So, good opportunity for you to get a little bit more educated and inundated by all things Carnival Corporation."
},
{
"speaker": "Dan Politzer",
"content": "That's great. Thanks so much and congrats on a nice quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks a lot Daniel."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Chris Stathoulopoulos with SIG. Please proceed with your question."
},
{
"speaker": "Chris Stathoulopoulos",
"content": "Good morning. Thanks for taking my question. So Josh, I'm going to ask the demand question here in a different way. As we think about global travel and tourism and think about different segments, if you will, within the ecosystem, so lodging, airlines, hearing is sort of a different dynamic here as we think about demand, certainly within lodging, lower to middle income consumer, some concerns around price sensitivity little bit of a mixed bag in airlines. In Cruise Lines, this is unique here with what feels like this sort of persistent demand and just kind of ongoing momentum, if you if you will. Now I was wondering could rank order or think about the moving pieces as to the why. So there's the new-to-cruise piece, I would say perhaps a later reopening of certain markets, strong U.S. dollar, discount to land-based trips, base-loading. Just if you could help us provide -- provide some context as we think about the moving parts of demand here. There's still some debate around whether this is any pent-up demand here, which I think is just not the case? Or what -- is this actual base load going forward? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Well, I guess, the most affirmative thing I'll say is completely agree with you, it's not pent-up demand anymore. We've been sailing for over three years now. So I don't -- I think that, that is coming down. I'm not going to answer your question by rank ordering, but I would say that when it comes to all of industry. I think we're all doing a pretty good job at that demand generation and creation and getting awareness, getting people interested in cruising who maybe have never thought about it before. With respect to us, there is a lot of activity going on at all of our brands to really just try to do better and better blocking and tackling when it comes to the commercial operations, right, generating new creative, generating more eyeballs in performance marketing looking for and then being looked at by the right potential customer, driving people to our trade partners, driving people to our websites, doing everything we can to just get the word out and get them interested. And I think that's part of what's driving us in a pretty significant way."
},
{
"speaker": "Chris Stathoulopoulos",
"content": "Okay. And then as my follow-up, David, so my math here, I have about a point and a quarter on the adjusted NCCs for next year, and we can come up with our own assumptions, as you said, on inflation. But as we think about the other moving pieces here, puts and takes, on the advertising side. I know I think that's expected to be elevated in 4Q. Is there a reason? Or how should we think about next year? And do we need this level of advertising per ALBD to continue? Is it part of the base load book plan? Or can we expect that to sort of get softer, if you will, as that initiative continues to take hold. Thanks."
},
{
"speaker": "David Bernstein",
"content": "Yes. So the advertising as well as many other decisions are things that we really need to talk about over the next month or two in the planning process, which we're in the midst of doing. And we'll give guidance in December relative to all of those items. It would be premature for us to be making a decision today exactly what we want to do, particularly for next summer or the back half of next year in advertising. So we'll give you more insight into that in three months."
},
{
"speaker": "Josh Weinstein",
"content": "I'd just add a couple of things. One is, remember, we just talked about a record-setting 2026 booking period. So we're not just booking for the short-term. We're booking for the long-term and advertising is a combination of getting people to consider things for the longer-term and getting the ships filled as we need to in the shorter-term. So the metric of just looking at it on an ALBD basis is, it's useful for benchmarking, but it's not too scientific. It's really about how much bookings we want to generate and how we think we need to spend to go get it. And I think we're doing a good job. And when you do look at rest of the benchmark basis, even though we're higher than we were back in 2019, and I think a couple of percent higher year-over-year, we're still quite a bit lower than most if not everyone. So we'll continue to be thoughtful about it and do what we think we need to do to drive the business. I think we got time for one more – yes, thank you. I think we've got time for one more if there are any more, operator?"
},
{
"speaker": "Operator",
"content": "Thank you. Our final question comes from the line of Fred Wightman with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Fred Wightman",
"content": "Hi, guys. Thanks for squeezing me in. I just wanted to come back to new-to-cruise, Josh. I think you said that was up 17% this quarter. Last quarter, that was up 10%. So it's a pretty big acceleration per brand that's as big as you guys are. Can you touch on -- what drove that? Was there a reallocation of some of the ad spend? And maybe how you think strategically that could sort of increase that penetration step from 2% to something larger as a percentage of total vacation spend? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. So there's no one thing that's going to be the answer for driving new-to-cruise either. It is that same combination of better advertising, the trade doing a great job, better usability of our websites. I'd say Alaska in particular for this past year was off the charts. It was absolutely phenomenal, and that tends to skew higher to new-to-cruise because -- if you're going to go to Alaska, which everybody should go do, the only way you can go see it is by a cruise ship to really appreciate it. And the only way you should do that is by one of our brands because they do it amazingly, and we have more permits for Glacier Bay than anybody else, and we have the shoreside footprint that nobody else has and can replicate. So that has served us very, very well. And I'd say it's the same things that you've heard me talk about in the past quarters that hopefully, I'll continue to talk about in the quarters to come about just doing the basics better."
},
{
"speaker": "Fred Wightman",
"content": "Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "I appreciate it. Well, thank you, everybody, for joining us and look forward to talking again in a few months for those of you that I don't see next week. Take care."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ccl | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings and welcome to the Carnival Corporation & plc's Conference 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, Beth Roberts, Senior Vice President, Investor Relations. Thank you, Beth. You may begin."
},
{
"speaker": "Beth Roberts",
"content": "Thank you. Good morning and welcome to our second quarter 2024 earnings conference call. I'm joined today by our CEO, Josh Weinstein; our Chief Financial Officer, David Bernstein and our Chair, Micky Arison. Before we begin, please note that some of our remarks on this call will be forward-looking. Therefore, I will refer you to the forward-looking statement in today's press release. All references to ticket prices, net per diem, net yields and adjusted cruise costs without fuel will be in constant currency unless otherwise stated. References to per diems and yields will be on a net basis. Our comments may also reference cruise costs without fuel, EBITDA, net income, earnings per share, free cash flow, and ROIC, all of which will be on an adjusted basis unless otherwise stated. All these references are non-GAAP financial measures defined in our earnings press release. A reconciliation to the most directly comparable US GAAP financial measures and other associated disclosures are also contained in our earnings press release and in our investor presentation. Please visit our corporate website where our earnings press release and investor presentation can be found. With that I'd like to turn the call over to Josh."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Beth. Inside of two years, we've made incredible strides in improving our commercial operations, strategically reallocating our portfolio composition, formulating growth plans and strengthening even further our global team Ship and Shore, the best in the business. Off the back of these efforts, we've closed yet another quarter delivering records. This time across revenues, operating income, customer deposits and booking levels, exceeding our guidance on every measure. Yields increased over 12% in Q2 over 1.5 points more than March guidance as we continue to drive strong per diem growth, up over 6%. And this is on over 10% more passenger cruise days, which is a combination of capacity growth and sailing at historical occupancy levels. Our European brand experienced extraordinary yield improvement again this quarter, up over 20%, while North America continued to improve on last year's highs up a healthy 7%. We hit record second quarter adjusted EBITDA, roughly $150 million more than guidance. Encouragingly on a per ALBD basis to highlight operational improvement and even with significantly higher fuel prices, adjusted EBITDA not only surpassed the second quarter of 2019, it was also our highest second quarter mark in over 15 years. Coupled with flat cruise costs excluding fuel on a unit basis, which David will elaborate on, we delivered $500 million more to the bottom line year-over-year and outperformed our earnings guidance by $170 million. Based on continued strong demand trends, we are also taking up our expectations for the full year by $275 million driven by double-digit yield growth. Now this would get us to double-digit ROIC this year. And while that will be a strong outcome for 2024, it is nowhere near what our business is capable of delivering. Our current booking trends are a testament to that. We are hitting records on top of previous records, which clearly tells us the strength and demand we have been building is continuing into next year and beyond. In the near-term, pricing on bookings taken in the second quarter has continued to run considerably higher for each of the third and fourth quarters. And again that's on top of record per diems last year. This strength has enabled us to take up yield guidance for the year by another 75 basis points. We expect to deliver consistent mid-single-digit per diem growth through the balance of the year, which would mark eighth consecutive quarters that we are achieving mid-single-digit or higher per diem improvements. Our continued focus on optimizing our yield curve is not just a near-term benefit. We entered the second quarter with much less 2024 inventory to sell and have been able to lean even more into future periods. Accordingly, in the last three months not only did we take more bookings for post-2024 sailing than we did for in-year sailings, we set yet another record for the most future bookings ever taken during the second quarter. The unprecedented level of demand for 2025 sailings coupled with flat capacity growth next year translates into meaningful pricing power. And while it is still early for 2025 both price and occupancy are already ahead of where we were last year, leaving us in a position of strength with less inventory remaining for 2025. It also shows in our more than $8 billion of customer deposits, which shattered last year's record by $1.1 billion. You have heard me say this before, this is not pent-up demand. It is the compounding effect of building increased consideration in our cruise brands over time and improvement in our yield management techniques to translate that demand into higher ticket prices. And it is further evidence of the strength of our consumer. Encouragingly, we're enjoying consistent growth in both repeat guests and new guests with each segment up 10% this quarter over last year. We also continue to actively manage our portfolio to further accelerate our underlying execution improvements. As previously announced, early next year we will sunset the P&0 Cruises Australia brand, selling the 28 year old Pacific Explorer and transferring P&0 Australia's two remaining vessels to Carnival Cruise Line. Of course, we will still retain our leading presence in the Australian market, carrying over 60% of all Aussie Cruisers. It is a great market for us, especially since the Australian summer coincides with the Northern Hemisphere winter, enabling our seasonal ships to capitalize on two summer periods. And now we get to optimize our presence in this market by consolidating into Carnival Cruise Line. Not only will we gain operational, administrative and back office scale, we will ultimately have greater deployment flexibility compared to a dedicated Australian brand. At the same time, this move will further boost capacity for our highest returning brand, bringing the total to nine new ships joining Carnival Cruise Lines fleet since 2019, including the successful ship of three vessels from Costa Cruises. These actions combined with the 2 Excel-class ships scheduled for delivery in 2027 and 2028 will grow Carnival Cruise Line's capacity by about 50% over 2019. By 2028, the Carnival brand will represent 37% of our portfolio, up from 29% as we continue to reshape our portfolio to maximize ROIC. Of course, our amazing destination experience, Celebration Key, purpose built for Carnival Cruise Line will soon support that growth and bolster returns through incremental revenue uplift coupled with improved fuel efficiency given its strategic location. We're introducing voyages to Celebration Key beginning in the second half of 2025 and ramp up to 18 ships calling Celebration Key in 2026. This quarter, we also delivered Queen Anne, Cunard's fourth Queen with an amazing naming celebration in Liverpool, England, Cunard's birthplace. The streets of Liverpool were walled with tens of thousands of people joining the festivities as the City of Liverpool became the ship's official godparent. It was a historic moment and the first time an entire city ever christened a ship. The event generated overwhelming coverage and as intended broke booking records on the back of it. The new Queen is a step forward in every way for Cunard, while still retaining the DNA of British elegance and refinery that the brand is known for. We enjoyed another high profile naming event for Sun Princess in Barcelona with Godmother Hannah Waddington of Ted Lasso fame. Sun Princess has had great media coverage leading up to and following the naming ceremony with particular focus on its expansive specialty dining and beverage offerings and one of a kind Magic Castle experience. Sun Princess, the first of its class has also been a big hit with guests as evidenced by outsized yield and high guest satisfaction scores. Last but not least, we held a naming event for Carnival Firenze in Long Beach, California, home for Carnival second ship featuring Fun Italian Style with Godfather Jonathan Bennett fresh off his Broadway stint starring in Spamalot. Welcoming Fun Italian Style to the West Coast generated nearly 2.5 billion media impressions to date and of course triggered a step-up in bookings. While these amazing new ships all contributed to the strong yield improvement we generated in the second quarter, even excluding them, yields on our existing fleet were up double-digits demonstrating fundamental strength on a same ship basis. In addition, we completed the rollout of Starlink this quarter, another revenue uplift opportunity and a real game changer for our onboard connectivity experience, enabling us to deliver the same high speed WiFi service available on land throughout our fleet. Not only does this technology provide our guests with more flexibility to stay connected, it enables our crew to stay in touch with friends and loved ones and it enhances our onboard operational systems a win-win-win. Also, our consistent track record, our book position, our focus on commercial activity improvement, our portfolio management and the yet to be realized future benefits we'll receive from our Celebration Key destination development builds increased confidence in achieving the low to mid-single-digit yield growth set out in our long-term targets. In fact, based on our upwardly revised guidance, we will be on average two-thirds of the way to achieving our three 2026 SEA Change targets. EBITDA for ALBD of $69, 12% ROIC and a 20% reduction in carbon intensity after just one year. With two years remaining, it gives us even greater confidence in achieving our target. At the same time, we continue to aggressively manage down debt and interest expense, while reducing the complexity of our capital structure, which David will elaborate on. The number of actions we've taken to improve our balance sheet this quarter puts us further down the path on our return to investment grade credit ratings over time. It's hard to believe in just over a month it will have been two years since I had the privilege of stepping into the role of CEO. I am very proud of all we've accomplished in such a short time. Credit for our achievements go to our global team, 160,000 strong. Everyone has worked very hard to deliver yet another strong quarter, solidifying an amazing 2024 and setting us up well to top it in 2025. Equally important, they've all had a hand in delivering amazing vacation experiences and unforgettable happiness to 3 million guests yet again this quarter. So, to our amazing team, thank you. And of course, we couldn't do it without the support from our amazing travel agent partners and so many other stakeholders. Thanks to all of you. With that, I'll turn the call over to David."
},
{
"speaker": "David Bernstein",
"content": "Thank you, Josh. I'll start today with a summary of our 2024 second quarter results. Next, I'll provide the highlight of our third quarter June guidance and some color on our improved full year guidance. Then I'll finish up with an update on our refinancing and deleveraging efforts. Let's turn to the summary of our second quarter results. Our bottom line exceeded March guidance by nearly $170 million as we outperformed once again. The outperformance was essentially driven by three things. First, favorability in revenue worth almost $65 million as yields came in up over 12% compared to the prior year. This was more than a point and a half better than March guidance driven by close in strength in ticket prices as well as onboard spending. Second, cruise costs without fuel per available lower berth-day or ALBD came in flat compared to the prior year and were three points better than March guidance, which was worth over $85 million. Some cost savings were identified during the quarter which flowed through as improvements to our full year June guidance. However, most of the favorability in cruise costs for the second quarter was due to the timing of expenses between the quarters. And third, other operational improvements slightly offset by higher fuel prices and currency were worth $20 million. Per diems for the second quarter improved 6% versus the prior year driven on both sides of the Atlantic by considerably higher ticket prices and improved onboard spending. At the same time, our European brands on their path back to historical occupancy saw outside growth in their occupancy of over 10 percentage points as compared to the second quarter of 2023. Our second quarter was fantastic across the board with strong demand delivering record revenues, record yields, record per diems and record operating income. Now one thing to highlight about our third quarter June guidance. The positive trends we saw in the second quarter are expected to continue in the third. Yield guidance for the third quarter is set at a strong 8%. The difference between the yield guidance for the third quarter and the second quarter yield improvement of over 12% is simply the result of the greater occupancy opportunity we had in the second quarter 2024 as we began sailing within our historical occupancy range in the second half of 2023. It is great to see that we anticipate continued strong per diem growth in the third quarter, which we are forecasting will drive the majority of the 8% yield improvement. Turning to our improved full year June guidance. June guidance for net income is $1.55 billion, an improvement over our March guidance of approximately $275 million. This improvement was driven by three things. First, three quarters of a point increase in yields to approximately 10.25% based on the considerably higher prices we have been seeing in booking trends so far this year and the continued strength in demand we anticipate going forward. All of this is expected to drive an increase in net revenue of about $190 million. Second, as I previously mentioned, we identified cost savings that we flow through to our full year June guidance. However, they will be partially offset by higher variable compensation driven by our forecast for improved operating income. Net, we are flowing through $25 million of cost savings for the full year. And third, an improvement in net interest expense of $60 million driven by our second quarter refinancing, repricing and debt prepayment activities. The strong 10.25% improvement in 2024 yields is a result of the increase in all the component parts. Higher ticket prices, higher onboard spending and higher occupancy at historical levels with all three components improving on both sides of the Atlantic. We recognize that even within our industry leading cost structure, there will always be cost opportunities which we can focus on and harvest over time. While we identify cost saving opportunities during the second quarter, we will not stop there. We will continue our endless quest for greater efficiency in our cost structure. I will finish up with a summary of our refinancing and deleveraging efforts. During the second quarter, we generated cash from operations of $2 billion and free cash flow of $1.3 billion. We took delivery of one spectacular new ship Queen Anne and drew on her associated export credit facility continuing our strategy to finance our new bill program at preferential interest rates. Our efforts to proactively manage our debt profile continued throughout the quarter. We prepaid 1.6 billion of secured term loan facilities. We also repriced approximately 2.75 billion of the same secured term loan facilities. And we issued 535 million of unsecured notes due 2030, refinancing our unsecured notes due 2026, extending those maturities and reducing interest expense. These transactions simplified our capital structure, reduced net interest expense in the second quarter by $10 million will reduce net interest expense for 2024 by $55 million and $85 million on an annualized basis. Our decision to prepay 1.6 billion of debt during the second quarter was based on our strong liquidity, our improved financial performance and our optimism about the future. We will continue to look for more opportunistic refinancings over time. Our leverage metrics will continue to improve throughout 2024 as our EBITDA continues to grow and our debt levels improve. Using our June guidance EBITDA of $5.83 billion, we expect a two turn improvement in net debt to EBITDA leverage compared to year end 2023 approaching 4.5 times and positioning us two-thirds of the way down the path to invest in great metrics. Looking forward, we expect substantial free cash flow driven by our ongoing operational execution and the lowest newbuild order book in decades to deliver continued improvements in our leverage metrics and balance sheet moving us further down the road to rebuilding our financial fortress, while continuing the process of transferring value from debt holders back to shareholders. Now operator, let's open the call for questions."
},
{
"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 Matthew Boss with JPMorgan. Please go ahead with your question."
},
{
"speaker": "Matthew Boss",
"content": "Great. Thanks and congrats on a really nice quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks very much, Matt."
},
{
"speaker": "Matthew Boss",
"content": "So, Josh, maybe could you elaborate on the global momentum that you're seeing, notably any callouts in Europe? And then just given the booked position for 2025, which you cited as higher than '24 a year ago, how does that translate to the forward progression of pricing power and just the promotional backdrop maybe versus historical periods in your view?"
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So global momentum, I think that's probably the key term. It is global momentum. And so we're seeing strength from our North American brands, from our European brands. As you started hearing me say probably about six quarters ago, diversity sometimes it helps and sometimes you got to wait a little bit, because different places come out of different situations and different times, and this is the strength that we're seeing right now in this portfolio, and we're really hitting it on all cylinders, which is really gratifying. North America, the booking curve is higher than it's ever been and Europe, it's highest in the last 15 years. So the teams are doing a really good job of speaking to the consumer, pricing things right and getting people on our ships and happy. As far as 2025 goes, this is the first year that where we currently are where we've been able to stop firefighting in the short-term while figuring out how to also extend the booking curve and trying to do both of those things at once which is not an easy balance for revenue managers to have to do and the brands to do. So I do feel like we are firmly positioned and although it is early days as you heard us say on the call being ahead in bookings and ahead in pricing is a good place to be, and our team can really focus on optimizing that longer-term period, which is exactly what they're doing."
},
{
"speaker": "Matthew Boss",
"content": "It's great color. Best of luck."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Steve Wieczynski with Stifel. Please proceed with your question."
},
{
"speaker": "Steven Wieczynski",
"content": "Hey, guys. Good morning. So Josh, look, I know it's still early on, but your commentary around 2025 bookings is really encouraging at this point. And to add on to the last question there, I mean, could you elaborate a little bit more about where you're seeing that strength in 2025? Is the strong demand pretty much across the board? Or are there certain brands or itineraries that are showing more strength versus others?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes. At this point, I'll just tell you, it's global. It's the brands and it's the deployments. So the brands are doing an extraordinary good job of getting their messages out and getting people interested. And there's a hard a lot of hard work behind that across the commercial space. So I wouldn't give any shout outs one way or another because we're seeing it so broadly."
},
{
"speaker": "Steven Wieczynski",
"content": "Okay. And then yeah, sorry, David, go ahead."
},
{
"speaker": "David Bernstein",
"content": "Yes. So Josh also talked about the portfolio modifications we made, which should help in 2025 as well as Celebration Key. And keep in mind, on top of that, we also don't have capacity increase next year. It's relatively flat. So I hope that should provide us with some pricing power in 2025 as we move through the booking cycle."
},
{
"speaker": "Steven Wieczynski",
"content": "Okay. Thanks for that, David. And then second question, a bigger picture question around capital allocation. So based on how strong early demand is for next year bookings, it just doesn't seem like there's any slowdown at this point taking place. So I guess the question is, if we look out a year from now and bookings continue to look solid, your SEA Change targets are essentially in sight and you're even closer to an investment grade rating. I mean, is it fair to think you guys could be in a position to bring the dividend back to this story? I mean, just think it's another important milestone and something that investors are becoming more focused on. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "I probably sound like a broken record here too. Right now our priority is generate all that free cash flow, pay down debt and restrengthen the balance sheet. And in that process returning value from the debt side to the equity holders. I can't wait to have those conversations, but I'd say that's premature. We've got a lot of work to do. And when we get there you'll be the first to know Steve."
},
{
"speaker": "Steven Wieczynski",
"content": "Okay. Thanks guys. Appreciate it."
},
{
"speaker": "Josh Weinstein",
"content": "All right."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Patrick Scholes with Truist Securities. Please proceed with your question."
},
{
"speaker": "Patrick Scholes",
"content": "Hi. Good morning."
},
{
"speaker": "Josh Weinstein",
"content": "Good morning, Patrick."
},
{
"speaker": "Patrick Scholes",
"content": "Good morning. I have some questions on return on invested capital. First one and then I'll have a follow-up question. What kind of ballpark return on invested capital do you target for Celebration Key? I wonder if you could give us some color on that. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. What we've talked about is you could almost look at this like a newbuild investment. And so from a newbuild perspective, we're looking for at least mid to high teens and we'd expect no less from our land based investments as well. And obviously, the beauty of Celebration Key is it will benefit across dozens of ships over time not one newbuild."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. A follow-up question. Certainly with a new public an existing company going public in the luxury river space, they're doing 30% ROIC. Now granted, it's bit of a niche. Would you ever rule out you folks getting in that line of business? I certainly could envision seaborne river cruises being quite popular and a good crossover for your existing customers. Just some thoughts around that. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "We've looked at river cruising in the past, and I wouldn't say we'll never look at it again. It's just, it's a niche, and it's rather small. And for something like us to move the needle, it'd have to be pretty grand. And as you've heard me say before, Patrick, I think if we focus on our brands and we focus on doing all the things that we do in the normal course better, we'll make much more of an impact on this business."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. Josh, I appreciate it. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Patrick."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ben Chaiken with Mizuho. Please proceed with your question."
},
{
"speaker": "Benjamin Chaiken",
"content": "Hey, good morning. You're two-thirds of the way to your 2026 targets with two years remaining. As you think about the remaining bridge to your targets in the toggle between costs and yields, do you feel tied to a specific yield requirement or threshold or is there enough opportunity in the cost side to generate the operating leverage necessary to reach your goals? And then related costs were better in the quarter. Can you maybe provide a little more greater specifics around what you're seeing or where you're getting more operating leverage than expected? And then I have one quick follow-up. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "So on the first question, we're going to move forward as a company trying to focus on both certainly generating outsized revenue versus our historical norms and maintaining our cost leadership position. We set out when we set out SEA Change a basic math that would tell you from a pricing perspective after we get the occupancy back, we're looking at low to mid-single-digit price increases on the revenue side and that's certainly what I expect and I expect that to continue well beyond SEA Change. We also need to do a good job of managing the cost. So I don't think we have to tether SEA Change to any one particular thing. It's just doing our jobs well across the board. As far as yes, David, you want to go ahead?"
},
{
"speaker": "David Bernstein",
"content": "Yes. As far as cost is concerned, in the second quarter, remember, we did identify cost savings, but the majority of the favorability was timing between the quarters. But if you look broadly at the year, we are seeing a number of opportunities in the sourcing area, other efficiencies as well. So it is broad based. There isn't one any one particular item. Our teams are working hard all across the board and there are hundreds of cost savings items that flowed into that full year savings."
},
{
"speaker": "Benjamin Chaiken",
"content": "Got it. And then, Josh, in the quarter, you announced the P&O Australia will sunset into Carnival. You still have a number of brands across geographies and customer preferences. Do you feel there are other areas of the portfolio you can streamline and realign? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Yes. P&O Cruises in Australia is a bit unique. It's a dedicated brand to a tremendous market, but it's a small market. And so the ability to really grow a single source market brand of that size is not very feasible. And so we're going to get a lot of operational synergy out of the moves that we made with P&O Australia. We've been looking at our portfolio management for the last couple of years as you know moving ships from one brand to another retiring ships formulating our growth plans. We'll continue to do that. There's nothing on the horizon, but it's something we do on a very frequent basis to try to figure out how to optimize over time."
},
{
"speaker": "Benjamin Chaiken",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Robin Farley with UBS. Please proceed with your question."
},
{
"speaker": "Robin Farley",
"content": "Great. Thanks. The commentary has been very helpful. Thanks in addressing a lot of the concerns out there, especially I think showing that slide you have showing the momentum in Q4 pricing in particular. So thanks for giving that additional clarity. Just one question, there have been some headlines out there about some of the Greek Islands limiting the number of ships that might call next year. It's not even clear whether that's official or just something that is being considered. Can you just put some context around that, whether that would just be changing itinerary to go somewhere on a Tuesday rather than a Wednesday, right, as opposed to not being able to go there at all. In other words, is there anything when we think about there's been different itinerary changes in the last year or so that so looking ahead to next year, is that anything that we should be thinking about? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So, obviously, we have a great relationship with Greece and its local communities and it's our job to make sure we're doing things sustainably. In fact, a lot of the news that's come up lately, these islands have had caps in place for many years and we work with them and we have worked with them. We'll continue to work with them as we can really figure out how to coincide with their needs as well. I mean, that's our job. So I don't expect anything incredibly disruptive. We unfortunately for us this is just par for the course, right? We do this all the time in lots of places and you've seen it work successfully in places like Dubrovnik. And we'll continue to partner with local communities who want our economic benefit and move on. It's a relatively, I mean, if you want context, just so you know, it's a relatively small part of our overall mix. You're talking low-single-digit percentages, but it's important to us and we want to show up and we want to show up well."
},
{
"speaker": "Robin Farley",
"content": "Okay, great. Thanks. And just one follow-up. I think last quarter you might have given the different percentage growth for new-to-brand versus new-to-cruise overall. Is that something you can give a little bit more color on this quarter as well? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. New-to-cruise was up 10%, new-to-brand was up a little bit less about 6%. So we're pretty much moving forward with all components and as you heard brand repeaters is also up 10%."
},
{
"speaker": "Robin Farley",
"content": "Great. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "No problem."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of James Hardiman with Citi. Please proceed with your question."
},
{
"speaker": "James Hardiman",
"content": "Hey, good morning. Thanks for taking my question. So just a point of clarification, you talked about same ship yields being up double-digits. Can you help us with how much of that is pricing? Obviously, you're getting some occupancy benefit there. And then sort of I guess the bigger picture question there is you've had mid-single-digit per diem growth for eight quarters. You don't think it's pent-up demand. It sounds like you made that point a couple of times, Josh. When and why do you think that ultimately decelerates? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So on the same fleet, it's almost 50-50 between price and occupancy. It's a little bit more occupancy than price, but the per diems are there as well, which is really gratifying to see. As far as when our growth has to end, I wouldn't give you a timeline for that. I think all of the things that we've been talking about for the last two years are still in process. And we still have a lot of room to grow and making sure we're doing the right things as far as our creative marketing to reach the right people, the performance marketing and making sure we're getting in front of the right people in the right ways getting them to click through and book with us, book with our trade partners. The one great thing I'd say is whether it's a 25 year old ship with 2,000 guests or it's one of our newest with 5,500 guests, people love what we actually do. And we actually deliver on board and that's okay. Some coming back. So I don't see a natural ending point as long as we're focused on those things."
},
{
"speaker": "David Bernstein",
"content": "And let me add to that, because we are still in tremendous value compared to land based alternatives. And so as we continue to close that value gap, and raise the price, we should be able to continue the progression over time. And on top of that, keep in mind that, as Josh, I think, mentioned on his last call, the service levels on land based resorts have deteriorated. And on our ships, we're doing a great job keeping our guest satisfaction levels up. And people it's a hassle free vacation, and people love to cruise. And so we are expect to keep demand generation's efforts high. And hopefully, we can continue to see price improvements. And as Josh said, prices are up in 2025 in our book position, and we expect to see that continue."
},
{
"speaker": "James Hardiman",
"content": "Got it. And then sort of as a follow-up along the same lines, right, as we think about Europe versus NAA per diems. Obviously, Europe had a big occupancy tailwind in the last couple of quarters, and it seems like that is now dissipating. You've guided per diems to be up, I think, at that mid-single-digit range for each of the next few quarters. Any way we could sort of slice the Europe versus North America as we think about per diems? Are they pretty similar as we move forward? Or is one stronger than the other? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. I wouldn't peg it in any one particular quarter, given that there's always noise in the thing that you're comparing. But I'd say that we expect both North America and EU to show up on pricing over time in the normal course. I think it's particularly gratifying frankly that the EU brands not only were able to actually catch up on the occupancy, but to do so at significantly higher per diems means it's working. And so and I'd say the same thing for North America. I mean, yes, the per diems are a little bit lower, but at the end of the day, they've recovered quicker and they're still maintaining mid-single-digit pricing. So I think that bodes very well for the future."
},
{
"speaker": "James Hardiman",
"content": "Got it. Much appreciated."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, James."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Brandt Montour with Barclays. Please proceed with your question."
},
{
"speaker": "Brandt Montour",
"content": "Hey, good morning, everybody. Thanks for taking my question and congratulations on the quarter. Josh, I was wondering maybe you could elaborate a little bit on the revenue management strategy for '25. I know you have already. My question is more on the booking curve length, the optional booking curve length. You're ahead again on next year's booking curve. But is there a certain point where you feel like you don't want to go any further than that and it's not necessarily optimal? How do you think about that?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes, yes. So thank you, Brandt for the congratulations. 100%, I do feel that way. But also keep in mind, we give you up a very rolled up number when we say our occupancy is X and our booking curve is the farthest out in history. When we go through this with our teams and what they do on a daily basis, it is ship by ship, sailing by sailing, brand by brand to figure out what that optimal point is. And it could very well be that over time for lots of reasons you're not going to hear me say overall that we are increasing the booking curve. And that's okay. Our goal is not to get it as long as possible. It's to generate as much revenue as humanly possible by the time the ship leaves for sailing. And so there's a lot that goes into that mix. It's not just base loading, but what price are you base loading it at? How are you managing your metas against each other, the balconies versus the insides. I mean, so many variables go into it on a detailed basis and the output is what we talk about on this call. So the teams are very much aligned. Optimization does not mean elongation, it means optimization."
},
{
"speaker": "Brandt Montour",
"content": "That's super helpful. My follow-up is on three brands, Costa, Princess and Holland America. Those are three that we've been watching you guys talk about in your -- in sort of improving ROICs across those three brands. I know that you've been focused on them. How would you describe the success or versus your own benchmarks on those three brands improvement And are any three of them outperforming the others at this point along those guidelines?"
},
{
"speaker": "Josh Weinstein",
"content": "Sure. Well, I'll start with the fact that every single one of them is showing significant improvement year-over year-in ROIC which I'd expect. They were all coming from a different starting point back in the pre-pause world. So one of them is actually above where they were, one of them is at where they were and one of them is below where they were. But I'd say it's a little bit irrelevant because of the brand that's actually higher. I expect it to be even higher because 2019 wasn't very good for them. So from my perspective, the good news in this is none of them yet are at 12% ROIC. All of them have the potential to do that and we've got plans in place for them to do that over time. So progress across the board."
},
{
"speaker": "Brandt Montour",
"content": "Excellent. Thanks so much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Conor Cunningham with Melius Research. Please proceed with your question."
},
{
"speaker": "Conor Cunningham",
"content": "Hi, everyone. Thank you. Just on the, I think, you said 10% new-to-cruise. I was curious if you could talk a little bit about just the changing demographics of your customers in general. How much is the younger demographic engaging with the project or product? Is there anything that they're doing different than prior generations? Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. Well, that's a deep question, right? So everybody is engaging differently than they did 5 and 10 years ago, because everybody is getting more comfortable with everything digital and everything online. So that's a shift that's not just about millennials, it's about society. And when it comes to our mix, we've got brands that might be one or two years younger at average age than they were before the pandemic. We've got some that might be a year older. In the grand scheme of things, it's not a huge swing. We've got and you also got to remember with us, we've got brands that really do cater to a younger generation like a Carnival, like an AIDA. And they're going to be outsized in our portfolio mix when it comes to attracting millennials. We don't just want millennials though. I can't say it strongly enough, a brand like Holland America, a brand like Cunard, it is playing in a place where they need and want people that have time and money, which generally leads to an older crowd, a crowd that has time on their hands because maybe they're not working anymore. And so I'm very happy that we're getting a broad church because we are across the board. But make no mistake we're happy with our mix and we're happy to take many folks in the boomer generation and Gen X, Gen Y, Gen Z you name it. So we want it all."
},
{
"speaker": "Conor Cunningham",
"content": "Okay. Appreciate it. And then on the P&O Australia brand being sunsetting, just as you consolidate that into Carnival, is there any impact on the P&O or any investment needed to like during that transition time? Just curious like as it goes away is there potentially cost headwind associated with it? Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. We're going to -- for us, we're going to do some minimal CapEx investment primarily on the ships to get the IP stacks aligned to Carnival Cruise Line. But from a guest experience standpoint, we don't have to do much with those ships and they're great for that market. We obviously have in this particular instance because we're effectively sunsetting a brand. There are some one-time costs that we're absorbing, but it's really quite small. So nothing really significant to speak of."
},
{
"speaker": "David Bernstein",
"content": "And on the flip side, there'll be some operational efficiencies, which will also save costs on the P&O as well."
},
{
"speaker": "Josh Weinstein",
"content": "Yes."
},
{
"speaker": "Conor Cunningham",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Assia Georgieva with Infinity Research. Please proceed with your question."
},
{
"speaker": "Assia Georgieva",
"content": "Good morning, guys. Excellent quarter, really happy excuse me for what you have accomplished. I had two quick questions. The first one is more on the external or competitive environment. As David and Beth, you guys know, we do this really extensive pricing surveys, which are quantitative and we follow about 95% of the private and public companies. So we're seeing some discounting out of one of your competitors into Q4 and possibly into Q1 2025. And also seeing sort of encroaching on your territory by another brand that may be a private one. Would you, Josh, David, the best be willing to comment as to how these external pressures may carry a potential risk towards the winter season?"
},
{
"speaker": "Josh Weinstein",
"content": "I mean, so thanks for the kind words for us. As you heard, we gave you our forecast for effectively for each of the quarters by giving you the third quarter and the full year. So you can see we're expecting continued progress, continued mid-single-digit type of price improvements over time. With respect to any one competitor in the cruise space, because you got to remember we're not just competing with cruise companies, we're competing with vacation companies to get the traveler thinking about taking their vacation with us. None of it should be disruptive to us in the grand scheme of things. Given our size and scope, given the strength of our brands, given the continued focus that our brands have in differentiating themselves even further and providing amazing experiences. It's really our job to perform no matter what some nameless brand, which I have a feeling I know which one you're talking about, how you described it, how they choose to operate. And if we've seen this in markets all over the world. And yet here we are with record revenues, record per diems and really great momentum."
},
{
"speaker": "Assia Georgieva",
"content": "Thank you, Josh. And a quick follow-up question. You described both ticket price and occupancy being tailwinds in Q2. And I think, again, with Europe being somewhat slower on the uptake in 2023, should we expect a continued benefit from higher occupancies, especially out of the European sourced passenger in Q3? Or do we believe that going into Q4, Q1 and possibly next year, that benefit will start to subside a little bit just because of the catch up that's been going on?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes. If you recall last year and you actually heard David earlier on the call, we basically got back to historical occupancy levels in the second half of last year. So there's a little bit more opportunity on the occupancy side certainly in Q3 where we were a little farther behind in that range than we were by the time we got to Q4. But really as we move forward into 2025 and beyond, we got to get the demand to keep that momentum up on the mid-single-digit type of price increases that we want to push for. There will always be opportunities at the fringes and but as you've heard me say before, the reason why we're not giving you guidance on occupancy with specificity is we want to make sure that our brands are doing the right thing in managing the revenue and managing the curve and not simply trying to make an occupancy target to the point or decimal point at the expense of doing something they shouldn't be doing with the pricing. So our goal is very much how do we generate the most yield over time, which is that combination of the price and occupancy and making sure we kind of nail the dismount there."
},
{
"speaker": "Assia Georgieva",
"content": "And Josh that makes total sense, especially on the occupancy guidance. I understand and appreciate it. So good luck. We're expecting great things in September."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Jaime Katz with Morningstar. Please proceed with your question."
},
{
"speaker": "Jaime Katz",
"content": "Hi, guys. Good morning. I have a quick question. Given that the environment has been so strong for you guys, what keeps you up at night? Is it regulatory risk? Is there some ESG risk? Is it nothing right now? Just curious to hear sort of the other side of the attack. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Listen, we got through 2020, and I got three kids, so not much keeps me up at night. When it comes to this, I mean, anything within our control, I feel very comfortable that the team we can manage it all, frankly. And so I don't worry much about Black Swan because you really can't spend your life worried about Black Swan or you'll have a miserable life. So our attitude is we got to keep performing. We'll take what people throw at us and the world throws at us and we'll adapt and modify what we need to do as needed and move on. And the greatest part about this business from that perspective is we're mobile. And when you have that mobility, it gives you a lot of flexibility to figure things out."
},
{
"speaker": "Jaime Katz",
"content": "That's all I got. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Dan Politzer with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Daniel Politzer",
"content": "Hey, good morning, everyone. Thanks for taking my question. First one on Celebration Key, Josh, you mentioned you're ramping up there 18 ships calling on port there in 2026. Can you maybe talk about the uplift that you're expecting, whether it's in the form of ticket prices, onboard spend? I know you mentioned fuel. And then to what extent is this built into those SEA Change targets, which you're already tracking well ahead of at this point? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. Yes. Thanks, Dan. So you nailed the three components that are going to really be the things that drive the returns on Celebration Key. It's going to be incremental price because of the demand. It's going to be incremental spending on the island which we call onboard spending in this circumstance and fuel savings because of its location. We're not breaking those out for people. But yes to answer your question that did factor into really 2026 benefit for us as we think -- as we're thinking through that three year plan. It's fairly minimal for next year when it comes to the uplift because it's a fairly insignificant amount of our overall capacity that's hitting it as we ramp in starting in the second half of next year. But those were the three components, yes."
},
{
"speaker": "Daniel Politzer",
"content": "Got it. And then just for my follow-up, in terms of cost for next year and acknowledging it's still very early, but as you think about that marketing and advertising component, on the one hand, you don't have a ton of capacity growth, but with Celebration Key starting to opening in the back end of the year, how should we kind of think about that line item relative to 2024?"
},
{
"speaker": "David Bernstein",
"content": "So it clearly is from a cost perspective, Celebration Key will add cost, but hopefully and we do anticipate that it will be a great return and the benefits on the revenue and the onboard spend side and the fuel savings side. So it is we're not managing to any particular line item. We're managing to our operating income and our bottom line, and we're not afraid to invest in Celebration Key to make it a great success. While we're on the cost for 2025, I guess the only other thing I'd add on that front is we do also we announced the AIDA evolution program and those ships will be going into drydock. So we will also see an increase in drydock days in 2025 versus '24, which will also have a corresponding impact on cost."
},
{
"speaker": "Josh Weinstein",
"content": "And ultimately though, we're doing that for the right reasons as we I think I can't remember if we talked about this on the last call or not. I think we did. AIDA is one of our highest returning brands and we've gushed about them for a long time and this is going to make significant enhancements to their existing fleet, which is a great investment for us because we can get outsized returns on those investments. And then to your I think you were asking a question about advertising specifically as well. You're right, we might have flat capacity growth, but remember we're selling cruises that go beyond the current year. We're thinking well into the future as our brands do try to optimize whatever that booking curve is for that particular brand. I do not have a mandate or a cap or a floor on our spending for advertising, right? The key is what are we spending it on? How is it going to be effective? Is it going to generate incremental and outsized revenue for whatever that initiative might be in the marketing space? And we go through those plans with our brands not only every year as part of the planning process, but throughout the year I'm talking to my President to make sure we're being thoughtful. And so there's no -- there truly is no predetermined outcome. I think as you've seen we have significantly stepped up where we were before the pandemic to where we are now. It's been working. It's been helping to support the results that we've talked about today and the momentum that we've got and we'll continue to look at it critically."
},
{
"speaker": "Daniel Politzer",
"content": "Got it. And then just very one last very quick clarification. David, I know you mentioned returning to IG metrics. I just want to make sure that there's no change in your goal of getting back to IG, an investment grade credit rating?"
},
{
"speaker": "David Bernstein",
"content": "No changes. We can control the metrics. We can't control the decisions of the rating agencies."
},
{
"speaker": "Daniel Politzer",
"content": "Got it. Thanks so much."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of David Katz with Jefferies. Please proceed with your question."
},
{
"speaker": "David Katz",
"content": "Good morning, everyone. Thanks for taking my question. I wanted to follow on to that. Well, number one, congrats on the quarter. I wanted to just follow on, on the last question with respect to the balance sheet. And look, I think we probably all progressed through a period where we're expecting maybe a rate cut. Nonetheless, you're making some very good progress with respect to that balance sheet. Can you help us maybe shed a little light beyond just the obvious easy math around what a rate cut could or would do for you in progressing that balance sheet?"
},
{
"speaker": "David Bernstein",
"content": "Well, to start with, if you look at our whole portfolio, about 15% of our debt profile is variable rate debt. So as you saw in the earnings release, I think it's at a 100 basis point reduction in interest rates would benefit the back half of the year, I think, was 23 million or for the full year, it's double that. But really, from a rate cut perspective, we're in an environment where for us, we're an improving credit. And hopefully, our interest rate, our future interest rates will come down not just because of rate cuts but because of the improving credit and the lower credit spreads. And on top of that, we would expect to do some refinancings. And those refinancings should drive our interest expense down. So we do have some very good opportunities that we're looking at in the future, which should be net present value positive. And we'll keep evaluating that, and you'll hear more about refinancing over time."
},
{
"speaker": "David Katz",
"content": "Appreciate that. And if I may follow-up quickly, just going back, Josh, to one of the things you talked about that's a bit more specific, performance marketing, which was, I believe, a relatively new initiative. Could you give us an update on where that is, how it's done, what's next, etcetera, please?"
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So just to clarify, it wasn't a new initiative. It was just more focus and ensuring we had the right resources, the right capabilities and the right approaches. So that's I'd be shocked if we're ever at a point in time where we're not talking about performance marketing and how do we keep progressing it. I mean, the world changes around us, which is going to dictate we've got to always be nimble and thinking about how do we adapt to that consumer and how that consumer is going to see things and digest things and making sure we're actually being as forward thinking as we can to stay ahead of that curve. So as far as how it happens, it certainly does not happen from me. It doesn't happen from a centralized corporate group in Miami, because different brands are sourcing from different source markets, different segments, etcetera. So our six operating units really have teams that are focused on that for their brands to make sure we're doing it as optimally as we can."
},
{
"speaker": "David Katz",
"content": "Okay. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks. I think we've got time for one more, operator."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Sharon Zackfia with William Blair. Please proceed with your question."
},
{
"speaker": "Sharon Zackfia",
"content": "Hi. Good morning. I'm convinced you're going alphabetical order on these calls. I guess, I wanted to ask about kind of the tension between garnering or harvesting cost savings versus reinvesting in demand creation and how you think about that? I mean, Josh, you touched on different elements of demand creation, but I mean, historically Carnival has been known as kind of the cost leader. Is there an opportunity as you harvest these cost savings to kind of zap more of that gap in the marketing spend per berth that Carnival does relative to the competition and how far are you willing to go there?"
},
{
"speaker": "Josh Weinstein",
"content": "Yes, sure. So as you heard, so we want to continue to be the cost leader. I think they're not --they don't have to be mutually exclusive though. And so we have been bringing more cost into reinvesting in the business. And it's not just our marketing, it has been our marketing. I think it's what 18% per ALBD versus pre 17% to 18% per ALBD since before the pandemic. So certainly we see the value of that. But if you think about our onboard experience and making sure we're providing amazing food alternatives and services, we're reinvesting in bandwidth. We're spending more on bandwidth than we ever have and it's generating outsized returns because people love the service. It's land like and it's something people are willing to pay for. So there's examples up and down the P&O where we're very happy to reinvest to drive the right behaviors to get the revenue that we're looking for. I don't have a metric. I don't have a metric that says this is how much we're going to do in any particular quarter or any particular year. I mean clearly our operating margin, we still got work to do. Our EBITDA margins, if we get to June guidance, it WILL be about a five point bump from last year and it leaves us a few points short of where we were in 2019. So we got more work to do and so the team is very focused on it. And that will come from both sides though to your point. It won't just be cutting costs. We got to make sure we're doing the right things to drive that revenue."
},
{
"speaker": "Sharon Zackfia",
"content": "Okay. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Okay. Well, thanks everybody for joining the call today and look forward to talking to you again in September. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ccl | 2,024 | 1 | [
{
"speaker": "Beth Roberts",
"content": "Good morning. This is Beth Roberts, SVP, Investor Relations, Carnival Corporation & plc. Welcome to our First Quarter 2024 Earnings Conference Call. I'm joined today by our CEO, Josh Weinstein; our Chief Financial Officer, David Bernstein; and our Chair, Micky Arison. Before we begin, please note that some of our remarks on this call will be forward-looking. Therefore, I will refer you to the forward-looking statement in today's press release. All references to ticket prices, net per diem, net yields and adjusted cruise costs without fuel will be in constant currency unless otherwise stated. References to per diems and yields will be on a net basis. Our comments may also reference cruise costs without fuel, EBITDA, net income, net loss, earnings per share, free cash flow, and ROIC, all of which will be on an adjusted basis unless otherwise stated. All these references are non-GAAP financial measures defined in our earnings press release. A reconciliation to the most directly comparable US GAAP financial measures and other associated disclosures are also contained in our earnings press release and on our investor presentation. Please visit our corporate website where our earnings press release and investor presentation can be found. With that, I'd like to turn the call over to Josh."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you, Beth. Before I begin, I would like to express my support and heartfelt sympathy for all those impacted by yesterday's event at the Francis Scott Key Bridge in Baltimore and extend our appreciation to the co-stars and all first responders. The City and the Port of Baltimore have been our long-time partners and a home to many loyal guests as well as business and community colleagues. We proudly sail year round out of Baltimore through one of our Carnival Cruise Line ships, which was scheduled to return this weekend. Fortunately, our team has quickly secured a temporary home port in Norfolk for as long as it's needed, which should help to minimize operational changes. So we look forward to getting back to our home in Baltimore as soon as possible. Now, given that this happened just yesterday and the situation is fluid, we did not build this into our earnings materials or full-year guidance. However, we did provide a current perspective that we expect this situation to have less than a $10 million impact on a full-year guidance. With that, I'll turn to our prepared remarks which address the accomplishments included in our strong results and outlook. The first quarter has been fantastic across the board and yet another set of records. We delivered record revenues, record bookings and record customer deposits again this quarter, a great start to the year. I want to acknowledge our global team right off the bat. Everyone has worked very hard to deliver another strong quarter in a very strong way. In fact, we outperformed our first-quarter guidance on every measure. Yields, cruise cost, ex-fuel, and EBITDA enabling us to take our expectations up for the full year. Yields increased over 17% year-over-year, another record, and more than double the increase in unit costs. This was driven not only by closing the occupancy gap but also through solid mid-single digit price increases. Customer deposits beat last year's record by another $1.3 billion, contributing to our strong cash flow and enabling us to prepay another $1.8 billion of debt already this year, which is on top of the $4 billion we prepaid last year. This is meaningful progress on our return to investment grade credit. Most important, we achieved all-time high booking volumes at considerably higher prices. In fact, our North American and European brands both set booking records in the first quarter with pricing strong across all core deployments and across all quarters. Prices ran up double-digits on limited inventory left for Q2. They ran considerably higher for our peak summer period in Q3. And they were also considerably higher for Q4 while still building on our occupancy advantage. Our record book position and activity did not just happen and it is not the result of pent-up demand from repeat guests built up during the pause, which is now years in the rear-view mirror. It is because we have been creating more consideration and broad-based demand for cruise travel in all of our source markets across our well-balanced portfolio. And as a result, we are capturing more new guests than ever before which coupled with our growing base of repeat guests, delivers greater overall demand. Our brands are delivering sustainable revenue growth that hits the bottom line. At the same time, our brands are continuing to pull the booking curve forward in line with our yield management strategy to base load bookings and ultimately support higher overall pricing over the course of the booking curve. As you know, before even entering the year, we already had the best book position on record with less 2024 inventory remaining for sale after absorbing double-digit guest growth, half of which was from closing the occupancy gap and half from higher ship capacity. Those efforts have enabled us to maintain price integrity on the remaining '24 inventory and sets us up nicely to deliver a nearly double-digit improvement in yields this year. This also allowed us to focus more of our efforts through wave on further out bookings, helping to lay the foundation for an early build 2025. It is remarkable that we are even better positioned now for 2025 than we were last year at this time, heading into what is shaping up to be a phenomenal 2024. To aid in that effort, we have been rolling out an enhancement to YODA, our yield management tool designed to facilitate an even more optimal booking curve and which will continue to pay dividends well into the future. Of course, we have more in the pipeline to sustain our momentum and capitalize on this untapped revenue opportunity. For instance, we have three fantastic new ships driving increased consideration and demand to their respective brands. Carnival Jubilee, Carnival Cruise Line's third Excel-class ship was recently christened by Gwen Stefani at her inaugural home port in Galveston, Texas. Sun Princess was recently delivered the first of its class and a real game changer for Princess and soon to be delivered is Queen Anne, a new flagship for Cunard and its first new ship in 14 years. Of course, as you've heard me say before, we do not need new ships to increase yield as we continue to position our brands to drive demand in excess of supply and address the unreasonable value gap to land-based alternatives. We are also continuing to invest in the existing fleet with AIDA evolution, the largest modernization program in that brand history. The planned enhancements to the guest experience are designed to deliver a meaningful revenue uplift across the brand while further reducing its environmental footprint and bolster the performance of one of our highest-returning brands. And speaking of brands that truly outperform, we are also continuing to strategically invest in growth for Carnival Cruise Line. Celebration Key, our exclusive destination purpose-built for that brand's target guest is really starting to capture the imagination as they launched a new marketing campaign right in the heart of wave season. Although early days Celebration Key is already delivering an initial halo for bookings in the second half of 2025 across 18 Carnival Cruise Line ships departing from 10 home ports. We also announced the second phase of development for Celebration Key with a peer extension that can berth two additional ships in future years, further leveraging what will be a best-in-class asset for us. We expect ticket revenue uplift from this incredible destination as the guest experience delivers unmatched funds as well as incremental in-port spending. And this will be coupled with cost benefits driven by considerable fuel savings as it will be the closest destination of our seven owned and operated ports in the Caribbean. This destination is designed to support the continued growth plan for Carnival Cruise Line, including the two recently announced additions to its highly successful Excel-class for delivery in 2027 and 2028. All of these investments demonstrate our disciplined capital allocation strategy. We continue to prioritize our investments towards our highest returning brands and biggest opportunities. This includes investments to reduce our carbon footprint, which will not only have a measurable impact on the environment, but also improve our bottom line. Our strategic investment in advertising is also paying dividends, driving demand across our portfolio with several new campaigns launched during wave. In fact, our web visits are up over a very strong 2023 with increases in both natural search and paid search. We increased our advertising efforts around our strategic foothold in Alaska. Alaska has long been the lifeblood for both Princess and Holland America, and they have launched new campaigns to build even greater awareness for our unmatched land-sea experiences. This initiative isn't just US based. We have stepped up our marketing efforts across Europe with new campaigns for all our major European brands. AIDA's new campaign, Experience Yourself Differently launched in Germany to rave reviews, P&O Cruises' new campaign, Holiday Like Never Before, really hit home with its British guest base. And Costa's newly released campaign focusing on moments where guests are left speechless, has been met with much success in its core markets of Italy, France and Spain. These campaigns have contributed to the continued strength of our European brands, which has been a meaningful driver of our improved outlook. It is particularly rewarding to see our European brands flexing their muscles across their core European deployments. It is a real testament to the strength of our portfolio. The outperformance we've experienced this quarter has been a continuation of the strong demand we've been experiencing for all our core deployments. The Caribbean, Alaska and Europe have all helped deliver over a point of incremental yield improvement. This more than offsets the impact of the Red Sea rerouting as well as changes in the price of fuel and currency exchange rates since our last update. It has also enabled us to raise our full-year guidance for EBITDA and net income. Our improving operational performance coupled with excess liquidity and the lowest order book in decades leaves us well positioned to continue to opportunistically manage down debt and interest expense while reducing the complexity of our capital structure. This is very much aligned with our return to investment grade credit over time and our treasury team has been quick to capitalize on this trajectory with an ongoing stream of well-executed transactions to strengthen our balance sheet. With the vast majority of this year's business now booked, we have even more conviction in delivering record revenues and EBITDA, along with a step change improvement in operating performance lasting well beyond 2024. While we continue to optimize yield on the limited inventory we have remaining and still manage down costs, we have been turning more of our attention to delivering an even stronger 2025. We're gaining traction on improvements across the commercial space along our path of continued margin enhancement and increased returns. Again, I would like to thank our team members, ship and shore, the best in all of travel and leisure for delivering unforgettable happiness to another 3 million guests this past quarter by providing them with extraordinary cruise vacations. Of course, we couldn't do it without the support from our travel agent partners and so many other stakeholders. With that, I'll turn the call over to David."
},
{
"speaker": "David Bernstein",
"content": "Thank you, Josh. I'll start today with a summary of our 2024 first-quarter results. Next, I will provide a couple of highlights about our second quarter and some color on our improved full-year March guidance. Then I'll finish up with an update on our refinancing and deleveraging efforts. Let's turn to the summary of our first quarter results. Our bottom line exceeded December guidance by $100 million as we outperformed once again. The improvement was essentially driven by two things, favorability in revenue from higher ticket prices as yields were up over 17%, nearly three-quarters of a point better than December guidance worth almost $30 million, while cruise costs without fuel per available lower berth day or ALBD came in over two points better than December guidance due to the timing of expenses between the quarters, which was worth over $50 million. Per diems improved 5% with improvements on both sides of the Atlantic driven by considerably higher ticket prices. At the same time, we saw outsized growth in occupancy of nearly 20 percentage points at our European brands on their path back to historical occupancy. Our North American brands of occupancy grew strong mid-single digits. The difference in occupancy growth on the two sides of the Atlantic resulted in a sizable mix impact on our consolidated onboard revenue per diems since as we have discussed in the past, our North American brand customers naturally spend more on board than their European counterparts. However, the underlying fact is that we saw an increase in onboard revenue per diems on both sides of the Atlantic, driven in part by the acceleration of strong pre-cruise sales growth. In fact, we saw a continuation of strong consumer behavior by guests onboarders trips, much like our booking trends this past quarter. As Josh indicated, first quarter was fantastic across the board with strong demand for our brands delivering record revenues, record yields and record per diems. Before I discuss our second quarter and full year guidance, I would like to add that given the timing of yesterday's events in Baltimore that Josh mentioned, our guidance does not include the current estimated impact of up to $10 million for the full year 2024 from the temporary change in homeport. Now a couple of things to highlight about our second quarter March guidance. The positive trends we saw in the first quarter are expected to continue in the second. Yield guidance for the second quarter is set at a strong 10.5%. The difference between the yield guidance for the second quarter and the first quarter yield improvement of over 17% is simply the result of the greater opportunity we had in occupancy in the first quarter 2024. With the improving trends we experienced during the first half of last year, 2023 second quarter occupancy was already seven percentage points higher than the first quarter. In addition, I did want to point out that nearly three-quarters of the full-year impact from the Red Sea rerouting is expected to occur in the second quarter with the remainder expected in the fourth quarter. Turning to our improved full-year March guidance. We are now forecasting a capacity increase of 4.5% compared to 2023. March guidance for net income of $1.28 billion is an $80 million improvement over our December guidance. The improvement was driven by two things, more than a point increase in yields to approximately 9.5% based on the considerably higher prices we have seen in booking trends so far this year and the continued strength in demand we anticipate going forward worth about $200 million. In addition, we are forecasting a collective improvement in all our cost lines, excluding fuel of over $50 million, including an improvement in cruise costs without fuel. This improvement of over $250 million is partially offset by the Red Sea rerouting impact of $130 million and the net impact from higher fuel price and currency of almost $45 million. The strong 9.5% improvement in 2024 yields is a result of an increase in all the component parts, higher ticket prices, higher onboard spending and higher occupancy at historical levels with all component parts improving on both sides of the Atlantic. I did want to point out that cruise costs, excluding fuel is expected to be better than December guidance due in part to cost savings related to Red Sea rerouting as certain ships reposition without guest as well as other efficiencies we identified that are included in our March guidance. While absolute costs are lower, the change in cruise costs without fuel per available lower berth day of 0.5 point from December to March guidance is simply the math of spreading all costs over the lower ALBDs resulting from the Red Sea rerouting as certain ships reposition without guests. We recognize that even within our industry-leading cost structure, there are opportunities which we can focus on and harvest over time. A great example is our Maritime Asset Strategy Transformation system, or what we refer to internally as MAST. As previously mentioned, MAST is a centralized system developed to optimize the management of equipment and machinery across all brands and all our ships. As we continue to roll-out MAST, it will allow us to leverage spare parts more effectively across the entire fleet and optimize our maintenance schedules and practices, all of which will strengthen our efficiency and reduce costs from unplanned maintenance over time. I will finish up with a summary of our refinancing and deleveraging efforts. During the first quarter, we generated cash from operations of $1.8 billion and free cash flow of $1.4 billion. We took delivery of two spectacular new ships and utilized two export credit facilities, continuing our strategy to finance our new build program at preferential interest rates. Also during the quarter, we successfully extended the maturity of our forward starting revolving credit facility by two years to August 2027 and upsized the borrowing capacity by $400 million, bringing the total commitment to $2.5 billion. We will continue to look for opportunities to upsize the facility through its accordion feature that allows us to add new banks and grow the commitment. Our efforts to proactively manage our debt profile continue throughout the quarter between open market repurchases early in the quarter and then our call of the remaining 9.9% second priority secured notes, we redeemed over $600 million of debt, removing the secured second lien layer from our capital structure. In addition to our second lien notes, we were able to repurchase almost $400 million of debt at a discount, adding power to our deleveraging efforts. We expect to continue our open market repurchase program on an opportunistic basis. We will continue to call some of our existing debt. In fact, yesterday we prepaid our $837 million euro term loan due in 2025 removing higher-than-average interest rate debt and another secured instrument from our capital structure. This further demonstrates our commitment to an investment-grade balance sheet. Our leverage metrics will continue to improve throughout 2024 as our EBITDA continues to grow and our debt levels improve. Using our March guidance EBITDA of $5.63 billion, we expect a two-turn improvement in net debt to EBITDA leverage positioning us more than halfway down the path to investment grade metrics. In summary, continued execution coupled with strengthening demand for our brands is driving increased confidence in our ongoing performance. We are pleased this has been recognized by S&P and Moody's with their recent upgrades as well as by our banking partners with their recent upsizing and two-year extension of our revolving credit facility. Looking forward, over the next several years, substantial free cash flow will significantly reduce our leverage, moving us further down the road to rebuilding our financial fortress, while continuing the process of transferring value from debt holders back to shareholders. Now, operator, let's open the call for questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] One moment please for the first question. Our first question comes from Robin Farley with UBS. Please proceed."
},
{
"speaker": "Robin Farley",
"content": "Great. Thanks very much. I wanted to ask about your commentary about considerably higher for the remainder of the year. Just looking at the math of that, is it fair to say that it looks like your per diem growth in the rest of the year is accelerating to maybe 6% or higher compared to the 5% in Q1? I just wanted to get it if that sounds right in terms of what your -- what you think considerably may mean. And then just if I could ask as a follow-up, in terms of ship orders, obviously saw your second ship order yesterday since the pandemic, and there was a line in it that said you continue to review fleet plans or there was some wording that I thought maybe suggested you might have another ship order later this year for 2028, which would be completely in line with what you've said long-term, but is that kind of what the language is suggesting? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Hi. Good morning, Robin. This is Josh. So, yeah, I mean, the good news is we just experienced a first-quarter booking activity that really knocked the cover off the ball, which is really gratifying to see. The volumes are going to naturally taper down, as we talked about, but the good thing is people are paying for what we have left to offer. And so when we came up with our guidance for yields overall, it was not just based on occupancy, it was based on occupancy plus per diem growth in pricing, and that is playing out. So I won't give you a specific number for rest of year or fourth quarter, but we know the comps get harder, but that's not an excuse. We just need to make sure we're doing what we need to do on the demand and get the per diems up year-over-year every quarter, which is what our expectation is. So that trend has continued well, and the great thing is that hasn't stopped. If you look at the first month of our next quarter of March, that trend has continued. So we're in good stead there, and that's spilling into 2025 as well, where, as you heard me say and David say, we're off to another unprecedented start, which is great to see. As far as the newbuild, yeah, we're incredibly excited that we've restarted our newbuild ordering. But as you mentioned, in line with what I've been saying for almost two years now, which is when we restart, which is what we've done, we're talking about one to two chips a year starting in 2027. There won't be another one in 2027. That will be what we've got. As far as 2028 goes, could there be another one? It's not closed, but I wouldn't necessarily bank on it either. We are working on more things that are going to be geared towards our highest returning brands as we've been talking about. And when there's something to talk about, we'll certainly share it."
},
{
"speaker": "Robin Farley",
"content": "Okay, great. Thanks very much."
},
{
"speaker": "Josh Weinstein",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Katz with Jefferies. Please proceed."
},
{
"speaker": "David Katz",
"content": "Hi. Good morning. David, appreciate all the insights so far with respect to the guidance et cetera. But with the ship orders and just taking a much longer-term view, presuming, and I just looking for confirmation that, that doesn't change or alter the path to investment grade by sort of adding some more CapEx to the system longer term."
},
{
"speaker": "David Bernstein",
"content": "No, not at all. We are working down our road to investment grade. We are prioritizing the repayment of debt and the repurchase of debt. And we look -- as we did in the first quarter, as Josh indicated, and I gave the details, we prepaid $1.8 billion of debt so far this year. And with improved EBITDA, we expect to get to investment-grade metrics in 2026. And remember, Josh, we're only talking one ship to two ships a year and with the cash generation, we expect to continue to see improved debt, net debt to EBITDA in 2027 and '28 as well with -- even with the new orders on our path to investment grade."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, when we came up with our roadmap, sorry, this is Josh. We did factor in the assumption that there would be future newbuilds with stage payments in advance. So that was already factored into how we were thinking about the world and still being able to pay down the debt and get to those investment-grade metrics."
},
{
"speaker": "David Katz",
"content": "Understood, Josh. And if I can just follow up quickly, and I know I asked this repeatedly, I'd love to just get your sense for sort of what's at or near the top of the list in terms of just the business in general and other change in execution or how things are done or other improvements that you're working on. Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. I'm going to sound like a broken record. When it comes to the commercial side of the operations, I think everybody has room to improve across all areas and that's never going to stop being a focus. And we're seeing a good amount of progress and that's across the advertising, across revenue management, across onboard execution, certainly deployment planning, I mean, you name it, we just expect to continually understand our business, understand our guests brand by brand, and have them execute at the highest level possible. So we've talked about some game changers for us around Celebration Key, which will be coming in 2025, a new period, Half Moon Cay, which will open up that destination which is a true jewel to even more guest flow. So there's certainly some very specific strategic assets that we've got moving in place which are going to be a great tailwind for us. But I think the bigger tailwind is really having our brands perform across their core markets, to their core guests, to the best of their abilities."
},
{
"speaker": "David Katz",
"content": "Thank you. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question comes from Brandt Montour with Barclays. Please proceed."
},
{
"speaker": "Brandt Montour",
"content": "Hey, everybody. Good morning. Thanks for taking my question. Josh, when we look at your per diem growth for '24 guidance and we think about what went into that and we rewind the clock six, nine, 12 months, we remember that you guys were what we call -- what you call base building for '24 throughout last year, and it was a pricing environment that arguably isn't as good as it is now. And so I guess the question is, when you think about where you were last year and where you are this year, is the strategy going to -- do you feel better and is the strategy any different when you're thinking about base loading '25 and where we could be in 12 months from now thinking about pricing growth?"
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, I mean, I do feel better. I feel better because we have another year under our belt of our brands, really focused on optimizing their booking curves. We're doing it in an environment which we get the benefit of, let's call it a full year of somewhat normal, whereas last year, depending on the brand, it was a struggle of trying to fill short-term and think long-term. This year we -- because of what we've been able to build going into the year, we -- I mean, it's historical. We have the ability to really lean in even more into optimizing from a strategic perspective as opposed to plugging holes along the way, which we were focused on as well last year. So I think the future is quite bright."
},
{
"speaker": "Brandt Montour",
"content": "Okay, that's helpful. And then you guys did touch on the EA brands and the European brands and how they're doing. I was wondering if we could just sort of double-click on that and talk about -- and maybe you could tell us those brands' recovery versus '19 and how they're tracking versus your North American brands and just sort of split it out between occupancy, ticket and onboard and sort of what inning those brands are in across those three metrics. That would be helpful."
},
{
"speaker": "Josh Weinstein",
"content": "So, let me give you -- I'll give you overall, and David, if you want to add some color, certainly feel free. I think the biggest difference between the brands by segment, when you think about this year is the huge occupancy jump that the European brands are making year-over-year. And it's an occupancy jump that was really focused primarily on the first half of the year. And then it all started to normalize a good amount more as we got to the second half of last year. From a pricing perspective, from an onboard spending perspective, and as we make our way through this year from an occupancy perspective, everybody is moving on both sides of the Atlantic in a positive way. So this -- as expected, we knew that the European brands would be an outsized driver of yield improvement for us simply because of the occupancy. But I can tell you this, they're not doing it at the expense of price. Our European brands are getting price and occupancy."
},
{
"speaker": "Brandt Montour",
"content": "Okay."
},
{
"speaker": "Josh Weinstein",
"content": "David gave me a thumbs up, so I hope that answers your question."
},
{
"speaker": "Brandt Montour",
"content": "Great. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from James Hardiman with Citi. Please proceed."
},
{
"speaker": "James Hardiman",
"content": "Hi. Good morning. So maybe just to belabor that last point about occupancy, it seems like at least part of the first quarter success was occupancy was better than you thought. I'm assuming we're at a place now where it's not just about filling rooms, it's about filling rooms with more people to get to higher occupancy. So what drove that outperformance? And is there a way to think about the full year and/or the second quarter occupancy number? Obviously, there's a wide range to what could be considered historical. But I don't know, versus 2019, how should we think about occupancy this year? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Hey, James. So I think David talked about last quarter, the historical range, we're talking 104 to 107, and 2019 was the peak at 107. That may or may not be the right ending point for us. And I'm not trying to be vague, because we want to give our brands the flexibility to not optimize for occupancy or price, but it's about yield. It's about the combination of both. So I feel quite good about where we are. We did beat a little bit in occupancy, and we also beat a little bit in price in the first quarter, which was good to see. And from my perspective, I'd like us to outperform on both every single quarter. So, yeah, there's no games here. I expect us to be well in the historical range, and we'll take it and our brands will take it as far as they think it should be in order to get the price combination along with the occupancy."
},
{
"speaker": "James Hardiman",
"content": "Got it. And then, yeah, go ahead, David."
},
{
"speaker": "David Bernstein",
"content": "Yeah. The only thing I'll add is, keep in mind is that we essentially got back to historical occupancy in the back half of 2023. So the occupancy opportunity in 2024 is much more heavily weighted to the first half, which I described in the -- in my prepared remarks, where we were able to increase occupancy considerably by 11% in the first quarter. And we do expect occupancy to go up in the second quarter as well."
},
{
"speaker": "Josh Weinstein",
"content": "And our brands, I don't want you to take this the wrong way. Our brands are being quite thoughtful about opportunities to introduce more families than they maybe had in the past, looking at their cabin configuration. So there's always opportunities and we encourage our brands to certainly lean into that."
},
{
"speaker": "James Hardiman",
"content": "That's helpful. And then, Josh, you seem to make a point of noting that you don't think the current demand strength is really pent-up demand at this point, which seems to suggest that maybe we've graduated from the post-pandemic phase to the post-pandemic phase. Maybe speak to the secular story that seems to be building here whether it be from an industry perspective or a company-specific perspective, I think a lot of people are just trying to figure out the sustainability of the demand growth that we're seeing. Obviously, per diems are ahead of sort of that long-term algo, right? How long can that ultimately last, and what are going to be the drivers there? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So I'll -- I think I'll speak for the industry. Jason, Harry, hope you don't mind. But I would say that there is more and more of a realization of the value and experience gap that cruising has to other alternatives. And since the pandemic, both of those things have effectively gapped out because it's a greater value because of the price jacking that the land-based operations have been able to do and they've done it without providing a comparable guest experience. And when you compare that to us, even with our outsized per diem growth, it's still a value gap. People are not stupid. Consumers are not stupid. They are looking for value and they're looking for experiences that are worth paying for. And when you line that up, it is boating very well for the cruise industry. We now speak on behalf of the corporation, we are also leaning more into advertising, getting our messaging out, doing it more effectively, which is additional tailwinds. We -- our new to cruise is up over 30% versus last year first quarter. It's not pent-up demand. It is truly casting the wide net, having a great experience and delivering. And so I do not see an ending point. We have room to close the gap to land when it comes to the value and still be able to champion the value while leaning into the experience. So I think that backdrop is incredibly encouraging for the industry."
},
{
"speaker": "James Hardiman",
"content": "That's really good color. Thanks, Josh."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, thanks, James."
},
{
"speaker": "Operator",
"content": "Our next question comes from Steve Wieczynski with Stifel. Please proceed."
},
{
"speaker": "Steven Wieczynski",
"content": "Yeah. Hey, guys. Good morning. So, Josh or David, if we go back to the yield guidance for the year or the revised yield guidance, I should say, moving it up 100 basis points, I mean, I think that makes total sense, given you have a lot more visibility into the way that the year is going to look, and you're not -- you're probably in an extremely, extremely well-booked position. I guess my question is going to be more on the onboard side. And as you kind of think about the rest of the year, I would assume you guys are probably taking somewhat of a conservative view around the onboard metrics. And I guess saying that even differently is if onboard kind of stays where it is today, I would assume there's probably then upside to the -- to your guidance. That -- can I ask that that way, hopefully?"
},
{
"speaker": "David Bernstein",
"content": "Steve, I think one of the things, remember onboard, as I mentioned in my prepared remarks, we are seeing increases on both sides of the Atlantic. It's just that there's a mix impact, and you're going to see somewhat of a mix impact in the second quarter as well although not nearly as big for the first -- as the first quarter because of the occupancy growth will not be as great or I should say the opportunity will not be as great in the European brands in the second quarter. But on both sides of the Atlantic, it's going up and we feel very good. We're -- as I said, we're seeing continued strength in onboard on the guests. We are accelerating the pre-cruise sales. We saw a double-digit increase in terms of the percent of pre-cruise sales of onboard revenue in the first quarter. So a lot of positive things are happening and all of that was built into our guidance."
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, I'd say, Steve, as always, we try to give our best understanding of how the world looks today while continuing to push and press internally with our brands to optimize and maximize both on the ticket and on the onboard spending, which is more important as we move forward to look at on a combined basis, given bundling and how we package things for our guests. And it just hasn't slowed down, which is really the message that people should take. And I know there was some commentary that came out that caused some noise about are there -- is there anything that we need to be worried about for Q4 slowing down? And for us at least, it's the opposite. The acceleration has included Q4 both on the volume and the price. So long may it last."
},
{
"speaker": "Steven Wieczynski",
"content": "Okay, thanks for that, guys. And then second question, I'm going to ask about 2025. And look, I'm sure you're obviously very limited in what you can say around bookings, given it's still so far out. But if you look at bookings for next year, I guess what I'm trying to get a sense is, are you seeing a change in who's booking today? And what I mean by that is normally you'd be booking your longer, more exotic itineraries right now, but are you starting to see more, what we would call the normal itineraries being booked this far out? And are you continuing to see that new-to-cruise category for next year still be pretty strong or is it just still too early?"
},
{
"speaker": "Josh Weinstein",
"content": "So the -- as to the first part, the good news is it really is across the board. It's not just more people on world cruises, which we are seeing. So not to discount that, but what we are seeing is an improvement in the revenue management and booking curve across the board. So I think that bodes well for 2025. I think it's probably too early to talk about composition of guests, other than to say, our profile as we have been going quarter by quarter, has been improving that casting of the net to go beyond brand repeaters and going into new-to-cruise, which I think is probably the greatest litmus test that things are working, that the message is getting through. Now, we also have -- we also do have Celebration key, which as we get closer and closer to 2025 and closer and closer to its opening, which isn't until the second half of '25, I think we'll be able to see and talk more and more about the halo impact of that in our arsenal."
},
{
"speaker": "Steven Wieczynski",
"content": "Okay, great. Thanks, guys."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jaime Katz with Morningstar. Please proceed."
},
{
"speaker": "Jaime Katz",
"content": "Hi. Good morning. I want to piggyback onto that value proposition question we had earlier from James. And I guess, can you talk a little bit about what is motivating consumers to actually convert the booking? Is it bundling? Is it traditional marketing like advertising? Is there something else or has there been sort of any change in the pattern to what is motivating people to make that decision? Thanks."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. I don't think there's necessarily a change other than we are doing things better than we used to. We are doing a better job, I believe, investing more in advertising and doing a better job of getting the word out. Like I said, the revenue management, right, pricing it right at the right point in the curve to get people to commit is quite important. But the other, sorry, I just lost my train of thought. So I just leave it at that. I don't see anything that's inherently different other than being able to go deeper into what we are doing and doing it well. And the results that we see, not only from the bookings, but from the search activity, from the website visits, from the conversion, it's all moving in the right direction. That says all of those commercial activities are supporting our ability to get that message out. And the other thing -- I know what I was going to say. The other thing I'd say and this is not a thing about pre-pause versus post-pause. This is -- you also got to remember that if you think about the four-year period that we have just gone through where we had no sailings and then slowly ramping up, this is the first year that we've really got full capacity. All guests on board our ships that then get off of our ships. And when they get off of our ships, they go tell their friends and their family how amazing it is and help us convince newcomers to come aboard. And so we really are finally back at this point where we have all of those channels and all of those avenues at our back to support the future."
},
{
"speaker": "Jaime Katz",
"content": "Okay, that's helpful. And then I think there was a comment that there was some benefit to a timing of expenses in the first quarter. Is there any shift in the timing of expenses over the back three quarters that would be helpful to be aware about. Thanks."
},
{
"speaker": "David Bernstein",
"content": "We gave guidance for the second quarter. The third and fourth quarter, probably the third quarter might be a little bit lower than the fourth overall, but nothing that was -- no shifts that we're seeing at the moment."
},
{
"speaker": "Jaime Katz",
"content": "Excellent. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Matthew Boss with JPMorgan. Please proceed."
},
{
"speaker": "Matthew Boss",
"content": "Great, thanks, and congrats on another nice quarter."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Matthew Boss",
"content": "So, Josh --"
},
{
"speaker": "Josh Weinstein",
"content": "Is that a question? All right. Go ahead, Matt."
},
{
"speaker": "Matthew Boss",
"content": "So near term and maybe relative to the phenomenal wave season and the strength that you cited across brands, I was hoping maybe, could you elaborate on trends that you're seeing today at the Carnival and AIDA brands, maybe relative to the direction of improvement that you're seeing across your other seven brands as we think about maybe just the remaining opportunity across the portfolio in 2025 and beyond?"
},
{
"speaker": "Josh Weinstein",
"content": "I think -- that's a good question. Let me think about how I want to answer that. I would say that both of those brands have actually fully recovered at this point to pre-pause. Their ROIC is already back to where it was and in fact exceeding. When we talk about the spectrum and where all of our brands have been and where they currently are on the commercial space, right, when it comes to revenue management, when it comes to the deployment planning, when it comes to the performance marketing, brand marketing. I would say those two brands, not surprisingly, are our leaders in those categories. And so it does give us the roadmap for the other brands to follow suit, right? And that is what we're doing. I mean, I don't want anyone to call to misunderstand what I'm saying. All of our brands are improving. Not surprisingly, the ones that performed at the top before are back at the top again. And we are making sure that the learnings and the practices are being shared and disseminated and utilized across the board, which is why we are getting back our ROIC piece by piece. And we -- on this guidance, we'll be back to above 9% at the end of this year. We've got three more points after that to meet our targets for 2026, which I'm confident in, and then to go further. And we're going to do that by continuing that progress on the commercial space."
},
{
"speaker": "Matthew Boss",
"content": "And then maybe just a follow-up. So if we think about the booking curve at record levels and obviously providing some increased forward visibility. When we think about pricing power in '25 or multi-year, and I'm just thinking back to the baseline of low-to-mid single-digits, historically, the incremental seems like the experiences and the investments that you've made as we think about opening of Celebration Key in the second half of '25. So just thinking about pricing power moving forward, maybe relative to the historical baseline, what the opportunities may be?"
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, although I'd love to say that's what we're banking on and it's that easy. It's not. I mean, it is. Celebration Key is going to be fantastic and we're already seeing the start of that impact. But I cannot -- I can't emphasize enough when we are doing a good job on revenue management and pulling that booking curve forward and managing the pricing through the curve as opposed to tanking pricing at the end. You don't need, it's math, right, and it works. And it means that we can maintain that price consistency and pricing is going to go up as we go year-over-year. And to the point you're asking about our other brands, some of our brands have been doing that well for years, some of them have not. But the ones that have not are leaning into it now and we're starting to see -- starting to see that improvement. And the great thing is there is a long runway for that to continue."
},
{
"speaker": "Matthew Boss",
"content": "Great. Best of luck."
},
{
"speaker": "Josh Weinstein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Patrick Scholes with Truist Securities. Please proceed."
},
{
"speaker": "Patrick Scholes",
"content": "Great. Good morning. Thank you. Josh, certainly, you've talked sort of high level on positives around Celebration Key. I'm wondering what sort of daily cruise pricing premium you're seeing or maybe expecting for itineraries that do stop at Celebration Key. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Hey, Patrick. So we're not giving guidance for '25 yet. And since we're not sailing there until 25, I'm going to be careful about how I answer this. I would say, first of all, we are expecting -- we are, as I said in my notes, we're expecting an uplift both on the ticket side and the import spending, which effectively will come across as onboard revenue. It's too early to give you specifics. When we did our investment for Celebration Key, and then we effectively just doubled down to get a peer for two more berths. We did that with a very healthy ROIC. And that ROIC is coming from three main components. One is the incremental ticket, two is incremental import spending, and three is the benefit we get from creating something so close to so many home ports in the United States that it cuts our fuel consumption considerably. So those three components are what's driving that decision-making, and it's going to be a great guest experience and be an incredible asset for us."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. And then just a follow-up on that. What -- from a high level, what are some of those opportunities for upsell once you are on the island of Celebration Key? Obviously, I'm familiar with competitors, what they -- what items they charge, what they don't. Maybe a bit of a softball question, but what do you think people will be saying? We'll be really willing to pay up for to have an extra, extra special time on your island. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Sure. So it'll be a combination of things. We have a private beach club as part of the bigger development of Celebration Key, which isn't an island. It is part of Grand Bahama, which is a phenomenal home for us. We're going to also have a huge capacity of cabanas, overwater cabanas, different sized cabanas that people will be able to rent for the day, which you'd be surprised at how much people are willing to pay to rent cabanas for the day. There's going to be F&B opportunities. There are retail opportunities. And that's just the start of phase one, because we have only built on or we will have built on about a quarter of the property that we got our -- that we own. And so phase one is that. And phase two will be incremental guest experiences and spaces and revenue opportunities."
},
{
"speaker": "Patrick Scholes",
"content": "Okay. I'm all set. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Thanks, Patrick."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ben Chaiken with Mizuho. Please proceed."
},
{
"speaker": "Ben Chaiken",
"content": "Hey, good morning. Thanks for taking my question. Just to dig in on the cost cadence a little bit more. 1Q better than guide sounds like some timing, I guess to clarify, does that mean it slipped into 2Q a little bit and then 2Q also includes 1.3 points from Red Sea? I guess with this -- with that in mind, the full-year cost guide is 5% constant currency which I think suggests something around mid-single digit in the back half in the context of the year-over-year occupancy is getting easier relative to the one-half. I guess, one, do I have those moving parts correct? And then two, could you help us better understand the variables that you're considering in the second half? Thanks."
},
{
"speaker": "David Bernstein",
"content": "Sure. The moving parts are correct. The average for the first half of the year that the 7 point -- 7% in the first quarter and 3% in the second is about 5%, and the back half is also about 5%. Some of the difference is driven by dry dock days as well because we had a different timing between the quarters. I think in December I had indicated the amount of dry dock that increased in the first quarter. There's also differences in advertising and a number of other things between the quarters. I always talk to people about measuring us on our full-year cost guidance because the timing of expenses between the quarters sometimes is a choice of things that we want to spend either on repair, maintenance or other things. So look at it from a full-year perspective and that's the best way to judge us."
},
{
"speaker": "Ben Chaiken",
"content": "That makes sense. Just maybe a little bit more detail on the dry dock. Could you maybe clarify the quarters? I believe originally it was 1Q and 4Q were the heavy dry dock quarters. Is that still the right way to think about it or how would you?"
},
{
"speaker": "David Bernstein",
"content": "Yeah, that is. And the 1Q is considerably higher than the second quarter or the fourth quarter."
},
{
"speaker": "Ben Chaiken",
"content": "Thank you. I appreciate it."
},
{
"speaker": "Josh Weinstein",
"content": "So, operator, I think we got time for one more question."
},
{
"speaker": "Operator",
"content": "We have a question from Lizzie Dove with Goldman Sachs. Please proceed."
},
{
"speaker": "Lizzie Dove",
"content": "Hi. Good morning. Thanks for taking the question. I think your ticket price per passenger is very strong this quarter, and it sounds like a pretty decent outlook for this year and '25. I'm curious how much of that is kind of benefit from some of the new hardware. The Firenze joining the fleet over from the other brand, Carnival Jubilee, Sun Princess. How much do these new ships impact pricing? What kind of premium are you getting and how does it change how you manage the pricing for the rest of the fleet?"
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, so, good morning, Lizzie. Welcome to the first -- I think your first call or the first call since you've been covering us. So the new ships get a premium. There is no doubt that the new ships get a premium. The way we manage brand by brand, how much of that premium to get. It also depends on where we're putting that ship because we're not going to necessarily want to put the best ship on the best itinerary because that's not the good thing for the overall brand. So there is a -- obviously a bunch of different components to get into. What I will tell you though, I mean, just to take a step back, because remember, we've got nine brands, most of which have not had a new build and will not have a new build for some time. And the pricing improvements that we're getting are not focused solely on the brands that get the new ships. Brands that have not gotten new ships are seeing nice improvements as well in pricing. And so while I do love them, it's three this year out of 95 ships. And so the 92 ships, having them deliver outsized demand and pricing is going to move us more so than a premium on one or two of the ships. So I'm not disagreeing with the question, but I think to put it into perspective, it's much more important for us to get the per diems up on the rest of the fleet, which is what we've been very, very focused on."
},
{
"speaker": "Lizzie Dove",
"content": "Got it. That's helpful. And then just one follow-up. I thought James question about the secular growth outlook was interesting. I know you guys tend to index higher on new-to-cruise than some of your peers. I think you said you captured 3.5 million of new-to-cruise guests last year. How many of those do you see then convert into second-time, third-time cruisers? And so how can we -- what's the outlook for like real category expansion here?"
},
{
"speaker": "Josh Weinstein",
"content": "Yeah, well, our brand repeaters were up 9% year-over-year. So it's -- it is -- it does translate into incremental overall demand for the long term. Now, cruisers don't generally go every year. We're looking for every three years to four years would be ideal for those of them that have decided they like what we do and want to come back. So that's part of the growth plan. It's casting our net wide and getting a good portion of them to sail with us again in the next three to four years."
},
{
"speaker": "Lizzie Dove",
"content": "Got it. Thank you."
},
{
"speaker": "Josh Weinstein",
"content": "Okay. Well, thank you, everybody. I appreciate the questions and look forward to seeing you all soon."
},
{
"speaker": "Operator",
"content": "That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line. Have a great day, everyone."
}
] |
cdns | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, good afternoon. My name is Abby and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Fourth Quarter and Fiscal-Year 2024 Earnings Conference Call. [Operator Instructions] Thank you. And I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead."
},
{
"speaker": "Richard Gu",
"content": "Thank you, operator. I would like to welcome everyone to our fourth quarter of 2024 earnings conference call. I'm joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call and a copy of today's prepared remarks will be available on our website, cadence.com. Today's discussion will contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q, CFO commentary and today's earnings release. All forward-looking statements during this call are based on estimates and information available to us as of today, and we disclaim any obligation to update them. In addition, all financial measures discussed on this call are non-GAAP unless otherwise specified. The non-GAAP measures should not be considered in isolation from or as a substitute for GAAP results. Reconciliations of GAAP to non-GAAP measures are included in today's earnings release. For the Q&A session today, we would ask that you observe a limit of one question only. If time permits, you can requeue with additional questions. Now, I'll turn the call over to Anirudh."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you, Richard. Good afternoon everyone, and thank you for joining us today. I'm pleased to report that Cadence delivered exceptional results in the fourth quarter capping off a strong 2024 with 13.5% revenue growth and 42.5% non-GAAP operating margin for the year. We exited 2024 with a record backlog of $6.8 billion, which is a testament to our compelling AI-driven chip to systems portfolio and its growing proliferation among marquee, system and semi customers. The AI supercycle is entering a new phase, with Generative AI, Agentic AI and Physical AI fueling explosion in compute demand and semiconductor innovation. We see AI adoption unfolding in multiple phases, starting with the build-out of the AI infrastructure where we are already deeply engaged. At the same time, we are actively integrating AI into our own product and we are also exploring AI potential to create new markets. The Infrastructure AI phase is well underway. And we have been closely collaborating with market leaders on their next generation AI design across both training and inferencing. In Q4, we advanced our long standing partnership with NVIDIA through commitments across a range of our EDA, hardware, IP and system software solutions. We are also using NVIDIA's latest NeMo and NIM microservices to build customized Gen AI applications, delivering enhanced optimization and productivity. We deepened our collaboration with Qualcomm through a significant expansion of our EDA and system software solutions. Also, we meaningfully expanded our strategic partnership with Marvell through a broad proliferation of our portfolio of products. Our Cadence.ai portfolio continued gaining strong momentum with market shaping customers. Our AI powered products such as Cadence Cerebrus, SimAI and Allegro X AI are proliferating at scale. And our LLM based Design Agents powered by JedAI data platform, are showing promising results in early engagement. Cadence Cerebrus is rapidly becoming essential part of the design flow as it continued to deliver transformative PPA benefits to customers, with more than 750 tape-outs to-date and over 300 in Q4 alone. Our Verisium AI driven verification platform with its SimAI and debug AI apps, gained share at key comparative accounts as customers embraced the significant boost in verification quality and efficiency. Additionally, we are also applying AI to new market opportunities, such as life sciences with our OpenEye drug discovery software. The growing foundry ecosystem is driving increased design activity and creating significant opportunities for our products. In 2024, we strengthened our collaboration with existing foundry partners and entered into new strategic engagement. We furthered our partnership with TSMC with AI-optimized design flows certified for TSMC's N3 and N2P technologies. We strengthened our collaboration with GlobalFoundries and are partnering with Samsung on their SF2 gate-all-around process. We also partnered with Intel Foundry to provide design software and leading IP solutions at multiple Intel advanced nodes and in Q4 entered into a strategic collaboration with Rapidus for 2-nanometer enablement technology. We deepened our partnership with ARM, through a broad expansion of our IP, hardware and AI driven design enablement solutions and in Q4 successfully taped out industry's first ARM CSA standard-based system Chiplet. Now let's talk about some of the specific product level highlights for Q4 and 2024. Our System Design & Analysis business delivered strong results, achieving over 40% growth in 2024. Our multi-physics analysis platform with AI-driven optimization is delivering superior results to a rapidly expanding customer-base across multiple verticals, especially Aerospace & Defense and Automotive. Our millennium CFD simulation platform ramped-up over the year, closing two meaningful deals in Q4 in the Aerospace & Defense and Energy verticals. With BETA CAE, we now provide a comprehensive multi-physics platform covering electromagnetics, electrothermal, PFD, and structural analysis. BETA CAE performed ahead of our expectations, with major expansion at several marquee automakers, including at some of the fastest growing EV companies. Our Allegro X design platform with its significant productivity and next-generation capabilities continued its momentum, especially at Aerospace & Defense, hyperscale and EV customers. Allegro X AI, the industry's first fully automated PCB design engine, is enabling customers to realize up to a 10x productivity gain. Our Integrity 3D-IC platform with its unified design, analysis and sign-off capabilities for multi-Chiplet architectures expanded its footprint at hyperscale and memory customers, OSATs and foundries. Our IP business drove a strong finish to the year, growing 28% year-over-year in Q4. Our AI HPC protocols, including our flagship HBM, DDR, PCIe and UCIe solutions propelled our business, with significant expansions and competitive displacement at top tier customers. We continue to broaden our IP portfolio, with high growth star IP products and last month, we entered into a definitive agreement to acquire Secure-IC. The addition of their embedded security IP product will augment our rapidly expanding portfolio of leading edge silicon-proven IP, including interface, memory, AI and DSP solutions. We announced a collaboration with Rapidus to provide a broad set of our advanced memory interface IP for their 2 nanometer backside power process node. AST SpaceMobile, committed to our AI-driven IP solutions and EDA tools on their AST5000 ASIC, a custom low-power architecture for global space-based cellular broadband services. Our core EDA business, comprising our digital, custom analog and verification portfolios grew 15% year-over-year in Q4. Insatiable demand for more compute along with system complexity and the need for first time right silicon, continued to drive strong demand for our best-in-class Palladium Z3 and Protium X3 systems. Our hardware family delivered yet another record year, adding over 30 new customers and almost 200 repeat customers in 2024, with particularly strong demand from AI and hyperscale customers. Our digital portfolio had another strong year, gaining 36 new full-flow customers in 2024, including 17 in Q4. Cadence partnered with Equal1 on the development of its Alpha 5 Quantum SoC that runs at cryogenic temperatures with our design and implementation tools being central to this revolutionary design. Our Virtuoso inspector franchise solutions tackle the most complex design and simulation challenges in analog, mixed signal, and RF design. Virtuoso Studio, delivering industry's leading AI-powered layout automation and optimization continued its strong ramp and is now deployed at over 450 customers. MediaTek adopted Spectre X running on NVIDIA's Hopper GPUs for its 2-nanometer designs, achieving up to a 6x performance boost while maintaining full accuracy. Spectre FX FastSPICE is now in production usage at more than 75 customers, including top memory vendors as well as SOC and mixed signal companies. In closing, I'm pleased with our outstanding performance in 2024 and excited about the business momentum and opportunities ahead. As the AI era continues to unfold, our AI-driven EDA, SDA and IP portfolio powered by Gen AI agents and accelerated computing is delivering transformative results, uniquely positioning us to capitalize on these massive opportunities. Now, I will turn it over to John to provide more details on the Q4 results and our 2025 outlook."
},
{
"speaker": "John Wall",
"content": "Thanks Anirudh, and good afternoon, everyone. I'm pleased to report that Cadence delivered an outstanding Q4 and 2024 with broad-based strength across all of our businesses. Robust design activity and customer demand, combined with our strong execution, drove 13.5% revenue growth and 42.5% non-GAAP operating margin for the year. Fourth quarter bookings were exceptionally strong, and we ended the year with a record backlog of $6.8 billion and a record cRPO of $3.4 billion. Here are some of the financial highlights from the fourth quarter and the year, starting with the P&L. Total revenue was $1.356 billion for the quarter and $4.641 billion for the year. GAAP operating margin was 33.7% for the quarter and 29.1% for the year. Non-GAAP operating margin was 46% for the quarter and 42.5% for the year. GAAP EPS was $1.24 for the quarter and $3.85 for the year and non-GAAP EPS was $1.88 for the quarter and $5.97 for the year. Next, turning to the balance sheet and cash flow. Our cash balance was $2.644 billion at year-end, while the principal value of debt outstanding was $2.500 billion. Operating cash flow was $441 million in the fourth quarter and $1.261 billion for the full year. DSOs were 48 days, and we used $550 million to repurchase Cadence shares during the year. Before I provide our outlook for 2025, I'd like to share some assumptions that are embedded. Our outlook is based on our usual assumption that export control regulations in place today, remain substantially similar for the remainder of the year. At the midpoint of revenue guidance, we are assuming 2025 China revenue will be flat year-over-year, and Our non-GAAP EPS outlook continues to be based on a tax rate of 16.5%. In our outlook for 2025, we expect revenue in the range of $5.14 billion to $5.22 billion, GAAP operating margin in the range of 30.3% to 31.3%, non-GAAP operating margin in the range of 43.25% to 44.25%, GAAP EPS in the range of $4.19 to $4.29, non-GAAP EPS in the range of $6.65 to $6.75, operating cash flow in the range of $1.6 billion to $1.7 billion, and we expect to use approximately 50% of our free cash flow to repurchase Cadence shares in 2025. For Q1, we expect revenue in the range of $1.23 billion to $1.25 billion, GAAP operating margin in the range of 27% to 28%, non-GAAP operating margin in the range of 40% to 41%, GAAP EPS in the range of $0.93 to $0.99, and non-GAAP EPS in the range of $1.46 to $1.52. And as usual, we've published a CFO Commentary document on our Investor Relations website, which includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, I am pleased that we finished the year with record backlog and cRPO. We are starting 2025 with a very strong outlook for non-GAAP incremental margin. As always, I'd like to thank our customers, partners, and our employees for their continued support. And with that, operator, we will now take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And your first question comes from the line of Jason Celino with KeyBanc Capital Markets. Your line is open."
},
{
"speaker": "Jason Celino",
"content": "Hi, thanks for taking my question. You know when we look at the backlog number, you know the $1,200 or the $1.2 billion of sequential improvement, that's like the biggest we've ever seen, much higher than kind of what I think some of us were expecting. But then when we look at the guide for the full-year, the 11.5% starting point is a little lower than where you've started other years in the past. So maybe, John, can you help us just reconcile the confidence in the backlog and kind of how you're approaching guidance for 2025? Thank you."
},
{
"speaker": "John Wall",
"content": "Yes, sure, Jason. Thanks for the opportunity to clarify. Yes, we're very pleased with the strength and momentum that we carried into year-end and into this year, but we did allude to it on the call last time that we thought the pipeline looked extremely strong and we just wanted the team to focus on converting that. We saw broad-based strength across all of the businesses on backlog, on bookings for Q4, but it was a strong renewal quarter, Q4. But in contrast, I mean the - when I look at this year, second-half is probably stronger for renewals than the first-half. So we'll probably burn some of that backlog in the first-half of the year, but it will come back in Q3 and Q4. And the duration - our backlog duration is normally somewhere in the region of 2.4 to 2.6 years every year and we ended-up at the high-end of the - of that range for this year. When I look at the year in total for 2024, we were super pleased with the strength ex-China. The growth outside of China was high-teens. China, of course declined just over $100 million in dollar terms from 2023 to 2024. And we did back test that, I think I mentioned that on the last call as well. We went back to 1999 and looked at the last 25 years of performance in China in dollar terms. And there were only three years where we had down years and 2024 was the third time we experienced a down year in dollar terms in China. We've never had two consecutive down years in China and we thought it would be prudent to assume in the guide for 2025 that China was flat because it's notoriously hard to predict and I want to manage an expense plan based on a prudent guide."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Joe Quatrochi with Wells Fargo. Your line is open."
},
{
"speaker": "Joe Quatrochi",
"content": "Yes, thanks for taking the question. I wanted to follow-up on that note on the China piece. One, was there any change into the RPO balance from the export restrictions? And then two, I guess on that flat kind of expectation for 2025, should we assume that the hardware cycle specifically in China is maybe more of a 2026 driver then?"
},
{
"speaker": "John Wall",
"content": "Oh, yes, good question. I mean, basically, I was just trying to be prudent with the guide and make sure that we are managing expenses very effectively for 2025. But I mean, when I look at the booking activity for Q4, it was quite strong. I think we're seeing strong design activity in China. Anirudh, do you want to comment on any of that?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes. Actually it's good to see design activity across-the-board, and in all verticals. Now talking specifically about China, actually I was there in November and it's good to see design activity picking-up, right? I think even our China results in '24 improved through the year from Q1 to Q2 to Q3 and Q4. And China, especially, as you know, there's a lot of design activity in - for example, in automotive, where at least five or six like major auto companies, driving the EV revolution and almost all of them are designing chips now and we have privilege of working with all the major auto companies there. And also with our new systems portfolio, especially including BETA, not only we are engaged with them on the chip design side, but also on the packaging board and system side. So overall, I do think that the China activity is strong, like it is strong in a lot of other regions. I think in terms of the guide, it's just best to be prudent and then see how it goes, given all these macro uncertainty, we thought it's better to be prudent on the guide. But the design activity seems to be actually picking up and we'll see, it's difficult to predict how that goes through the year, but so far so good."
},
{
"speaker": "John Wall",
"content": "And Joe, you mentioned the specific metrics in terms of cRPO. There's nothing - no real material impact on any of that from what we're seeing in China, but you're right to call out hardware though. I mean we had a strong hardware year in 2023 in China and it was kind of weaker in '24 and that's why the year is down year-over-year in China. And I just didn't want to be predicting what would happen for '25. It's just very, very difficult for us to predict what happens in China for '25."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Ruben Roy with Stifel. Your line is open."
},
{
"speaker": "Ruben Roy",
"content": "John, I hate to waste my one question on another follow-up on China. But I am getting this question from investors and just around the Entity List, wondering if there had been any changes. It seemed like there were additions to the Entity List kind of going into the end-of-the year. And is that informing sort of your prudent view on China or is it really just kind of coming off of that down year and kind of assessing renewals and kind of timing of hardware ramp or has something changed, I guess is the question around Entity List? Thank you."
},
{
"speaker": "John Wall",
"content": "Yes, thanks Ruben. No - I think I would put it down to general prudence. There's nothing really changed in China, but we did see - we had a down year - our third down year in '25 in 25 years and we just thought it would be prudent to assume flat and that would de-risk the guide for everybody."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Vivek Arya with Bank of America Securities. Your line is open."
},
{
"speaker": "Vivek Arya",
"content": "Thanks for taking my question. I'm trying to get a better handle on what's the right interpretation of the recurring revenue growth that is slowing down? I assume obviously China is one aspect of it, but if I were to just take the '24 recurring revenue right and then look at I think you're guiding 80% recurring revenue. So that does suggest a bit of a deceleration. Why is that when the market for AI and all these other products is improving so much, why is the recurring revenue sales growth decelerating so much?"
},
{
"speaker": "John Wall",
"content": "Hi, Vivek. Thanks for the question. The - yes, when we look at recurring revenue growth, of course, the assumption that we have in for China being flat is a headwind for that recurring revenue growth because like if we look at the impact of China decelerating by like $100 million from '23 to '24, the vast majority of that was in core EDA and mainly on the hardware side. But we're seeing that impact the recurring revenue numbers. The - of course, the recurring revenue is - the expected mix for this year is expected to go to 80% recurring, 20% upfront, but that's more a reflection of the strength that we're seeing in our upfront revenue businesses. They're growing faster than the average Cadence business. Anirudh, do you want to talk to any of that?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, absolutely. I mean, of course, I think we're good to see strength across the board, but especially hardware and IP has performed really well in '24 and I expect that they will do well in '25. There are multiple reasons driving that, which we can get into, but we have a phenomenal product in hardware, we're well ahead of what the customers will need for several years. And in terms of all our kind of engagements with the customers, they are very pleased with our hardware system. So we had a record '24 also. We had strong demand hardware going forward. And same thing on IP. IP I think has been a weaker area for us over the years. But I think it did turn-around. Of course, one year doesn't make a trend, but it did turn-around significantly in '24. So I think it is up, IP is up roughly 30% in '24 and is driven by multiple reasons. So one reason our portfolio is just better technically. The PPA, especially at advanced nodes, we are delivering better power performance area for our IP products. Also, customers are - we are engaged now with almost all the major customers in IP. We always engage with them on EDA and hardware. At this point, customers want more-and-more of our IP. And the third reason is, as you know, there is a lot more foundry activity, not just the leading foundry from Taiwan, but also in other parts of the world, whether it's Intel or Samsung or Rapidus and GlobalFoundries. So that also requires more and more IP and EDA. So as a result, we are - I am more confident in the IP business going forward. I think it should have another good year in '25 from what I can see right now. And also we are investing more in the IP business in terms of expanding the portfolio. So as you see, we acquired like last year, we acquired, you know, or about a year-ago, IP products from Rambus and then recently, we acquired Security IP, which is another critical piece of the IP portfolio. So overall, I think Cadence has been always very strong in EDA, always very strong in 3D-IC, always being very strong in hardware and IP has been one area that we wanted to do more and especially '24 is the turning point for IP and together positions us well into the future."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Lee Simpson with Morgan Stanley. Your line is open."
},
{
"speaker": "Lee Simpson",
"content": "Great. Thanks for squeezing me in here. I really just wanted to ask around the chiplets reference designs that you've clearly done very well with in China with the EV makers. Is this the sole source of strength for the chiplet reference design? And maybe if we ex that business out of China for this year, what does that do for the size of decline that we might see in China inferred in that flat number? Thanks."
},
{
"speaker": "John Wall",
"content": "Hi Lee, that's a good question. I mean, first thing I would like to say that chiplet design is happening across the globe and also in all verticals. It is not specific to a particular region or vertical. Of course, it started with, as you know, with high performance computing with all these big AI chips and server products, but now you know, automotive and even laptops, they're all getting disaggregated. So we are always being focused on 3D-IC and chiplet-based design from, I don't know, maybe 15 years ago, maybe it was too early. I think our first reference flow with TSMC on 3D-IC was like 2007 or 2008, okay. But of course, it has picked up steam in the last few years and we are particularly well-positioned given we have EDA products, packaging products, system products. And also IP needs to go that way. So we have, what I would call IP 2.0 is more focused not just on individual IP, but silicon solutions and chiplet architecture. So that's why you're seeing investment for us on chiplets, not just on the EDA side, but also on the IP side. But I think it's going to happen, I believe in across all geographies, across all verticals and it's only going to accelerate going forward."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Charles Shi with Needham & Company. Your line is open."
},
{
"speaker": "Charles Shi",
"content": "Hi, good afternoon, Anirudh and John. I think I do want to ask a little bit about the core EDA. It looks like the based on the segment information, the core EDA growth in '24 was somewhere in the high single-digit range. It seems like it had been growing at a more like a double-digit. But at the same time, as system design and analysis continue to grow at a very strong double-digit growth. I wonder if you can give us a little bit of your long-term view, is this going to be the new normal going forward like in a more traditional EDA actually going to more like a high single-digit grower, but SD&A is more like a - where that can contribute to Cadence outperformance going forward. I want to get some long-term thoughts there. Thanks."
},
{
"speaker": "John Wall",
"content": "Hi, Charles. Yes, generally in core EDA, I mean, we're always targeting double-digit revenue growth and profitable and sustainable revenue growth is really important to us. We'd be very, very pleased with the progress we're making with the hardware business over the last number of years but of course, the down year China from '23 to '24 impacts that core EDA growth year-over-year from '23 to '24. And then our assumption for '25 obviously impacts that as well. But we're delighted with the value we're providing to customers and with the - just the sheer demand for our products right across the core EDA space. Anirudh, do you want to add anything?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, in terms of product portfolio, I think we are better positioned than we ever have been. If you look at analog, digital verification in terms of core EDA and design activity is strong. Of course, in '24, there are two issues like John mentioned, one is the China and then also hardware had a transition year. So even though Q4 was phenomenally strong in hardware, we went through the transition in Q2 and Q3. So that's of course, part of core EDA. So we'll see how it proceeds going forward, but we are well positioned. We are doing very well with customers in all these evaluations and new design starts. So we'll see how things progress going-forward."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Gianmarco Conti with Deutsche Bank. Your line is open."
},
{
"speaker": "Gianmarco Conti",
"content": "Yes. Hi, thank you for taking my question. So firstly, congrats on another fantastic quarter. And perhaps just a follow-up question on hardware. And given again the impressive backlog number and the increase in upfront revenue we saw this quarter, is it fair to assume that Z3 and X3 is being adopted at a faster pace and that the mix of volume and pricing, is what's driving the strong Q1 guide? And going forward, is it fair to assume an acceleration, also not from revenue, given the closing of the air pocket? I think a fair few investors are looking at the strong hardware ramp. I'm wondering if there is much of it inside that $6.8 billion backlog number. Any color around that would be great. Thank you."
},
{
"speaker": "John Wall",
"content": "Yes Gianmarco, it's is a tremendously strong bookings quarter for hardware in Q4. We're seeing huge demand across all of our functional verification platform. But - so we were delighted with the progress that we've made there. We have strong backlog leading into the first quarter. So yes, I mean, you're seeing a more normal kind of shape to revenue this year for Cadence. We expect about 24% of the revenue in - to come in Q1. Similarly, about 24% in Q2. Second half of the year is going to be harder - or we expect Q4 to be higher than Q3, but we'll be able to tell you more about that in the second half when we see the pipeline for hardware in the middle of the year. Anirudh, anything?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, hardware demand is phenomenal. And of course, Q4 strength is not based on just hardware, even though it was phenomenal. Like I mentioned, IP is doing fabulous and, overall 3D-IC, overall, our complete EDA portfolio systems growth as you saw in Q4. But specifically on hardware, I mean, as you know, we have now both new systems, Z3 and X3 and they are in full production, we gained several competitive wins in Q3 and Q4. And it is the strength of our portfolio, which is a custom chip that we make, which is in Palladium Z3 and FPGA system for Protium. And almost all like large designs, especially all large AI designs are using Palladium as the platform of choice. And I do expect that this strength will increase over time. So because we are the only company that designs its own chip to do emulation. So if you look at some of the biggest chips in the world are designed through Palladium. And we have more than 100 chips in one rack, which are liquid cooled, connected optically and then you can connect 16 of these racks together. So it's like more than 2,000 full reticle TSMC chips are used to emulate the world's most complicated designs. And there is no other system that even comes close. So the nearest competitor to Palladium Z3 is actually Palladium Z2. And then I think going forward, this is the nature of the architecture also the inherent advantages it has over FPGAs. And we like FPGAs, it's useful for some software workloads in Protium, but the gap between custom ASIC and FPGA is only going to increase in the future because even Z3 is a more advanced node than FPGA. And you can see that in other workloads, too, not just in emulation, all the AI workloads, all acceleration. Custom ASIC is very superior to FPGA. And going forward, that will continue. And in terms of - we have at least a 10-year lead in designing these custom ASICs for emulation. So hardware was phenomenal, and we expect that to continue. Now of course, the actual second half, we'll have more update. We have good backlog for the first half. And depending on what happens in the first half, we can update the rest of the year in the middle of the year."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Your line is open."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Thank you. Good evening. Anirudh, John, your backlog came in at about $0.5 billion above where we were for the quarter. So I assume that NVIDIA alone could certainly have accounted for a large portion of that. But your current RPO year-over-year growth progressively slowed over the course of the year from 14% year-over-year in Q1, 11% and 7%, now 6% year-over-year as of Q4. Maybe you could dissect that in terms of the composition of software versus hardware and IP. And then maybe on the geo side, what the current RPO growth might look like if you were to exclude China."
},
{
"speaker": "John Wall",
"content": "Yes, Jay, thanks for the question. I think what you're focused on there is the annual value of the backlog. And yes, I mean we're very focused that we need to grow that annual value. And I think that would be an important focus point for us for 2025. We're very pleased with the amount of bookings that we recorded with customers in Q4, very, very strong pipeline got converted. But we know we can do better on the annual value and we're going to work on that for 2025. Ex China, of course, China is a headwind to that number. We would expect the cRPO to improve naturally in 2025. But I would expect the backlog number to decline a little bit in the first half. We'll burn some of it in the first half just because of the timing of when renewals come up in the year. Q4 2024 was a strong renewals quarter. Q3 and Q4 are the kind of the strongest renewal quarter for 2025."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Gary Mobley with Loop Capital. Your line is open."
},
{
"speaker": "Gary Mobley",
"content": "Hi, guys. Thanks for taking my question. John, you seem to imply that revenue will be split 48%, 52% first half versus second half of the year, but your OpEx guide or your operating margin guide seems to imply the opposite directional change for non-GAAP OpEx. Normally, you would see a second half increase versus first half. What's the dynamic there in the OpEx for the second half versus the first half?"
},
{
"speaker": "John Wall",
"content": "Hi Gary, thanks for spotting that and give me the opportunity to explain. We changed to a - we normally have a mid-year merit cycle where we increase salaries in July. We've moved that to January and started in 2025. So the profile for the year, typically in the past, you would have seen also improving margin Q1 to Q2 and then typically taking a drop off from Q2 to Q3. This year, we would expect the profitability profile to improve right throughout the year with Q2 margins exceeding Q1, Q3 exceeding Q2 and Q4 exceeding Q3. We thought that was - it was better to move to an annual cycle from the start of the year, so as not to cause that kind of disruption in the quarter-over-quarter numbers from Q2 to Q3 going forward."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Harlan Sur with JPMorgan. Your line is open."
},
{
"speaker": "Harlan Sur",
"content": "Good afternoon. Thanks for taking my question. On the full year guidance, if you drive within the upper range of the guidance for this year, your three year revenue CAGR is going to drop below 15%, to be more specific, more like 13.5% for the first time in a number of years. And if I look at the environment, right, you've got AI leading-edge design starts and activity are at an all-time high. You're going through a strong upgrade cycle on your hardware business. I know you're taking a more conservative view on China, which I think is prudent, but outside of China, we know auto and industrial semiconductor trends are still fairly muted. We also know a couple of your large leading-edge IDM customers continue to face competitive difficulties. So outside of China, can you guys just help us understand like where else are you taking a more cautious view on the 2025 outlook?"
},
{
"speaker": "John Wall",
"content": "Yes. I think, Harlan, what you're referring to is that, I mean, when you look ex China, I mean, if we exclude China, that last year, we were high teen year-over-year growth. And what's implied in the guide is low teen year-over-year growth. I mean normally, we start the year prudently anyway. And I think what you're highlighting is we believe we provide tremendous value to our customers, but - and it's important for our customers to extract that value from what we're providing today. We focus on proliferation and adoption of our technology. And we're confident we'll extract that value from customers over time. But essentially, so that's all in the guidance. China is the kind of headwind, I guess, is the assumption that that's flat. But we're pleased with low teens across the rest of the business."
},
{
"speaker": "Anirudh Devgan",
"content": "Also just to point out - yes, one thing to point out is, of course, we are always looking at both revenue growth and profitability. So and I think we expect not only, what I would consider good revenue growth in '25, but also good improvement in profitability. So if you add them together like Rule of 40, I think this is the first time we are guiding more than 55% in the beginning of the year. It's very important to focus on both those things like we have done for years now."
},
{
"speaker": "Operator",
"content": "And your next question comes from the line of Siti Panigrahi with Mizuho. Your line is open."
},
{
"speaker": "Siti Panigrahi",
"content": "Thanks for taking my question. Can you hear me?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes."
},
{
"speaker": "Siti Panigrahi",
"content": "Okay. Great. So Anirudh, you talked about some of your AI products, Cerebrus, SimAI and Allegro all that getting traction. Help us understand how is that driving your ACV uplift right now? Are you seeing more impacts on which segment, like digital design, verification, any of that. And in the same context, also, could you talk about - I know you talk about a design going into more edge devices as another area of growth, when do you think that's going to - are you going to see that inflection point?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, those are two good questions. So in terms of AI product itself, like we have mentioned in the past, we have these five major platforms, which now at this point, we are engaged with all our major customers on. Of course, the - a few years ago, we started with digital implementation, which is Cadence Cerebrus. I think at this point, we are - Cadence Cerebrus is adopted with all our major customers. And then verification with Verisium and then Allegro X, Optimality, Virtuoso Studio. And these are all platforms which are - something you have to add to your base config, right? So we are seeing customers adopt more and more of these solutions. Now in terms of your question on edge, I always believe, I said so many times in the past that AI will have multiple phases to it. Of course, the first phase was more infrastructure, more on the data center side. But I believe one of the biggest phases will be what we have called for a long time is physical AI, which will be more in the physical world, more edge devices, more cars and robots and drones and then also sciences AI, with things like life sciences and material sciences. So it will go through the - at least the three big horizons. So the good thing with the physical AI, which is more on the edge or more - if they are more power constrained applications. We're already seeing a lot of design activity starting on that. Now some of the products may come out a few years later. But just like on the data center side, we saw products in '22 or '23, but the design activity was there a few years before that. And especially in physical AI, they are, by nature, edge and also more mixed signal in which Cadence is very well positioned. So that's why I'm saying, even though there is weakness right now in the autos in terms of semi revenue, but in terms of investment in R&D, there's a lot of investment in R&D with EVs and self-driving same thing with drones and robot, which is independent of humanoid robots, industrial application and aero and defense applications will be huge for those things. So I think that will drive a different kind of AI and require even more domain-specific silicon for AI on those devices."
},
{
"speaker": "Operator",
"content": "And your final question comes from the line of Joshua Tilton with Wolfe Research. Your line is open."
},
{
"speaker": "Joshua Tilton",
"content": "Hi guys, thanks for sneaking me in at the end here. I'm just going to keep it to two quick clarifications. My first one is on China. I know there's been a lot of questions, but I guess, John, I'm just trying to understand, has anything changed since last quarter that's either increasing or decreasing your conviction that China won't have two down years in a row? And then on the hardware side, if I remember correctly, historically, you talked to how you tend to only guide for like six months of visibility, specifically for hardware. Are you taking a similar approach this year as you set the guidance for 2025?"
},
{
"speaker": "John Wall",
"content": "Thanks, Josh. Yes, so taking the second question first, yes, exactly the same approach that hardware is a pipeline business. We typically have a good visibility into the pipeline about two quarters out. We finished with a very, very strong kind of hardware bookings quarter in Q4 and have plenty of backlog to deliver against in the first half of the year. That demand, the pipeline still looks strong, but visibility into the pipeline this time of the year is more difficult. We'll have more visibility into hardware in the second half by the time we get to the summer. So that's exactly the same approach that you've seen us do in previous years. And then your question on China, can you repeat it again?"
},
{
"speaker": "Joshua Tilton",
"content": "Has anything changed since last quarter that's either increasing or decreasing your conviction that China won't have two down years in a row?"
},
{
"speaker": "John Wall",
"content": "I'll just - I'm just worried about my ability to predict what China revenue would be. I mean I was very pleased that like all through last year, Q1 was the low quarter. Q2 was higher than Q1. Q3 was higher in Q2, Q4 ended up higher than Q3 for China revenue. But just - it's tough to have visibility into the pipeline for Q1 because quarters are only getting assigned now and the salespeople tend to keep their cards very close to their chest this time of the year. So I thought in the absence of any other information, that the prudent thing would be to derisk the guide and assume flat for China. And then as - if our experience is better than that, we'll take the guide up through the year."
},
{
"speaker": "Operator",
"content": "And I will now turn the call back to Anirudh Devgan for closing remarks."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you all for joining us this afternoon. It is an exciting time for Cadence as we enter 2025 with product leadership and strong business momentum. Our continued execution of the Intelligent System Design strategy, customer first mindset, and our high-performance culture are driving growth and profitability. Fortune and Great Place to Work named Cadence as one of the World's Best Workplaces in 2024, ranking it Number 9. And on behalf of our employees and our Board of Directors, we thank our customers, partners, and investors for their continued trust and confidence in Cadence."
},
{
"speaker": "Operator",
"content": "And ladies and gentlemen, thank you for participating in today's Cadence fourth quarter and fiscal year 2024 earnings conference call. This concludes today's call, and you may now disconnect."
}
] |
cdns | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good afternoon. My name is Brianna and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Third Quarter 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. [Operator Instructions] I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead, sir."
},
{
"speaker": "Richard Gu",
"content": "Thank you, operator. I would like to welcome everyone to our third quarter of 2024 earnings conference call. I'm joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call and a copy of today's prepared remarks will be available on our website, cadence.com. Today's discussion will contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q, CFO commentary, and today's earnings release. All forward-looking statements during this call are based on estimates and information available to us as of today and we disclaim any obligation to update them. In addition, core financial measures discussed on this call are non-GAAP unless otherwise specified. The non-GAAP measures should not be considered in isolation from or as a substitute for GAAP results. Reconciliations of GAAP to non-GAAP measures are included in today's earnings release. For the Q&A session today, we would ask that you observe a limit of one question and one follow-up. Now, I'll turn the call over to Anirudh."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. Cadence delivered exceptional results for the third quarter of 2024 with broad-based strength across our product portfolio. We are on track for a strong second half and we are pleased to raise our full year EPS outlook. John will provide more details on our financials in a moment. Generational trends such as hyperscale computing, autonomous driving, and 5G, all accelerated by the AI super cycle, continue to fuel strong design activity across multiple verticals, especially in data center and automotive. Our cutting edge chip-to-system platforms empower customers to drive unprecedented innovation as they race to develop next-gen AI and agentic AI products while navigating escalating design complexities. We continue steadily executing to our intelligent system design strategy that triples our TAM opportunity while significantly expanding our portfolio across core EDA, IP, and system design and analysis. I'm excited about AI's incredible promise and how rapidly it is becoming an integral part of the design workflow, with customers steadily increasing their investments in AI-driven automation. Our Cadence.AI portfolio, powered by GenAI agents, AI-driven optimization, and big data analytics JedAI platform saw sales nearly triple over the last year, as it continued delivering unparalleled quality of results and productivity benefits. We continue partnering with NVIDIA to accelerate AI innovation and are using their latest NeMo and NIM microservices to build customized GenAI application, delivering enhanced optimization and productivity. In Q3, we deepened our partnership with Arm through a broad expansion of our IP, hardware, and AI-driven design enablement solutions to help deliver Arm’s next-generation AI technologies and advanced Arm compute subsystems across multiple markets. We expanded our long standing partnership with TSMC, with AI optimized design flows certified for TSMC's N3 and N2P technologies. We are also collaborating on innovative solutions for next-generation technologies, like TSMC A16 and 3Dblox, that are paving the way for the AI factories of tomorrow. Demand for our industry-leading Integrity 3D-IC solution that enables system level PPA optimization continues to grow with accelerating adoption by hyperscalers, OSAT, and foundries. We introduced the industry's first auto router for both die-to-die and die-to-substrate connectivity. And that was showcased at TSMC's 3DFabric Alliance Workshop. High-speed multi-layer PCB designs require increasing levels of miniaturization, advanced simulation, and AI-driven automation. Allegro X, with its tight integration with our analysis technology, an expanded collaboration platform, is ramping strongly and drove over 40% of our PCB sales this year. The transition to OrCAD X, our new mainstream PCB solution accelerated in Q3, with a third of our OrCAD customers converting to this new cloud enabled solution. Cadence OnCloud is a key go-to-market platform to reach the long tail of smaller system customers and is seeing strong traction with over 400 customers, tens of thousands of online users, and orders doubling over the past year. We recently launched the Cadence OnCloud Marketplace and announced Cadence online support through OnCloud, which uses GenAI technology to provide insightful, contextual, and accurate answers to customer queries. As the digital transformation in aerospace and defense accelerates, we saw continued strength in this vertical as the US Air Force and Army expanded their commitment to Cadence’s solutions spanning from chips to boards to systems. Our hardware-accurate digital twins have been successfully used by Northrop Grumman in taping out several ASICs, helping accelerate schedule by over two years. In Q3, we substantially grew our footprint at several marquee hyperscalers through a broad proliferation of our best-in-class hardware systems, IP, and software portfolio. Our system design and analysis business continued to outpace the market, delivering impressive results with over 40% year-over-year revenue growth in Q3. We are pleased with the strong growth of our multiphysics portfolio that couples our expertise in physics-based modeling with AI-driven optimization to deliver superior results to customers. Clarity and Celsius both grew strongly with competitive wins while our newly acquired BETA CAE products that round out our system analysis portfolio outperformed our expectations as we signed large deals with major EV companies. Our AI-driven optimality solution was adopted by several leading customers and Volta's Inside AI, used by top hyperscaler to successfully achieve an 80% AI drop reduction in their designs. Our IP business continued its strong momentum in Q3, delivering over 50% year-over-year revenue growth, as we executed to our profitable and scalable growth strategy. Increasing complexity of interconnect protocols, along with the growing outsourcing trend, and new foundry opportunities are providing strong tailwinds to our IP business. AI, HPC and chiplet use cases were the primary drivers for the adoption of our differentiated HBM, PCIe, UCIe, DDR and high-speed SerDes solutions in design ranging from 7 nanometer down to the most advanced gate-all-around nodes. Our AI-assisted Tensilica audio DSP scored multiple design wins with marquee global customers across HPC, mobile and automotive use cases. Our core EDA business comprised of our custom, digital and functional verification businesses delivered 9% year-over-year revenue growth in Q3. Our new groundbreaking hardware systems offering industries leading performance, capacity, and scalability experienced strong demand, especially at AI, hyperscale and automotive companies. Verisium, our AI-driven verification platform, continued seeing rapid customer adoption, with several leading customers successfully using Verisium Sim AI for highly efficient coverage maximization. Proliferation of our digital full flow at the most advanced nodes accelerated with over 30 new full flow logos added over the past year. With nearly 450 tapeouts, customers are increasingly deploying Cadence Cerebrus AI solution as it continues to deliver unparalleled PPA and productivity benefits on a broad spectrum of designs. Our AI driven Virtuoso Studio leverages the capabilities of our flagship Virtuoso platform while seamlessly integrating with other cadence cutting-edge technologies to drive significant productivity benefits for analog, RF, and mixed signal designers. With this GenAI-driven automated design migration and new layout placement and routing technologies, customers are rapidly adopting Virtuoso Studio and it won 30 new logos in Q3. In summary, I'm pleased with our Q3 results and the continuing momentum of our business. The AI driven automation era offers massive opportunities, and the co-optimization of our comprehensive EDA, SDA, and IP portfolio with accelerated compute and AI orchestration uniquely positions us to provide disruptive solutions to multiple verticals. Now, I will turn it over to John to provide more details on the Q3 results and our updated 2024 outlook."
},
{
"speaker": "John Wall",
"content": "Thanks, Anirudh, and good afternoon everyone. I'm pleased to report that Cadence delivered strong Q3 results with total revenue of over $1.2 billion. We achieved 19% year-over-year growth. Our Q3 recurring revenue growth returned to low teens on a year-over-year basis. Our intelligent system design strategy is paying off with our system design and analysis business delivering strong growth and we continue to see robust demand for our emulation and prototyping systems. Here are some of the financial highlights from the third quarter, starting with the P&L. Total revenue was $1.215 billion. GAAP operating margin was 28.8% and non-GAAP operating margin was 44.8%. And GAAP EPS was $0.87 with non-GAAP EPS of $1.64. Next, turning to the balance sheet and cash flow, we had a $2.5 billion senior notes offering in Q3 that was well received by the market. We have used the majority of the net proceeds to retire maturing notes and prepaid term loans as well as for other general corporate purposes. Cash balance at quarter end was $2.786 billion. While the principal value of debt outstanding was $2.850 billion. Operating cash flow was $410 million. DSOs were 44 days and we used $150 million to repurchase Cadence shares. Before I provide our updated outlook, I'd like to highlight that it contains the usual assumption that export control regulations that exist today remain substantially similar for the remainder of the year. Our updated outlook for 2024 is revenue in the range of $4.61 billion to $4.65 billion. GAAP operating margin in the range of 29% to 30%. Non-GAAP operating margin in the range of 42% to 43%. GAAP EPS in the range of $3.70 to $3.76. Non-GAAP EPS in the range of $5.87 to $5.93. Operating cash flow in the range of $1.0 billion to $1.2 billion. And we expect to use approximately 50% of our annual free cashflow to repurchase cadence shares. With that in mind, for Q4, we expect revenue in the range of $1.325 billion to $1.365 billion. GAAP operating margin in the range of 33.2% to 34.2%. Non-GAAP operating margin in the range of 45.2% to 46.2%. GAAP EPS in the range of $1.09 to $1.15, and non-GAAP EPS in the range of $1.78 to $1.84. And as usual, we published a CFO commentary document on our investor relations website, which includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, I'm pleased with our Q3 results. Our Q4 bookings pipeline looks exceptionally strong, and we are well positioned to deliver a strong 2024. As always, I'd like to close by thanking our customers, partners and our employees for their continued support. And with that, operator, we will now take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from Joe Vruwink with Baird."
},
{
"speaker": "Joe Vruwink",
"content": "Hi. Great. Hi, everyone. I appreciate the nature of your relationships with customers. Means, you typically know well in advance what product roadmaps might be. You're typically not learning new information off of public calls, but just given the number of headlines [that weighs] (ph) around advanced foundry efforts or maybe demand from China, I wanted to ask, have you learned anything over the past three months or so that you would point out as maybe being something worth considering, either good or bad as investors think about the 2025 opportunity for cadence?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Joe, this is Anirudh. That's a good question. Well, I would say that, I mean, as you know already that the importance of semiconductor to the overall global economy is increasing and is more well recognized now. And I did visit several countries over the last quarter and there is more and more kind of commitment to build that out. And you're seeing that in different countries and also like we highlighted even earlier in the year, the -- of course, TSMC is leading foundry, but our own relationship with Samsung and Intel in this area has improved and global also we have worked for several years. So I would like to say that in general we do see this continued investment in newer foundries, whether it's Intel, Samsung, and even like Rapidus in Japan and other countries. So when we continue to partner closely with the leading players like TSMC and Arm as we highlighted in this report, but it's good to see more investments being made in other areas."
},
{
"speaker": "Joe Vruwink",
"content": "Okay, thanks for that. And then, John, you don't normally give backlog guidance, but you did comment on bookings pipeline and 4Q, and that stands out. Are you maybe able to go into a bit more color on what you might expect or what you would be looking for as kind of the forerunner to your 2025 performance?"
},
{
"speaker": "John Wall",
"content": "Yeah, I mean thanks for picking up on that, Joe. I mean obviously we're not giving any outlook on 2025 yet. But it's a very, very strong pipeline right now for Q4. I think it's the biggest I've ever seen for Q4 pipeline. It reminds me a little bit. It's kind of similar to how we finished 2021. If you recall, in 2021, we had a really strong pickup in bookings in Q4 and ‘21. About 40% of our annual bookings came in Q4 of ‘21 and this year the second half seems to be setting up the same way but it's with exceptionally strong pipeline and we're seeing strong design activity everywhere."
},
{
"speaker": "Joe Vruwink",
"content": "Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Your next question comes from Jason Celino with KeyBanc Capital Markets."
},
{
"speaker": "Jason Celino",
"content": "Hey, thanks for taking my questions. Maybe just following up on Joe's backlog question. So understand that the pipeline looks quite large. Is it fair to say that the composition of that pipeline is mostly being hardware driven? I guess curious what you're seeing from a new order pipeline perspective on kind of the Z3/X3."
},
{
"speaker": "John Wall",
"content": "Hi Jason, thanks for the opportunity to clarify that -- I mean it's broad-based right across the board across all of our businesses and all the businesses are performing really really well. I mean when I look at our forecast for the remainder of the year, on a three-year CAGR basis, all business groups are on track for strong growth from low double-digit growth on the core EDA software side right through to mid-teen growth right up to almost 30% growth for like IP functional verification which hardware is part of and system design analysis."
},
{
"speaker": "Jason Celino",
"content": "Okay, perfect. And then just one really quick one on China. I think last quarter I think you were trying to de-risk some of your assumptions. Obviously, this quarter, there were some incremental worries that the region might be taking another leg down. But obviously, cadence and EDA can see very different purchasing habits and demand drivers from semi-cap and some of the smaller point solution providers. But do you still expect to see 13% of your revenues come from China this year? I guess what else can you tell us about the overall demand environment there?"
},
{
"speaker": "John Wall",
"content": "Yeah, great question again, Jason. I mean, you're reading my mind. I mean, myself and my team were looking through China. We went back, we're data driven. We went back 25 years to have a look at our China revenue. I mean, we're expecting China revenue to be lower this year than last year. That's only happened 3 times in the last 25 years. First time was 2008. Obviously, there were macro things going on back in 2008. And it took until 2011 for us to reach a new high in China revenue, but it recovered immediately in 2009. It dipped in 2021, recovered immediately to a new high in 2022, and it looks like it's dipping in 2024. But I'm very, very pleased that Q2 was stronger than Q1 on a dollar basis. Q3 was stronger than Q2, and China seems to be recovering well with strong design activity."
},
{
"speaker": "Jason Celino",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Gianmarco Conti with Deutsche Bank."
},
{
"speaker": "Gianmarco Conti",
"content": "Yeah, hi, thank you very much for my taking the questions and congrats again for a great quarter. Maybe perhaps if you could touch a little bit on the cadence.ed.ai suite. If you're seeing incremental appetite there, and is it going to be material for 2025 growth? If you could give us any data points or qualitative anecdotes, that would be amazing, thank you."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, absolutely. I mean, we are pretty pleased with how our Cadence.AI portfolio is doing. And like mentioned earlier, I mean, right now, I think it is used by all our top customers. So, now some of them are, the amount of proliferation is different at each customer, but right now we are engaged in all of our top customers with our AI solutions. And as you may know, we have five major AI platforms, analog, digital, verification, PCB and package and system analysis. So it's a pretty rich portfolio. And the customers are routinely seeing anywhere from 5% to 20% improvement in PPA, which is significant. I think the value of AI is not just productivity, which is huge. I mean, we have a history of productivity improvement in EDA, but the value of AI is when it can give a better result. So that's where I think the real value and monetization can happen if the result is better. And we also design our own chips as well. As you know, Palladium, we design our own chip, one of the most complicated chips that is made by TSMC. And we design our own IP, right, in our IP group. So we are also applying our own solutions internally as well. So these are like true comparisons of AI versus non-AI solutions. So even in the latest Palladium Z3 chip, we saw like 15% improvement in power using Cadence Cerebrus. And in the latest AI IP we designed, we saw anywhere from 13% to 20% improvement in our IP group using our own Cadence.AI solutions, which is very consistent with what we see with top customers. So overall we are pleased with the benefit we are getting, especially with the improvement in PPA. And productivity improvements can be anywhere between 5x to 10x, but the PPA benefits are truly remarkable and almost equivalent to one kind of node, one process node migration typically get 15% to 20% PPA improvement and we can get that with AI. And then the last thing I would like to highlight with AI is our cadence on cloud offering. So we do have a cadence customer support portal and we're applying GenAI in there to give better and response to our customers. And this is another big trend of applying AI to give better customer support. So overall, applying Cadence.AI, of course, working with all our top customers across all five major platforms, applying AI internally to improve our own designs, whether it's in hardware group or IP, and then applying AI for customer support can make us much more efficient."
},
{
"speaker": "Gianmarco Conti",
"content": "Amazing. I think I'll just ask a quick follow up. Is it safe to say that in Q4 we should see the air pocket of hardware kind of closing out? And if you could share sort of any commentary around 2025 visibility, particularly from your overordering of the FPGAs and the raw materials, I'm just kind of curious how does that translate into backlog? I know you don't specifically guide on backlog, but obviously, backlog was a little bit down sequentially. And so any commentary there, that will be amazing. Thank you."
},
{
"speaker": "John Wall",
"content": "Yes, Gianmarco, I certainly wouldn't categorize our ordering of FPGAs as over-ordering. We are ordering to fit the demand that we see. We're seeing very robust demand. The pipeline is super strong. But like I said, I haven't seen it as strong as this in any previous Q4 that I've been here. So we're set up for a tremendous Q4. At this time of the year, it's always difficult to give any indication as to what next year looks like and particularly in years like this, when you expect such a strong bookings quarter in Q4, we kind of have to get that landed and look at the quality of that before we give any indication as to what next year looks like. But I'm very, very pleased with the hardware demand, with the performance of the business and they're ramping up production all the time to meet the demand."
},
{
"speaker": "Gianmarco Conti",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Lee Simpson with Morgan Stanley."
},
{
"speaker": "Lee Simpson",
"content": "Great. Good evening, everyone. So a couple of quick ones from me actually. Just looking at the Millennium platform, following on from the last question there, could you maybe characterize what is the interest beyond NVIDIA. When, who and how big do we think the demand will be for that platform? And maybe as a follow-on question, I'm just interested on the timing of the impact from new collaboration with Arm on CSS. Does that have any specific vertical to it? Is that autos? Or is it maybe the aerospace stuff that you were talking about there? Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Good question, Lee. So first, in terms of Arm, I mean, we have a pretty broad partnership with Arm over the years. I mean, going back like 10 years, and especially in their IP development CPUs and GPUs. And this latest collaboration, which we highlighted, is also expanding to compute subsystems and total design, which is Arm doing more as you know, more chiplets and more droplets. And this is broad-based, but I think they are -- this is more a question for Arm, but they are seeing a lot of strength in multiple markets, including HPC and automotive. But this is expansion of as Arm kind of morph is their strategy, our relationship with Arm gets even stronger, not just in IP development but also for total compute. And in terms of your other questions on Millennium, in general, I am optimistic, like I've mentioned before that with these new systems we can accelerate a lot of our software on combination of CPUs and GPUs, okay? And Millennium is a perfect example. And the reason for that is -- I mean, of course, we can accelerate EDA. We got like fabulous results in Spectre. We are the leading provider of circuit simulation, which Spectre is the leading platform. And with these latest systems, we are able to accelerate circuit simulation by 5x to 10x by these CPU, GPU acceleration platforms, but also on system design and analysis, which is Millennium is a perfect example for that. And the reason for that is that system design and analysis by nature, the algorithms involved does a lot of matrix multiply. Like CFD is essentially a matrix multiply operation. And the other thing that is largely a matrix multiply is, of course, AI. So -- and these systems are well tuned for AI or matrix multiply operation. So they are very naturally tuned for SD&A kind of application. So I'm pretty optimistic that because we're getting tremendous results and we are seeing that CFD especially with the aerospace and automotive companies, okay? Because this is -- typically, they have been limited by how much simulation they can provide and I think we highlighted like for example, Honda is a great kind of early development partner for Millennium. And in general, as these platforms get more sophisticated, the CPU, GPU platforms, I think we can apply this acceleration to a broader portfolio, and you'll see that going forward."
},
{
"speaker": "Lee Simpson",
"content": "That’s great. Thanks so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Charles Shi with Needham."
},
{
"speaker": "Charles Shi",
"content": "Good afternoon, Anirudh and John. I want to ask another question about the Intel and Samsung. But from another perspective, I mean, despite all the headlines, which were not so positive, we know that those two customers will wear your market share historically has been a little bit underrepresented, but largely because they are still using the internal EDA tools. So I mean, given all the challenges, those two customers seems to be facing, although it doesn't sound like you're seeing any immediate changes. Is it possible that it can be a net positive for you guys? And if there is more dependence of those two customers on the commercial EDA tools, meaning more of the EDA development work being outsourced to the merchant EDA companies like Cadence, I want to get some thoughts on them and what could be, let's say, an inflection point for that to happen if it happens? Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Charles, that's a great observation. I mean, as you know, we are very strong in the -- historically strong over the last 5, 10 years in the TSMC ecosystem with partnership with TSMC and ARM and historically not as strong with Samsung and Intel. Though, I think that is beginning to change, especially last year and this year. And to me, there's always -- every company goes through ups and downs, as you know. And whenever -- I mean, both Intel and Samsung are great companies. And when they're going through more challenges, typically is more opportunities for us. We always lead with products. We believe we have the best solution. So -- and we are seeing that. We saw with Intel, we mentioned our IP partnership, also the strength of our new hardware platforms across we are working with both these companies on our new systems and then AI-enabled software. So typically, these things will take time. So -- but in general, whenever there is a competitive situation with some of these big customers, typically, we have done well historically in those situations."
},
{
"speaker": "Charles Shi",
"content": "Got it. Thanks. Maybe the other question I want to ask is, hopefully you can clarify because it has been the news that Cadence maybe acquiring Altair or maybe looking to acquire Altair Engineering Systems. So mind if you provide some comments here."
},
{
"speaker": "Anirudh Devgan",
"content": "Charles, yeah, I mean, as you know, we don't comment on specific rumors, but I mean, as we have said before, I mean, we are very pleased with our strategy. We are very pleased that most of our growth is organic and sometimes we do some small tuck-in M&A, and that strategy has not changed, okay? So that's our plan going forward, and we are pretty happy with how we are positioned. Yes."
},
{
"speaker": "Charles Shi",
"content": "Thanks so much, Anirudh."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Thank you, good evening. Anirudh, you may recall that on the conference call a quarter ago, you spoke about various AI ML use cases that you're beginning to see. And then separately, we also talked about how you might, over time, change your product packaging for different use cases or end markets. Maybe we can bring those two things together. And the question is do you see a likelihood of -- for AI ML applications, more and more vertical domain-specific packaging. I know you've got the branded apps right now. you're obviously selling into different verticals. But would you foresee taking any of those technologies and making them specifically packaged to specific end markets? And also before I get to my follow-up, could you also talk a little bit about your AI ML development roadmap. You've had customers speak at Cadence live about what they're looking for from you in that respect? And maybe you could talk about improvements you're going to be making in things like capacity, memory footprint, scenario proliferation, and so on and so forth. Then I'll ask my follow-up."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Jay, that's all great observations. I mean, we have, of course, one of the highest investments in R&D, and we are very pleased with our kind of roadmap for AI and AI products. But we will enroll that over time, right? As you know, it's kind of -- I don't want to preannounce anything here. But overall, I think we are investing heavily. And as AI itself gets more powerful, the three-layered cake that I always talk about the AI orchestration of the top, the middle layer of principal simulation and optimization and the bottom layer, like I mentioned earlier, with CPU, GPU and custom silicon. So we are investing in all these three areas. And it may make sense for some verticalization like we did for Millennium, right? That is a vertical targeted at a particular vertical with aerospace and automotive. But overall, we are pretty pleased with that. And like we -- I also believe that -- I mean, AI itself is a very big topic, but there are two parts of it. The initial phase is horizontal. And we are also -- we have a lot of horizontal technologies. But over time, I think the AI monetization will have to be more and more vertical. And I've talked about this publicly, the three phases of AI. So we are right now in what I would call infrastructure AI, starting with data centers and then going into edge devices like laptops and phones and even in data centers, we have more vertical solutions now with thermal management and things like that. But that's the horizon one, which is in infrastructure AI. Horizon two in my mind is physical AI, things like self-driving, drones, robots. And even though the auto market is weak right now, but in terms of design, it's not weak, okay? As you see a lot of the reporting on semiconductor autos is weak. But in terms of design activity, there's a lot of design activity for what is there to come. And this is what I saw a few years ago in data center as we are seeing in automotive. And a lot of the chips that are required for automotive are very similar to what are required for drones and robots, okay? So to me, that's like the second phase of AI, which is physical AI. And then the third phase of AI, which is Horizon 3, which is further out from the physical AI is what I would call sciences AI, and the biggest application will be life sciences, okay? And that's why the investment in open AI two years ago. So that's how we look at it. Infrastructure AI, followed by physical AI, followed by sciences AI, and we will have of course, horizontal solutions because our business is fundamentally horizontal for multiple end markets. But as these markets evolve, we will also have some vertical solutions that are tuned to especially these megatrends of infrastructure, physical AI and sciences AI, but exciting times."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Okay. Sorry about that. So, you noted the strength in SD&A generally including some upside for the first full quarter with BETA CAE. But from a larger perspective, the fact is since you did your first acquisition for the ISD strategy, you've done 7 or 8 acquisitions over $2.1 billion of cumulative value. But you're still very much the challenger in that market with a fraction of market share relative to the market leaders. So maybe you could talk about how you're thinking about more tightly coupling across the various applications you have in CFD and SD&A and talk about how you're thinking about ramping up in go-to-market, especially, which is also something that I think you need to do to supplement what you've done on the code acquisition side?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, Jay, that's a great observation. So first of all, especially like we mentioned earlier, with the BETA acquisition, and which is doing pretty well, we feel that our portfolio is fairly complete, okay? So whether it is electromagnetics or thermal and now with CFD and then structural. So -- and the key thing that I watch and you can see in our results is the growth rate, okay, not just how complete the portfolio is, but how well it's performing in the market. And we are pretty pleased to see that the growth rate is good and I believe, much better than the overall market. And part of it is now that one part is, of course, the products have to be good, and I believe our products are best-in-class, whether it's clarity for is routinely like 5 times to 10 times faster, Celsius, only unique solution that can do thermal both finite element and CFD for 3D IC and general applications with BETA or with Millennium, but also go-to-market. So I think we have highlighted before and especially this quarter, it really went into full effect is we want to go to market in three big ways. So one way is direct, right, which is Cadence trend, working with the top customers. Our history, especially in EDA is, of course, working directly with the world's best companies. So we are doing that in SD&A as well, and that's where we were focused last few years was -- and we still are with the top companies but we need to augment that with two other parts of the strategy, which the other system design companies do anyway. So the second part, apart from direct channel is what we would call indirect channel, through channel partners. And then the third part of go-to-market is e-commerce and cloud offerings, okay? So I think at this point, especially in Q3, I feel that we are hitting our stride in this go-to-market. And for example, this -- apart from the top customers where we go direct, with a channel partner or indirect channel, we have now more than 100 partners, okay, which is a significant increase from earlier. And also OnCloud itself, which is the e-commerce direct channel, we have tens of thousands of users. And what we are also doing is we are a -- we are -- all our channel partners are also going to market through OnCloud. So whether the customer directly buys through e-commerce, or buys in a traditional way, all the data is captured in this online platform, so which is great for cross-selling. It's great for lead generation. So I really feel that we'll see how it progresses in the future, but especially this year, we are go-to-market has improved now that our products are in good shape. We need to focus on go-to-market, especially indirect channel and direct customer sales."
},
{
"speaker": "John Wall",
"content": "And if I could add to that as well, Jay, it's way more than just BETA. I mean, BETA is fantastic in that we're getting more pull-through revenue, especially in automotive as a result of BETA rounding out our multiphysics platform. But we're also getting strong momentum in A&D. Do you want to talk more about the A&D?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, absolutely. I mean A&D, like we highlighted this time I mean not just the traditional -- see, what is exciting about A&D to me is not just the traditional dips like Northrop Grumman, which we have a long history of working with both on the silicon side and the system side. But also, we are now directly working with like we highlighted the US Air Force and US Army. So -- and in terms of SD&A, there's three big markets. There's the traditional markets of high-tech or electronics. Anyway, that's we are traditionally strong in. And the two other markets are aerospace and automotive. So apart from BETA helping us in automotive, I think Aerospace, our own history with Northrop and other and the strength of our portfolio. So we feel that we are well positioned in these three big markets."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Great. Thanks very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"content": "Thank for taking my question. So, Anil, despite all the secular drivers, the stock has underperformed this year because of revenue lumpiness and we have seen the core EDA growth slip below 10%. I know you're not guiding to '25, but do you think investors should be prepared for a smoother year? Or are there other lumpy effects in IT or hardware or anything else that we should keep in mind. And if I had to try to quantify it, if I look at this $1.3-ish billion kind of exiting run rate from Q4, is this sort of the trend line for next year? Just how would you suggest investors get a handle for 2025 because I think this lumpiness has really impacted the stock this year."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, Vivek, all I would say is that, I mean, first two quarters were not -- were atypical for Cadence. We have highlighted before like Q1 and Q2 because of certain kind of onetime things. But I do believe Q3 is more back to normal, but John can comment more."
},
{
"speaker": "John Wall",
"content": "No, I agree. I certainly Q3 feels like our back to normal quarter. I think Q4 has a lot of upfront revenue in -- unusual again in terms of Q4 and we've got that massive pipeline that we have to convert. We have a lot of work to do there before we can talk about 2025. But when I look at 2025, I kind of view Q3 as a more normal quarter for Cadence."
},
{
"speaker": "Vivek Arya",
"content": "Okay. And for my follow-up, I saw in the CFO commentary that you have something now called core EDA, You've always given the different segment sales, but if I'm not mistaken, you took SDA out and you have something called core EDA, I'm curious why you chose to do that? And do you have system design and analysis kind of growth CAGR in mind beyond just a generic kind of double digit. What is the organic growth rate that you think your SDA business can achieve over the next number of years?"
},
{
"speaker": "John Wall",
"content": "I’m sorry, asking about '25 again, Vivek, nice try. Look, when we talk about core EDA, we were talking about, basically, you have core EDA software and you have the, like, functional verification group and hardware on. We talk about core EDA, we talk about those three groups combined. The system design and analysis we typically talk about separately. And then, of course, we have the IP business. The IP business and systems in analysis business are growing really, really strongly right now. But the launch of the new hardware products has resulted in functional verification growing really strongly. But often when hardware is bundled alongside core EDA software that there's an allocation methodology to apply value between the software and the hardware. So often internally, we look at core EDA, the three of them combined. If you look at core EDA software, by the end of the year, we're on track to achieve double-digit revenue growth on a three-year CAGR basis, which is the way we track things. But on the functional verification side of things. It would be -- it looks like it's on track for like high-teen growth on a three-year CAGR basis, like mid to high-teen growth. But IP, again, looks very, very strong and SD&A is the strongest of all. And I think it's all those things that Anirudh just spoke to."
},
{
"speaker": "Vivek Arya",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Clarke Jeffries with Piper Sandler."
},
{
"speaker": "Clarke Jeffries",
"content": "Hello, thank you for taking the question. I wanted to more focus on fiscal '24 with my questioning around specifically what happened in the quarter versus the full year guide? I mean, there was great momentum in the IP business, 59% growth. I was wondering what -- if you could level set what you're expecting in terms of Q4 IP contribution? I know last quarter we talked a lot about IP and systems leading upfront revenue in the second half and verification maybe being in the high single-digits. Is that still fair or true? Just to the broader question of tightened the full year range, but a beat on Q3, what was happening behind the scenes that revenue landed differently than expected? And then one follow-up."
},
{
"speaker": "John Wall",
"content": "Yeah. Sure, Clarke. I don't think revenue landed differently to -- I mean basically, we were prudent with our guide in Q3, and it's -- we feel our team always does his best business when they're not chasing. And I think we were rewarded for that with Q3 business. But similarly, we're being prudent for Q4. IP has great momentum. I expect that momentum to carry on into the fourth quarter as well as SD&A. I think all businesses are performing really, really well now. Anything to add there, Anirudh?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Just some more comments on the IP business. I mean, of course, Q3 is strong, and we expect good growth in Q4. But like any business, we look at it over multiple quarters and multiple years, right? So if you look at IP on a two-year CAGR, I think it's, I would say, in which is still good. But Q3, I mean, there's a focus on what each quarter separately. But the key thing in IP growing at, let's say, 30% on a two-year CAGR basis, I think we are doing -- finally, we are in a very good position in IP. This is the way I see. I mean EDA, we have done historically very well. We are well recognized as the leader in EDA. But if you look back like last three years, we have not done as well in IP as we could have. But I finally feel that now our IP business is in its strongest position it has been, okay? And there's multiple reasons for that. I mean one key reason is that we always focus on advanced node, especially with our leading kind of TSMC advanced node. And now at 3-nanometer, 5-nanometer or PPA is finally industry-leading in the IPs we deliver. And they are for these kind of enterprise application. And that whole area is taking off. So I think that's the first main reason. The second reason is that we are now working with other foundries like we have highlighted and there is more and more IP development needed for kind of onshoring or trench-shoring activities throughout the world. And then the third reason is disaggregation. There's 3D-IC even not just in HPC but now in laptops and automotive, this aggregation trend and need for IP like UCIe and all the other memory interface IPs. So I do feel that -- we have a good portfolio and IP group is in a very good position, not just for Q3, but on a multiple year CAGR basis."
},
{
"speaker": "Clarke Jeffries",
"content": "Perfect. And just to clarify or follow-up on that. Just -- I think the number one question we're going to get from investors are there going to be remaining execution thresholds with some of the IP business you had anticipated in the second half. Does more of that come in Q4? Or did some of it land in Q3? And then just final point around margin outperformance. How would you attribute the margin outperformance that happened in the quarter, certainly, IP revenue may benefit the sort of optics of incremental margin, but anything to call out in terms of maybe how OpEx discipline came in compared to your expectations? Thank you."
},
{
"speaker": "John Wall",
"content": "Yeah. Sure, Clarke. Again, more great questions. The -- I mean on the IP side, I think we -- like I said, we've got great momentum there. You're probably referring to the -- we did a large contract at the start of the year with milestones that were in the second half of the year and some of those kicked in, of course, in Q3 and triggered revenue. There are more that will trigger revenue in Q4, but that's a multiyear contract that will -- that momentum should continue on into next year. And then on the margin side, I mean, Cadence is -- I mean it's a tremendous business. I mean, the core EDA business is a great foundation for margins and profitable sustainable revenue business that -- and growth we scale really well. As we grow in these other areas, a lot of the growth just slows down. Nice to hear you talking about incremental margin. Typically, a lot of that revenue growth just flows into operating margin. And you can see when the growth comes through, the impact it has on operating margin is incredible."
},
{
"speaker": "Clarke Jeffries",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Harlan Sur with JPMorgan."
},
{
"speaker": "Harlan Sur",
"content": "Hey, good afternoon. Thanks for taking my question. Your inventories are up sequentially, that's an all-time high. I think it's implying a very strong demand profile and backlog for your new Z3 and X3 hardware systems. Is demand exceeding your near-term supply and manufacturing capabilities? In other words, is the Q4 shipment profile for your hardware system supply or manufacturing constraint? I'm just trying to get a sense on how many quarters, the strong upgrade cycle can extend into next year?"
},
{
"speaker": "John Wall",
"content": "Yes, Harlan, the demand is very strong for our hardware. But in terms of inventory growth, that's really come as a result of us buying -- doing a multiyear contract with a key supplier. We mentioned that on last quarter's call, that's also impacting our operating cash this year, but it was in and around the kind of low to mid $100 million kind of level in terms of purchases for hardware inventory for the next three years."
},
{
"speaker": "Harlan Sur",
"content": "Perfect. Okay. And then back to the China business. So as you think about 2025 and anniversary in a more normalized business environment for your China business this year, there's a lot of puts and takes where you've got the hardware upgrade cycle, you've got the potential direct or indirect headwinds from maybe more US regulatory actions. You've got the macro environment, which in extreme cases, maybe does impact design activity. So kind of a lot of moving pieces, right, but I think that the best leading indicator over the next few quarters on growth is design starts and planned design starts, right? So Anirudh you track design starts in China, you track some of the upcoming programs. How does the design activity funnel look? Is it increasing? Is it staying flat? And then when you overlay your hardware upgrade cycle on top of this, what's the early sort of qualitative view on China as you look into next year, would you expect continued acceleration in year-over-year comps?"
},
{
"speaker": "Anirudh Devgan",
"content": "Harlan, that's a good question for me. First, overall, and then specifically on China. I mean, like we mentioned that China has improved last two quarters. I mean it's difficult to forecast that into next year. But I do think that there is improvement in China overall and also, now with our more richer portfolio is also especially with the auto sector. I mean what is interesting to me is, for China, we have luxury of like in China and other parts work on multiple end markets and we participate in all the markets that the customers are designing chips for. But what is interesting to see -- for me to see in China is how well they're doing in automotive and almost all of those major auto companies are also now designing chips. I mean this is well known now. And so we are glad to work with them both on the SDA, but also the EDA side with the silicon part. So I think we just have to see how it progresses into '25. But overall, I think the design activity is strong in China and elsewhere, especially driven by this AI super cycle and amount of activity we are seeing with the hyperscalers, both in China and of course, in the US and the demand of AI for next several years. So we'll see. We'll continue to monitor that."
},
{
"speaker": "John Wall",
"content": "Yeah. And Harlan. Although, I mean, obviously, we can't predict what 2025 is going to bring, we did go back and back test the last 25 years. It's only the third year that we've seen a down year in China revenue on a dollar basis. And we've never seen two down years in a row. And I'm pleased to see that Q2 was stronger than Q1 this year. Q3 is stronger than Q2 this year. Pipeline looks strong. Anecdotally, from the team out in China, they're seeing a lot of design activity strength out there. So we wouldn't expect a second down year based on that history, but it's just very hard to predict '25."
},
{
"speaker": "Harlan Sur",
"content": "Appreciate that. Thank you for the insights."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ruben Roy with Stifel."
},
{
"speaker": "Ruben Roy",
"content": "Thank you. John, I wanted to ask a quick question, returning to the bookings pipeline and the strength there, great to hear that. But I know you said it was broad-based. Just wondering if we could drill into the hardware part of it, just a little bit more. I think historically, you've said that hardware visibility is a little limited relative to the rest of your business. I'm just wondering given that you have this new ramp, has that changed at all? Is your visibility on kind of hardware bookings extending at this point? Or is it kind of similar to the previous systems?"
},
{
"speaker": "John Wall",
"content": "Yeah. Great question. I mean, typically, on the hardware side, you've kind of got a two-quarter view of the pipeline. Opportunities tend to turn up in the pipeline about two quarters at most in advance of when the customer plans to put the hardware into production. Because often it's based on design projects that customers are starting, and then they might need a hardware emulation system for that project. and they know the project will be like this quarter or next quarter. But -- so typically, we have kind of a six-month view. Now at this time of the year, six months view is tremendous because there's a lot that happens in Q4 every year. Q4 is always a strong bookings quarter for us. By the time, we obviously with a strong pipeline and everything, we've got to convert a bunch of that, but you have a great history of converting that. But we'd like you to just let us convert that now in Q4, and we'll come back to you as soon as we close Q4 and give you an outlook on '25."
},
{
"speaker": "Ruben Roy",
"content": "Understood. Thanks, John. And then a quick one, I hope for Anirudh. Just kind of thinking through what you said on some of the new AI kind of areas that you're working on, you mentioned NVIDIA and NIM, NeMo and I think your competitors talked a little bit about that. I imagine you would characterize that as a later phase AI revenue opportunity, but just wondering if you could maybe talk through how we should think about timing of when we might see some of those types of products at the market. And Also, you said that you're building custom applications. Are you getting inbound requests from customers like hyperscalers or otherwise for that type of AI feature set?"
},
{
"speaker": "Anirudh Devgan",
"content": "Well, one thing I would like to highlight is that is our JedAI platform. So it's an enterprise data and AI platform. And the way we go to market with that and it supports like multiple GenAI solution. So we become almost like LLM agnostic. We can plug in different -- and different customers will want like different kind of engines in there. But it becomes like a main deployment vehicles and it works with all our tools and all our major five AI platform. So we give that flexibility to us, depending on which -- some customers may want different kind of AI solutions there. And then that platform can also be used to customized, not just our solutions, but any customer-specific solutions can be deployed through JedAI and JedAI also works both on the cloud and on-prem because some customers, some really big customers don't want the AI to go to the cloud. So in that case, we have it on-prem. So I think JedAI and we have worked on this JedAI for several years, gives a unique position to Cadence to deploy these AI solutions and multiple kind of LLMs and ways to go to market."
},
{
"speaker": "Ruben Roy",
"content": "Thank you, Anirudh."
},
{
"speaker": "Operator",
"content": "Our next question comes from Siti Panigrahi with Mizuho."
},
{
"speaker": "Siti Panigrahi",
"content": "Thanks for squeezing me in. And Anirudh, it's good to be on the call, just initiated coverage. So I want to keep it at a high level and really just for the interest of time, 1 question here. When I look at your three years revenue CAGR trend, it has been accelerating from single digit to now mid-teens. And Anirudh, you talked about so many growth drivers and even products, new products coming to market. I'm wondering how would you rank order this growth opportunity and product when you think about the growth in the foreseeable future? And what gives you that confidence to sustain this kind of double-digit revenue growth?"
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you for the question. And also thank you for initiating coverage. I mean, as we have said before, I think one thing I just want to highlight is we are always looking at revenue growth, which has improved, like you mentioned, through a lot of these systemic drivers, but always at the same time, profitability, which has also improved and continues to improve every year. So -- and put that together, that, of course, delivers results to our shareholders. And even in Q3, right, not only we did better on revenue but also on profitability. So I think there are a lot of drivers, a lot of them driven by AI and then AI moving to the edge and our move into doing better in new areas like SD&A, but also IP. Like I mentioned, I'm optimistic about our IP business going forward. But at the same time, we put a focus on profitability. So we will continue to manage that going forward."
},
{
"speaker": "Siti Panigrahi",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our final question comes from Joshua Tilton with Wolfe Research."
},
{
"speaker": "Joshua Tilton",
"content": "Hey, guys. Thanks for squeezing mine in. I want to start with a bit of a nuanced question, although I think it is important. John, you talked to how previously you have seen down years in China, but you've never seen two down years in a row. And I guess you mentioned your data driven, you looked at the historical numbers. But can you give us any sense of what helps to drive the recovery a year after you had a down year? And what I'm trying to get at is, do I have to believe in some type of bigger hardware demand or more upfront contribution or something along the lines of things that may not be recurring? Or is it just more a function of we had a weak year and there was a return to normal demand environment going forward? I guess I'm just trying to understand outside of history, what is similar this year versus the previous years where you've seen down years and why you don't expect to once again not see two [net holders in] (ph) a row."
},
{
"speaker": "John Wall",
"content": "Yeah. Okay, thanks for the opportunity to provide a little bit more color. We look back over the last 25 years, and we've seen like tremendous momentum and design activity amongst our customer base, a growing customer base across China. There were only two previous years before this year where we saw a downtick in China revenue on a year-over-year basis. 2008, I know 2008 as somebody syncratic qualities to it. But 2008 also a year that we changed from an upfront revenue model to a ratable revenue model. And I think that's why it took a couple of years to get back to a new high in China. But then since then, it's only 2021. 2021 dipped -- China revenue dipped from 2020, but it recovered to a new high in 2022. Now incidentally, that was -- we launched new hardware systems. And we do find that there is a correlation between hardware revenue and China revenue. Hardware revenue tends to pull through more China revenue for us on the software side. And I think we're seeing a little bit of that this year in that the new hardware that's been launched is selling more and being delivered more outside of China. I would expect more of that to go to China next year, and it will help improve our software revenue. Also, if you look at this year, China dipped in Q1, but it's been recovering since Q2 has been higher, Q3 has been higher. And like I said, as hardware recovers out there, I think it will pull through more software revenue."
},
{
"speaker": "Joshua Tilton",
"content": "Super helpful. And then just maybe 1 very quick follow-up. Any updates on what you guys are -- or just in general, what the contribution from BETA was in the quarter and if you're still on track or expecting $40 million for the full year or if we should expect more from your original?"
},
{
"speaker": "John Wall",
"content": "The -- so we're seeing a big contribution with BETA when you include the pull-through revenue that we're getting across for all our automotive customers as a result of selling traditional Cadence technology alongside BETA. But we're -- but it's a small tuck-in. We're not guiding BETA separately."
},
{
"speaker": "Joshua Tilton",
"content": "Got it. Super helpful, guys. Thank you so much for squeezing me in."
},
{
"speaker": "John Wall",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "I will now turn it back to Anirudh Devgan for closing remarks."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you all for joining us this afternoon. It's an exciting time for Cadence with strong business momentum and growing opportunities with semiconductor and system customers. We launched the Fem.AI initiative and committed to an initial investment of $20 million to lead the gender equity revolution in the AI workspace. This has also led through our Cadence Giving Foundation. With a world-class employee base, we continue delivering to our innovative roadmap and working hard to delight our customers and partners. On behalf of our Board of Directors, we thank our customers, partners and investors for their continued trust and confidence in Cadence."
},
{
"speaker": "Operator",
"content": "Thank you for participating in today's Cadence third quarter 2024 earnings conference call. This concludes today's call. You may now disconnect."
}
] |
cdns | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good afternoon. My name is Brianna, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Second Quarter 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. [Operator Instructions] Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead."
},
{
"speaker": "Richard Gu",
"content": "Thank you, operator. I'd like to welcome everyone to our second quarter of 2024 earnings conference call. I'm joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President, and Chief Financial Officer. The webcast of this call and a copy of today's prepared remarks will be available on our website, cadence.com. Today's discussion will contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q, CFO commentary and today's earnings release. All forward-looking statements during this call are based on estimates and information available to us as of today and we disclaim any obligation to update them. In addition, we'll present certain non-GAAP measures, which should not be considered in isolation from or as a substitute for GAAP results. Reconciliation of GAAP to non-GAAP measures are included in today's earnings release. For the Q&A session today, we will ask that you observe a limit of one question and one follow-up. Now, I'll turn the call over to Anirudh."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. Cadence delivered strong financial results for the second quarter of 2024, with broad based momentum across our product portfolio. Bookings were stronger than expected, leading to a healthy backlog and underscoring the robust demand for our innovative technologies. We exceeded our outlook on all key metrics and are updating our revenue guidance for the year to over 13% year-over-year growth. John will provide more details on both our Q2 results and updated outlook for the year. Generational trends such as hyperscale computing, 5G and autonomous driving, all underpinned by the AI super cycle, are driving strong design activity across multiple verticals, particularly in data center and automotive. Along with increasing chip complexity and system companies building their own silicon, these trends are creating tremendous tailwinds for our differentiated solutions. We are steadfastly executing to our intelligent system design strategy, extending our leadership in core EDA, while steadily expanding our footprint in the new system design analysis area. Customers are ramping-up their R&D spend in AI driven automation. Our Cadence.AI portfolio offering unparalleled quality of results and productivity benefits continues to gain momentum with orders more than tripling over the last year. Our solutions are enabling the massive AI infrastructure build out across the semi and system space. Additionally, we continue embedding AI in our EDA, SDA and digital biology solutions. In Q2, our long-term development partner, NVIDIA, broadly deployed Palladium Z3 to deliver to its next generation AI product roadmap, further solidifying Cadence's leadership in the industry. A marquee hyperscaler meaningfully expanded its partnership with Cadence in Q2, through a broad proliferation of our Cadence.AI EDA, SDA and hardware portfolio. The growing foundry ecosystem is driving increased design activity and creating significant opportunities for our industry leading products. And in Q2, we expanded our collaboration with several leading foundry partners. We announced that Cadence.AI digital and analog tools were optimized for Samsung's advanced node SF2 gate all around process, driving enhanced quality of results and accelerating node migration. We extended our long standing collaboration with TSMC, through a very comprehensive and innovative technology advancement, ranging from 3D-IC to design IP and photonics and providing optimized digital and analog full flows for TSMC's latest N2 process technologies. Our integrity 3D-IC platform is the industry's leading unified design, analysis and sign-up platform for multi-chiplet architectures. Integrity has been certified for all of TSMC's latest 3D fabric offerings and now has enabled several new features like hierarchical 3D-IC design. We also announced that integrity has been enabled for all of Samsung foundry's multi-die integration offerings accelerating the designer assembly of stack chiplets. Additionally, we released a complete Intel Foundry EMIB advanced packaging reference flow that is optimized to work seamlessly with Intel 18A technology. We are also collaborating with multiple foundries to optimize our industry leading IP cores for AI, HPC, mobile and automotive applications for their advanced process technology, so as to ensure seamless integration into customer designs. We saw strong momentum in our IP business with a delivering 25% year-over-year growth in Q2. As we executed to our profitable and scalable growth strategy, AI use cases, HPC and heterogeneous integration were the primary drivers fueling the demand for our HBM, PCIe, DDDR, 112 gig SerDes and UCIe products. We expanded our system IP portfolio with the addition of Cadence Janus Network on a chip solution, that manages high speed communications effectively with minimum latency, enabling customers to achieve their PPA targets faster and with lower risk. Emulation and prototyping have become mission-critical elements of chip design and software bring of flows. Following the launch of our market leading Z3 and X3 platforms, there is robust demand for these best-in-class systems, particularly by AI, hyperscale and automotive companies and we continue to ramp-up our production capacity accordingly. Verisium, our AI-driven verification platform, continued seeing rapid customer adoption with several market shaping customers, including Qualcomm, successfully using Verisium Sim AI for coverage maximization and achieving up to a 20x reduction in verification workload time. Our system design and analysis business continued its strong momentum in Q2, delivering 20% year-over-year revenue growth. As chiplet based architectures gained traction, our industry-leading integrity 3D-IC platform had increased adoption and expansion from large deployments at 5G hyperscale, memory and consumer customers. Our AI enabled Allegro X design platform, which is being rapidly adopted and driving competitive displacement as multiple aerospace and defense hyperscalers and EV customers take advantage of the platform's productivity and next generation capabilities. Allegro X's in design analysis capabilities are also driving a pull through of our Multiphysics analysis solutions. In Q2, a leading EV auto company forged a strategic partnership with Cadence, making a significant investment across the breadth of our Multiphysics portfolio. With the close of BETA CAE in Q2, we now offer a comprehensive Multiphysics platform covering electromagnetics, electrothermal, CFD and structural analysis solutions. Our digital IC and custom businesses delivered another solid quarter. Proliferation of our digital full flow at the most advanced nodes continued with close to 40 full flow wins over the last 12 months, especially at hyperscalers. With over 400 tapeouts, customers are increasingly relying on Cadence Cerebrus, the leading AI tool in the industry as it continues to deliver amazing PPA and productivity benefits. For example, Cadence Cerebrus has been delivering up to a 10% PPA gain for a global marquee systems company and is now deployed as part of the default flow for their latest designs at the most advanced nodes. Samsung foundry leveraged Cadence Cerebrus in both DTCO and implementation to achieve more than a 10% leakage power reduction on their SF2 gate all around platform. Socionext utilized SerDes closure and temper sign-off to reduce timing closure time by 73% and doubled productivity while reducing memory cost by 90%. Our AI driven Virtuoso Studio is the leading automated solution for analog and RF designs. And its new AI features allow much more efficient migration from one process node to another. Virtuoso Studio added 35 new logos in Q2, led by top hyperscalers, aerospace and defense and automotive customers. In summary, I'm pleased with our Q2 results and the continuing momentum of our business. The AI driven automation era offers massive opportunities and the co-optimization of our comprehensive EDA and SDA portfolio with accelerated computing and AI orchestration uniquely positions us to provide disruptive solutions to multiple markets. Now I will turn it over to John to provide more details on the Q2 results and our updated 2024 outlook."
},
{
"speaker": "John Wall",
"content": "Thanks, Anirudh, and good afternoon, everyone. I'm pleased to report that Cadence delivered strong results for the second quarter of 2024, finishing the first half with backlog of approximately $6 billion. Also, we expanded our Multiphysics platform in Q2 by completing the acquisition of BETA CAE. Here are some of the financial highlights from the second quarter, starting with P&L. Total revenue was $1.061 billion. GAAP operating margin was 27.7% and non-GAAP operating margin was 40.1%, and GAAP EPS was $0.84 with non-GAAP EPS $1.28. Next, turning to the balance sheet and cash flow. Cash balance at quarter end was $1.059 billion, while the principal value of debt outstanding was $1.350 billion. Operating cash flow was $156 million. DSOs were 49 days and we used $125 million to repurchase Cadence shares in Q2. Before I provide our updated outlook, I'd like to share some assumptions that are embedded. Our updated outlook includes BETA CAE and it contains the usual assumption that export control regulations that exist today, remain substantially similar for the remainder of the year. Our updated outlook for 2024 is revenue in the range of $4.6 billion to $4.66 billion. GAAP operating margin in the range of 29.7% to 31.3%. Non-GAAP operating margin in the range of 41.7% to 43.3%. GAAP EPS in the range of $3.82 to $4.02. Non-GAAP EPS in the range of $5.77 to $5.97. Operating cash flow in the range of $1 billion to $1.2 billion and we expect to use approximately 50% of our annual free cash flow to repurchase Cadence shares. With that in mind, for Q3, we expect revenue in the range of $1.165 billion to $1.195 billion. GAAP operating margin in the range of 27.7% to 29.3%. Non-GAAP operating margin in the range of 40.7% to 42.3%. GAAP EPS in the range of $0.83 to $0.93 and non-GAAP EPS in the range of $1.39 to $1.49. And as usual, we published a CFO commentary document on our Investor Relations website, which includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, I am pleased with our strong Q2 results. We exceeded our outlook on all key financial metrics, a good finish to the first half and ongoing demand for our solutions sets us up for strong growth in the second half of 2024. As always, I'd like to close by thanking our customers, partners and our employees for their continued support. And with that, operator, we will now take questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will open the line for questions. [Operator Instructions] Your first question comes from Charles Shi with Needham & Company. Please go ahead."
},
{
"speaker": "Charles Shi",
"content": "Hi. Good afternoon. Thanks for taking my questions. Anirudh and John, maybe the first question, I do want to ask a fairly big question -- a big picture one. So, you did pick up your outlook for the year, but some of that really comes from BETA CAE. But the broader question is the semiconductor -- global semiconductor sales, it's on-track to grow a lot faster, let's say, compared with you and even your peers synopsis and -- but this seems to me kind of like a reversal of the trend of the last three years when you actually did outgrow the semiconductors. But with so much AI being a big driver for semiconductors, we do wonder whether it's either through pricing or through some other measures Cadence can actually gain a little bit bigger piece of the pie from overall semiconductor, especially from AI? I don't know if you can provide some thoughts today. I'm not necessarily asking how to change the trend in terms of the value capture, but any thoughts would be great. Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Charles. Thanks for the question. I mean, first of all, I'd like to say that overall we are pleased with how we are performing. If you step back -- because you asked a longer term question, right, if you step-back, we will deliver we expect more than 13% revenue growth and about 42.5% operating margin. So, I think that's a best-in-class combination of both revenue growth and operating margin. And then if you look at our CAGR over last three years, which is one of our kind of favorite metrics, that's also performing pretty well in terms of growth and margin expansion. And you mentioned semi-cycle, I mean, it's encouraging to see that there is going to be growth this year, which it was not there last year. But as you all know, Charles, we are tied to the R&D spend more than the revenue of our customers. And, of course, if the revenue goes up, they're more likely to spend on R&D, but in general, the -- our customers, both system and semi-companies continue to spend on R&D and these are long-term projects. So, we'll see how that goes as the semiconductor revenue improves, but this is not instantaneous effect on R&D spend. There is always some lag sometimes. And so we will -- but we are encouraged to see the improvement in semi spending overall in a semiconductor revenue. So, I would like to say -- and you can see in our backlog also, we maintain a pretty healthy backlog. So, overall, I think things are performing well and this AI is broadening out. I mean, you know this well. AI is broadening out beyond datacenter, which we are glad to have great partnerships, two automotive, two more edge consumer devices like phones and PCs. So overall I feel pretty good about the industry and, of course, our position in it as the essential provider of design software."
},
{
"speaker": "Charles Shi",
"content": "Got it. Maybe a quick follow up on China. It looks like China revenue is still pretty light in the second quarter. So, I recall you were thinking maybe China contribution is probably going to be slightly less than the mid-teens or 15% -- less than 15%. But even if -- let me assume the China revenue gets to like a 14%-ish, it still implies a little bit of a second half a reacceleration of the China revenue growth. Is that still the case or you think maybe compared with the three months ago, China actually may get a little bit weaker than you previously thought? Thanks."
},
{
"speaker": "John Wall",
"content": "Thanks for the question, Charles. And that's -- I mean, regional revenue is notoriously hard to predict. I will say that at the midpoint of our current revenue guide, we only need China to get to 13% of overall revenue to be able to hit that midpoint. I mean, when you look at performance in Q2 and the first half, we had a very strong bookings first half, very pleased with customers' response to our new hardware systems. The IP and SG&A businesses continue to grow strongly. Core businesses continue to scale really well and we're focused on profitable revenue growth. I know in your first question, you indicated that we hadn't raised the outlook, but we did raise non-GAAP EPS by $0.06. We're very pleased with the improvement in profitability. And when you look at the current guide, we're actually on track for 50% incremental margin excluding the impact of BETA CAE now. BETA CAE is in our guide, but it's in our guide at what we previously communicated in the press release is $40 million of revenue and about $0.12 dilution to non-GAAP EPS. There is an impact to OP cash as a result of BETA CAE as well. But overall, very, very pleased. We thought it was prudent to assume lower China revenue for this year at the midpoint of our guide puts the -- but that's it. We only need 13% to get to the midpoint of guidance."
},
{
"speaker": "Charles Shi",
"content": "Thanks, Anirudh and John for that additional color. I appreciate that."
},
{
"speaker": "Anirudh Devgan",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from Gianmarco Conti with Deutsche Bank. Please go ahead."
},
{
"speaker": "Gianmarco Conti",
"content": "Yeah. Hi, there. Thank you so much for taking my questions. And so on my first one, could you talk a little bit about the implied Q4 ramp-up to 29% growth at the midpoint of guidance? And what is giving you the confidence in reaching the target? Is it mostly hardware visibility coming through or are there an unusually higher number of Q4 renewals that you're waiting for? Any color here would be great. Thank you."
},
{
"speaker": "John Wall",
"content": "Yes, Gianmarco. I mean, there's no real change from what we said last quarter. I mean, it's effectively the shape of the revenue curve for the year. We're expecting upfront revenue -- a lot more upfront revenue in the second half, it's just the timing of shipments really that's -- upfront revenue typically comes from IP, hardware and to a lesser extent some software on the SG&A side. With the hardware, it takes time to build the systems, we have higher revenue in Q4 versus Q3 as a result. But also from IP, there is -- IP is -- we recognize revenue and IP based on the timing of deliveries. We're confident in that guide. It's just the shape of the -- shape of Q3 and Q4 is what we have in the guide now."
},
{
"speaker": "Gianmarco Conti",
"content": "Okay. Great. So my follow up would be on hardware. And if you could talk a little bit about how much visibility you have actually in H2? And are you booking and delivering in the same quarter, hence, while we're not seeing a major uplift in backlog growth or is it -- is there a different dynamic to it? I'm trying to understand if you're booking manufacturing and delivering all in the same quarter for hardware essentially? Thank you."
},
{
"speaker": "John Wall",
"content": "Thanks for the question. Yes, in some cases, on the newer systems, there is a timeline, a lead time to building the systems. We have more bookings than our ability to actually fulfill those bookings. But we do have some inventory of the older systems, we're able to deliver those in the quarter. So I mean, there's always a mix. We did have a challenge in the past with getting inventory and building the inventory as fast as we could for the demand. I think we've dealt with a lot of that. You'll also see in the OP cash guide, there is -- we're planning to purchase a significant amount of raw materials for building inventory in Q3. That's the biggest portion of the change in OP cash guys."
},
{
"speaker": "Anirudh Devgan",
"content": "Also just to add on overall -- yeah, hey, just to add on the overall hardware cycle, as you remember, we launched new systems in April, just couple of months ago, few months ago now. And the response to them has been phenomenal. Actually, we -- these palladium, especially both palladium and protium, but these systems can design chips like I mentioned last time with capacity of 1 trillion transistors and the current's biggest chip is like 200 billion transistors, most of them are 100 billion or less. So we are 5x to 10x higher capacity than what is needed. So that should suit the industry well for next several years. And I'm also what pretty pleased about is that we delivered production deployments of our new systems to some very major customers. So we highlighted the NVIDIA, our development partner with a significant deployment of Z3, also one of the leading mobile system -- mobile companies in the world and one of the leading hyperscalers. So it's across multiple markets that we delivered our latest systems, which are performing exceedingly well. So that sets up very well for the future and also competitively. And we have a significant lead given the nature of our systems. It's a combination of -- protium is based on FPGA and then palladium is based on our own chip at advanced TSMC process. And Cadence is the only solution that does that and provides a unique value. So overall, I think hardware business is performing well. And as you know, these are multi-year upgrade cycles. So this is not all-in in '24. So we'll see how things go in '25 and '26."
},
{
"speaker": "Gianmarco Conti",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Vivek Arya with Bank of America Securities. Please go ahead."
},
{
"speaker": "Vivek Arya",
"content": "Thanks for taking my questions. So on an absolute basis in fiscal '24, organic sales growth rate is robust. But in terms of revisions, it has stalled, right, essentially no real movement since what you suggested at the start of the year. So I'm curious, Anirudh, how has the year transpired versus what you thought and how do you think about bookings and backlog trends into the second half? Should we expect that backlog stays around the $6 billion? Will it start to pick up? Just I'm trying to understand that should we be thinking about sales accelerating from here or this being kind of the sustainable growth rate for the company?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Vivek. Good question. So in general, what I would like to say is, like we mentioned last two times, the shape of the curve this year is unique to Cadence, given multiple factors. This is not what we expected last two years. So this time it's more back end loaded for the reasons we mentioned before. So the guide is a little different and we are also given that shape of the curve more prudent in our guide like we were in Q2 and then we rather overachieve and deliver that and give the team flexibility to do the right business for the long term. So I think that's the difference this year versus last few years is given the shape of the curve, we have more prudence in our revenue guide like John mentioned and John can comment on the backlog expectations, yeah."
},
{
"speaker": "John Wall",
"content": "Yeah. I mean we don't guide bookings, but we were very pleased with the strong bookings in the first half. And I get the question, Vivek. I mean, essentially, we're seeing a strong demand for our hardware systems. We're seeing strength across all our businesses. And I guess your question is that when you add in BETA CAE, you're not really taking the revenue guide up. I think essentially I mean if your question is what would we like to see improve, I think it's the China revenue percentage. It was 12% in Q1, 12% in Q2. It improved in Q2 over Q1 and we think it will continue to improve through the year. But right now, our guide only assumes -- only needs to get to 13% China to hit the midpoint of that guidance."
},
{
"speaker": "Vivek Arya",
"content": "Got it. And for my follow-up, you mentioned BETA CAE quite a drag to EPS. I think you mentioned $0.12 dilution. And almost, I think what is like a $300 million hit to operating cash flows. Can you describe that acquisition a little more? And when does it start to become accretive to your financials? Thank you."
},
{
"speaker": "John Wall",
"content": "So yes, Vivek. On the $300 million drop in operating cash, just to clarify that, about 40% of that $300 million drop is due to M&A. I mean, in things like BETA CAE, some of the purchase price, the geography of where the operating -- where the cash impact goes, it flows -- some of that payment flows through OP cash. The bigger portion of the impact on operating cash is our plan to purchase a lot of inventory raw materials for the hardware demand that we're seeing. We're pre-purchasing a lot of inventory. So you'll see our inventory spike in Q3 with all of the raw materials we're purchasing. We want to make sure that we have all the raw materials necessary to ramp-up the build out of our hardware systems. And then in relation to BETA CAE, there's -- I mean it's very recent acquisition. The -- it's no different to what we have in the press release. In fact, on the press release, we said we were expecting $40 million of revenue at the midpoint. That's embedded now in the guide. We're expecting $0.12 dilution on -- from our non-GAAP EPS, that's also in the guide now. And we expect it to be -- I mean, operationally, it will be accretive next year that there is some interest cost associated with the test that -- but we think it will be accretive next year."
},
{
"speaker": "Anirudh Devgan",
"content": "Also, a couple of things to clarify. So one thing, this purchase of inventory for the hardware systems. I mean, that will be used over multiple years. It's not just for '24. So I think it's a one-time investment that pays for several years and that's a prudent decision to make to get the right kind of parts for the future. And then on BETA, it completes our system analysis portfolio to add structural analysis and it also strengthens our position in automotive. Of course, data center is a big vertical with all the AI super cycles. But I think one of the other exciting verticals is automotive with all this electrification and also AI getting added in the self-driving or driver assistance. So we see a lot of design activity in automotive. Also, automotive is also moving through chiplets and 3D-IC. So I think automotive has all the three tenants of our IST strategy. It has silicon content that is increasing and more and more system design, of course, is needed for the design of automotive. And AI for all the data and computational software. So for that reason, BETA CAE is -- completes our portfolio in automotive and positions us well in the future. And this is not just with the semiconductor companies doing automotive, but also the system companies now. OEMs doing more and more chip design, doing more of our system solutions. And I also want to highlight and congratulate McLaren. There was a big news this weekend. McLaren got one and two in Hungarian F1 and we have been working with them for last few months and years and it's good to see them do well as we deploy. So I think the automotive solution that we are driving is a combination of silicon system and then AI and we are seeing the results of that through organic and inorganic expansion."
},
{
"speaker": "Vivek Arya",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Joshua Tilton with Wolfe Research. Please go ahead."
},
{
"speaker": "Joshua Tilton",
"content": "Hey, guys. Can you hear me?"
},
{
"speaker": "John Wall",
"content": "Loud and clear, Josh."
},
{
"speaker": "Joshua Tilton",
"content": "Great. The first one is just kind of more of a clarification. I know there's been a lot of questions around the mix in upfront first recurring. I guess what I'm just trying to understand is -- and I could be wrong with my math here, but it feels like it was -- the upfront component was still a little light in 2Q and now we're a little bit more second half weighted, more 4Q weighted because you need time to develop inventory. Am I thinking about that the right way?"
},
{
"speaker": "John Wall",
"content": "That's fair, Josh. I would do the inverse on you in terms of bookings were stronger than we expected in Q2 and we got some uplift in recurring revenue. It took a bit of pressure off on the upfront side that -- and we are -- I mean, we're taking orders. We've got strong demand for the hardware and we're building those hardware systems as quickly as we can, particularly the newer hardware orders. IP is doing really well and system design and analysis is doing really well. And what we've reflected in the guide is our expectation of how much of that revenue will fall in Q3 and Q4. We took the opportunity, we really derisked the guide for the year by reducing our expectations for China. Upfront, we still expect to be in a range of 80% to 85%, but I think we might get slightly more recurring revenue as a result of the strong bookings in the first half."
},
{
"speaker": "Joshua Tilton",
"content": "That makes super clear. And then I guess just my follow up to that is and I guess it's another visibility question, but how much of what's baked into the guide from an upfront perspective? Do you feel like you have like good inventory levels to meet that guidance or does the guidance that you put out today still require you to build and develop inventory between now and shipping those boxes?"
},
{
"speaker": "John Wall",
"content": "Yes. But it's -- we definitely need to build hardware and you'll see the impact on our inventory in Q3 with the amount of raw materials we're purchasing. But as Anirudh says, that's a one-time thing that we're doing to try and get raw materials and to build those systems quickly as we can. But the -- a lot of the upfront revenue in the second half comes from the strength in our IP business and we have those orders in backlog and it's just a case of executing against those. We also have some SD&A, our system design analysis upfront revenue that's scheduled to occur in Q3 and Q4. Again, most of that is from orders in the system. On the hardware side, it's kind of mid to high-single digits is what we were expecting the SPG Group to deliver to be able to hit the midpoint of that guidance."
},
{
"speaker": "Joshua Tilton",
"content": "Super helpful. And then just -- but just a quick follow up is, really often to see the recurring revenue growing sequentially this quarter. Is there any way you can maybe help us on what the expected recurring versus upfront mix is supposed to be in 3Q? And then I'll see the floor."
},
{
"speaker": "John Wall",
"content": "I don't have that to hand, but just let me come back to that. Let's see if I can dig it out here."
},
{
"speaker": "Joshua Tilton",
"content": "Thanks, guys. Congrats."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ruben Roy with Stifel. Please go ahead."
},
{
"speaker": "Ruben Roy",
"content": "Yes. Thank you. John, just a very quick question and then I guess a follow up and then I'll ask a real question. But on the inventory purchases, is -- am I right in assuming that that's mostly for the Z3/X3? And has anything changed in terms of when you're thinking about general availability of those hardware products?"
},
{
"speaker": "John Wall",
"content": "Yes, that's correct. But the vast majority of the purchases are to -- to get raw materials to help build those new systems."
},
{
"speaker": "Ruben Roy",
"content": "And then in terms of the time?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Just to clarify, I mean, also -- I mean, we have two systems, right? So, palladiums, we design ourselves and we manufacture the chip in TSMC and protium. We also design ourselves, but the silicon itself is primarily from AMD with Xilinx FPGAs. So, a lot of this purchase is for X3s and the FPGAs and that should serve us for multiple years. On Z3, like we said, we are already shipping them and they already deployed in production this quarter. So, I think Z3 is slightly different than X3 in terms of the mix of the silicon content, just to clarify that."
},
{
"speaker": "Ruben Roy",
"content": "Yeah. Okay. I apologize, Anirudh. I thought they were going to sort of certain customers not generally available. But thank you for that. And then the real question just around -- some of your top customers have been accelerating the rhythm of bringing sort of their very complex chips to market. NVIDIA and AMD certainly have accelerated their roadmaps to sort of a one year rhythm. Are you seeing any changes in sort of the way your business is impacted or affected kind of by the acceleration of their product roadmaps yet?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, I would like to -- I think we're seeing more and more design activity like you said the rhythm or the Cadence of the products. And also different kind of chips. It's not just that big data center chips, but even within them, there is more and more customization. Of course, the hyperscalers doing their own silicon. And then now we talked about our partnership with, for example, Qualcomm and they are doing a consumer or edge laptop AI devices. So, the amount of AI is also spreading to other verticals, not just obvious, the big one on data center and data center design is accelerating. And I think when we look at it, we still see that the data center part of AI still should accelerate, at least the visibility we have for next couple of years, so we'll see how that goes. And therefore -- and the other thing is automotive -- automotive takes normally a little longer, but we're already seeing design activity and the deployment may be few years down, maybe after data center. And then consumer and PCs already starting with phones and laptops. So, overall we do see accelerating deployment of AI through the whole semiconductor ecosystem. And we are very proud of our position in it, whether it's 3D-IC, whether it is data center chips, whether it's our own AI products, we are winning almost all kind of engagements on all -- on our kind of Cadence.AI portfolio. So, overall we do see more and more design and deployment of AI infrastructure and our own AI product."
},
{
"speaker": "Ruben Roy",
"content": "Yeah. And if I could just come back to Josh's question, sorry, if I could just come back to Josh's question on the revenue mix for Q3 that for recurring revenue, we expect -- sorry, 80% to 85% of revenue to be recurring for the year and Q3 includes the middle of that range and then the balance is Q4, so you can do the math and work out what the upfront piece is."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Thank you. Good evening. Anirudh, the question about the evolution of the product portfolio for EDA generally and perhaps for SG&A specifically. What I'd like to ask about is how you're thinking about packaging the products? Over the last year, you've introduced a couple of products with the term Studio in the name. And I'm wondering if you're thinking about more and more bundling or packaging of that kind via that nomenclature for the EDA products and then specifically for SG&A? And now that you do have multiple codes, how are you thinking about packaging or integrating across the various simulation codes that you've assembled now in acquisition? Then I'll ask my follow-up."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Hi, Jay. Good question. So, I mean, as you know, in EDA when we go to lower nodes, there is more integrated solutions which are required, whether it's digital or analog or verification. And that is further accelerated by use of AI. So, like Cerebrus, for example, in digital will integrate not just place and route, but also synthesis and sign-off. So, I think that trend is definitely there. And same thing with Verisium, our leading AI product for verification also integrates the four major verification platforms we have. So, it is more and more platform driven approach. And we can do that now with SD&A now that we have a complete portfolio. And we mentioned like a leading EV company like OEM, one of the leading -- the most advanced EV companies deployed our entire portfolio. So as we have a bigger portfolio in SD&A, it does let us do what we have always done in EDA, focus on solutions, not just on individual products and integrate solutions with our own kind of native integrations, whether it's analog, digital verification and now with SD&A."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "All right. As follow up, I know it's still quite early in the propagation of AI and ML by you and your peers to the customers, but are you beginning to see any commonality or convergence towards a relatively small number of use cases that customers are mostly employing the tools for? And then relatedly, are you also seeing AIML adoption having any meaningful effect on your services revenue?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, Jay. So what I would like to say is that the number of use cases I see is increasing at this point. I mean, of course, one of the biggest use case that we started with was digital implementation since it is so kind of heavy kind of design process. So automating the digital implementation process was huge benefit. And we talked even this quarter Cerebrus being deployed at one of the leading system companies for the default flow also used by Samsung. Also you see verification be used by Qualcomm. So I think what is happening in that Cerebrus or the implementation use case, two things. One is that it is going not just for design, but also for DTCO, design technology co-optimization and also for higher level in the design process like floor planning and 3D-IC exploration. So it's all not just for implementation of the design, but also for architecture and exploration. And the other thing is like there is more workflow automation. As customers get used to Cerebrus, they are using it not just towards the end of the design process, they're using it right from the beginning throughout the design process. So it allows us to do more workflow automation. And Cerebrus has also evolved to allow much more of an entire workflow rather than a specific implementation use case. And then same thing is happening in terms of more and more use cases, for example, packaging. Allegro X is doing pretty well. And recently one of the leading customers in 3D-IC used its capability to automate, for example, routing for automating placement, which was not there before in PCB and package design. So overall, I do think it's maturing of the workflows. And then with this LLMs and Gen AI, we have kind of several workflows for taking spec to RTL and we highlighted some of them last quarter. So I actually do see finally that in the -- we are always kind of building out the AI infrastructure, these big companies designing chips. But I do see now there is a turning point in deployment of AI for the design process with the initial workflow being Cerebrus and digital implementation now to expanding to LLM based art, spec -- expanding to DTCO, expanding to 3D-IC, of course, expanding to analog, packaging, verification. And we do have the most comprehensive AI portfolio in terms of all five major kind of product lines. So actually, it's a pretty encouraging view compared to a year ago."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Thank you, Anirudh. Thank you, John."
},
{
"speaker": "Operator",
"content": "Our next question comes from Harlan Sur with J.P. Morgan. Please go ahead."
},
{
"speaker": "Harlan Sur",
"content": "Hi. Good afternoon. Thanks for taking my question. Is the bookings profile for the full year still expected to be 40% first half, 60% second half? Because if it is, then that would imply book-to-bill greater than 1 for the full year, total backlog up about 9% this year to about $6.5 billion. But, I guess, how much of that backlog is due to the BETA CAE acquisition? What I'm just trying to figure out is ex BETA CAE, if core cadence orders and backlog are expected to be up this year, which would continue the strong sort of six to seven year trend of increasing orders and backlog for the team?"
},
{
"speaker": "John Wall",
"content": "Yes, it's hard. And again, like I say, it's -- we're not guiding bookings, but we were very, very pleased with the strong first half for bookings. The BETA CAE contribution to backlog is very, very small. It's immaterial because BETA CAE, their revenue is upfront. So that's the upfront piece of the business rather than the recurring revenue. But yeah, we're very pleased. I mean, you can typically expect us to always be driving for a book-to-bill of greater than 1, but we don't guide. We don't guide bookings though."
},
{
"speaker": "Harlan Sur",
"content": "Okay. Perfect. Thank you. Anirudh, there's a pretty interesting dynamic with your memory customers, right? They're big customers of your custom product family Virtuoso, but they are moving more and more to advanced digital design, right? The HBM control logic chip, for example, is moving to leading edge technologies and advanced chip design. Similarly, with some of your NAND customers, they're moving towards more of this sort of bonded CMOS periphery to array. The periphery chip again is also moving towards advanced digital design as well. So are you starting to see more adoption of your advanced digital implementation and verification products by your memory customers? And then does the leadership in memory via Virtuoso sort of give you an advantage as they bring on more advanced logic design capabilities?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, Harlan. That's a great observation and we are fortunate to have very deep and long standing partnership with all the major memory companies. At least there are three big ones and then maybe two the next level. But overall, we are -- given our strength, like you mentioned in Virtuoso, which is the platform for choice for all memory implementation. And yes, there is a lot more digital and implementation design happening at memory companies, primarily driven by HBM and other trends. And actually also there is some kind of -- I mean, they were always doing -- they were always doing digital, but it's lot more now. And there is trend of even integrating TSMC's technologies with kind of memory. And given our strong partnership with TSMC, that also helps us with the memory companies. And as you know, they are also doing a lot more 3D-IC, all the three big memory companies and these memory layers are going from -- they're actually one of the most advanced 3D-IC with the memory layers going from 8 to 12 and that also plays to our strengths. And even in my prepared remarks, I mentioned, for example, our partnership with Samsung and 3D-IC. And then so is true with the other kind of two major players in memory. So we are pleased in our position in memory and the emerging trends of HBM and 3D-IC integration and we'll see how that progresses. But I think memory is often overlooked in -- I don't need to tell you, but just in general, memory is often overlooked in the big AI super-cycle. It's not the big chips, logic chips, but memories play a very essential role and we are very well-positioned both with the leaders like NVIDIA on the logic side and then we highlighted Samsung and the other big memory players in general."
},
{
"speaker": "Harlan Sur",
"content": "Thank you for the insights."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jason Celino with KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Jason Celino",
"content": "Great. Thanks for taking my questions. So lots of questions so far on the hardware timing. But I think, John, on prior calls, you said that the hardware delivery times typically are like eight to 10 weeks, that's what it is for like a normal cycle. But are you saying the lead times for the Z3/X3 are longer than this because the demand is much better than what you're seeing?"
},
{
"speaker": "John Wall",
"content": "Demand is strong. Demand is strong. What I was trying to point out was that we do have inventory of the older systems that we can deliver right away. The newer systems we're having to build them as quickly as we can because the orders are coming in faster than we can build them. So the lead times is a bit of a moving target in that respect. We are planning to purchase a lot of raw materials and build as quickly as we can in Q3. So you'll see a significant uptick in our inventory balance at the end of Q3."
},
{
"speaker": "Jason Celino",
"content": "Okay. No, that's helpful. And then just a clarification, I think you were saying like the SDA group to hit your guide needed to do like mid to high-single digit growth with -- I'm not familiar with FDG, is that the functional verification kind of guide for the year? And then if you're parsing out, like does that imply like what do we need to see on IP since that's the other upfront component to hit the guide? Thanks."
},
{
"speaker": "John Wall",
"content": "Yeah. That's fair. That's -- yeah, IP is having a really, really strong year as is system design analysis, that'll be our two fastest growers for the year. And then again, there's some upfront revenue from them. It's more weighted towards Q4 versus Q3. So, we have the shape of the curve is really driving our guide and I would clarify -- I would categorize it as prudent. Anirudh, would you add anything?"
},
{
"speaker": "Anirudh Devgan",
"content": "No. That's right, John. And sorry for the acronym. SVG is System Verification Group. So, when we say SVG, that means verification. Yeah. So, I think that's what John was implying. Verification should grow, but right now, we are not assuming massive growth in verification for this year, but it should grow compared to last year. And then like you mentioned, some of the upfront revenue is also IP. If you remember, we highlighted in Q1, a new partnership with Intel and they are -- we are deploying our IP portfolio for the Intel process. So, it takes time to do that and deliver to that and some of it is in Q3 and Q4. And also this time, we talked about our expansion partnership with Intel on both on EMIB, their packaging and 3D-IC platform and 18A, just to clarify."
},
{
"speaker": "Jason Celino",
"content": "Very good stuff. And, yeah, thanks for the lingo acronym help, Anirudh. Very helpful."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Lee Simpson with Morgan Stanley. Please go ahead."
},
{
"speaker": "Lee Simpson",
"content": "Great. Thanks for fitting me in and well done in a good quarter. Just wanted to get some clarification. I don't know if I heard correctly, but I think I heard you say that a mobile OEM had taken the Z3 platform. And if that's the case, do you have a sense for what the emulation work might be? Would it be for chips on device or would it be for chips both on device and perhaps in, let's say, a network situation? Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Well, good question. We don't comment on individual customer or specific customer use cases, but in general, these hardware systems, as you know, are used both for chip design and for system software bring up. So, both use cases are there and we are the leading platform given Palladium and Protium and this is true for all -- even in the AI use case, even in the data center AI use case, lot of it is for software development. Actually Palladium is a platform for choice to even our AI chip customers to give a model to their customers because even before they have a chip, they can give a Palladium model to see how it performs. So, it's both for chip design and also for system design and system software. And that's true for multiple major verticals, data center, mobile, automotive, these things. Yes, thank you."
},
{
"speaker": "Lee Simpson",
"content": "Yeah. Thanks. Just on those multiple verticals, if we look at the incidence of 3D-ICs coming through, I get the sense that that's starting to hit the tape now in automotive. You have mentioned EV companies as a collaboration of late, but you have mentioned a number of chip makers also. I wonder if it's possible at this point or even if it's relevant to just maybe talk about the split between the customers? Are we talking system customers, i.e., OEMs and Tier-1s in the majority right now or is it still major semis, chip makers for the automotive work? Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "So, great question. So, first to -- yes, like you correctly pointed out, I think the 3D-IC is a lot more prevalent in automotive than, let's say, six to 12 months ago. And, of course, the original Genesis is HPC and data center AI, but now all these chiplets and 3D-IC platforms are moving to automotive, okay. And I think over-time, we'll move to other verticals like consumer. They already moved to laptop, for example. Several of the laptop chips are 3D-IC, but I think that will be the progression. It will gradually go to all verticals, but definitely active in automotive. Because, as you know, with the chiplet architecture, the customer doesn't have to redesign all the chips and also they can use some standard chips and have some specific chips which are more value added for them and that's particularly true in automotive as each OEM wants to differentiate versus the other OEM. So, this trend is not just for semi-companies to your question, it's also there in OEMs. And I think actually it'll be more -- I do think that the 3D-IC trend makes even more sense for end OEMs because then they're able to customize and differentiate versus the other. So, we are seeing that and we are seeing that in other geographies as well because as you know, China is pretty strong in EVs and then US and then Japan, there's a lot of activity. So, overall, I think automotive, there is more activity on 3D-IC, including both semi and end OEMs."
},
{
"speaker": "Lee Simpson",
"content": "Great. Thanks, Anirudh. Great color."
},
{
"speaker": "Operator",
"content": "Our next question comes from Clarke Jeffries with Piper Sandler. Please go ahead."
},
{
"speaker": "Clarke Jeffries",
"content": "Hello. Thank you for taking the question. My first question is, Anirudh, how do you expect the delivery of these third generation systems to translate to additional software consumption in the recurring revenue portfolio? These products are happening with verification acceleration software bring up, but how do you see that additional consumption panning out after the delivery of a new ZRX system? And then I have one follow-up."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Great question. I mean, like what John was saying, when we say SVG, System Verification Group, so hardware is part of that group. Even though hardware is a significant business, we organize as part of verification. And one of the big reasons for that is apart from -- in verification, apart from the hardware systems, we have a lot of other verification products which are doing pretty well like Jasper for formal verification, Xcelium for logic stimulation. And the customer is looking for an integrated solution on verification. To the earlier question that Jay had about what is happening in SDA, in EDA, we always have believed for last several years that it's going to be integrated solution in verification. So, the stronger our hardware products get, we do expect it should help our software verification products, things like Xcelium and Jasper and Verisium because lot of -- some of the hardware capacity is also used for what is called sim accel, simulation acceleration in which they use Palladium to accelerate logic simulation. So, there is a natural tie in between verification software products and verification hardware products. Now exactly how it pans out, we just have to see, but the strength in hardware should help us in our overall portfolio strength."
},
{
"speaker": "Clarke Jeffries",
"content": "Perfect. And then one follow-up for John. I think just to kind of finally put a cap on the whole discussion around timing. I guess, then is it fair to say that sort of $600 million odd of upfront revenue in the second half, maybe a majority of that is coming from IP and SG&A and not necessarily the Gen 3 systems and that maybe the interpretation is that there's going to be more of a demand curve in the beginning of '25 rather than this $600 million being strongly driven by third gen Palladium and Protium. Is that a fair takeaway?"
},
{
"speaker": "John Wall",
"content": "No. I think that is, Clarke. Yeah. That's exactly right. I mean, we always knew that it would take time to build the hardware system. So, we originally included that in our guide in the first place."
},
{
"speaker": "Clarke Jeffries",
"content": "All right. Perfect. Thank you for taking the questions."
},
{
"speaker": "Operator",
"content": "Our final question comes from Joe Vruwink with Baird. Please go ahead."
},
{
"speaker": "Joe Vruwink",
"content": "Great. Thanks for fitting me in. I did want to follow up to stay with verification and just this raw material investment. So, the thing I'm trying to reconcile is, I would imagine you entered this year expecting the new platform, strong demand, meeting the scale production and therefore invest in inventory. So, I guess, I'm wondering what changed in the quarter that warranted this updated assumption for cash flow and raw material purchase? And really at the heart of the question, did something change about your hardware demand expectation, not necessarily for 2024, but maybe out into 2025 and we just happen to be getting that news now because of the need to update your cash from OPs forecast associated with the inventory input?"
},
{
"speaker": "John Wall",
"content": "Yeah. That's a great question, Joe. I mean, the leaders of that business, I spent plenty of time with them this last quarter because they were monitoring what the demand was like for the new systems. Demand is quite strong. And then the key thing to highlight here is it's a one-time multi-year purchase of inventory raw materials. They feel very, very confident in the longevity of these systems and the longevity of that demand. And they wanted to pre-purchase multi-years of inventory in Q3. Now that was news to us, if you like. So we thought that one-time thing we wanted to include it all now in Q3 and not impact -- that doesn't impact next -- I mean, it will be favorable for next year's operating cash."
},
{
"speaker": "Joe Vruwink",
"content": "Okay. Great. Then lastly, you mentioned at the start, orders for Cadence.AI tripled year-over-year. I don't think that's possible without also getting a lift in the base business, both across EDA and SD&A. I guess, on an ACV run rate basis, what has the AI lineup meant for Cadence overall? And does this create a step up in value where as you start pulling these contracts from backlog in coming quarters, it will become more noticeable in revenue and we'll kind of see the AI contribution more than we have to this point?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah. Good question. I mean AI is adding the -- like I was mentioning before, I mean, it's almost become like table stakes now. So all our new contracts include our Cadence.AI portfolio as customers get more and more kind of used to using them. And once you start using the AI portfolio, it's difficult to go back to not using them. So without getting into like what happens exactly to future revenues and bookings, we are always cautious about that. But, in general, there is uptick with more customers deploying AI. And whenever we have new contracts, we are including them as it makes sense in them."
},
{
"speaker": "Joe Vruwink",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "I will now turn the call back to Anirudh Devgan for closing remarks."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you all for joining us this afternoon. It's an exciting time for Cadence with strong business momentum and growing opportunities with semiconductor and system customers. With a world class employee base, we continue in delivering to our innovative roadmap and working hard to delight our customers and partners. On behalf of our Board of Directors, we thank our customers, partners and investors for their continued trust and confidence in Cadence."
},
{
"speaker": "Operator",
"content": "Thank you for participating in today's Cadence second quarter 2024 earnings conference call. This concludes today's call. You may now disconnect."
}
] |
cdns | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good afternoon. My name is Regina and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence First Quarter 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. [Operator Instructions] Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead."
},
{
"speaker": "Richard Gu",
"content": "Thank you, operator. I'd like to Welcome everyone to our First Quarter of 2024 Earnings Conference Call. I'm joined today by Anirudh Devgan, President and Chief Executive Officer and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call and a copy of today's prepared remarks will be available on our website cadence.com. Today's discussion will contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q, CFO Commentary, and today's earnings release. All forward-looking statements during this call are based on estimates and information available to us as of today, and we disclaim any obligation to update them. In addition, we'll present certain non-GAAP measures which should not be considered in isolation from or as a substitute for GAAP results. Reconciliation of GAAP to non-GAAP measures are included in today's earnings release. For the Q&A session today, We would ask that you observe a limit of one question and one follow-up. Now I'll turn the call over to Anirudh."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you, Richard. Good afternoon, everyone. And thank you for joining us today. I'm pleased to report that Cadence had a strong start to the year delivering solid results for the first quarter of 2024. We came in at the upper end of our guidance range on all key financial metrics and are raising our financial outlook for the year. We exited Q1 with a better than expected record backlog of $6 billion, which sets us up nicely for the year and beyond. John will provide more details in a moment. Long-term trends of hyperscale computing, autonomous driving, and 5G, all turbocharged by AI super-cycle, are fueling strong broad-based design activity. We continue to execute our long-standing Intelligent system design strategy as we systematically build out our portfolio to deliver differentiated end-to-end solutions to our growing customer base. Technology leadership is foundational to Cadence and we are excited by the momentum of our product advancement over the last few years, and the promise of our newly unveiled products. Generative AI is reshaping the entire chip and system development process. And our Cadence.AI portfolio provides customers with the most comprehensive and impactful solutions for chip-to-systems intelligent design acceleration. Built upon AI-enhanced core design engines, our GenAI solution boosted by foundational LLM co-pilot are delivering unparalleled productivity, quality of results and time to market benefit for our customers. Last week at CadenceLIVE Silicon Valley, several customers including Intel, Broadcom, Qualcomm, Juniper, and Arm shared their remarkable successes with solutions in our Cadence.AI portfolio. Last week, we launched our third-generation dynamic duo, the Palladium Z3 emulation and Protium X3 prototyping platform to address the insatiable demand for higher performance and increased capacity hardware accelerated verification solutions. Building upon the successes of the industry leading Z2, X2 systems, this new platform set a new standard of excellence, delivering more than twice the capacity and 50% higher performance per rack than the previous generation. Palladium Z3 is powered by our next generation custom processor and was designed with Cadence AI tools and IP. The Z3 system is future proof with its massive 48 billion gate capacity, enabling emulation of the industry's largest design for the next several generations. The Z3 X3 systems have been deployed at select customers and were endorsed by Nvidia, Arm and AMD at launch. We also introduced the Cadence Reality Digital Twin Platform which virtualizes the entire data center and uses AI, high-performance computing, and physics-based simulation to significantly improve data center energy efficiency by up to 30%. Additionally, Cadence's cloud native molecular design platform Orion will be supercharged with Nvidia's BioNemo and Nvidia microservices for drug discovery to broaden therapeutic design capabilities and shorten time to trusted results. In Q1, we expanded our footprint at several top tier customers and furthered our relationship with key ecosystem partners. We deepened our partnership with IBM across our core EDA and systems portfolio, including a broad proliferation of our digital, analog and verification software and expansion of our 3D-IC packaging and system analysis solutions. We strengthened our collaboration with Global Foundry through a significant expansion of our EDA and system solutions that will enable GF to develop key digital analog RF/MM-Wave and silicon photonics design for aerospace and defense IoT and automotive end-markets. We announced a collaboration with Arm to develop a chiplet-based reference design and software development platform to accelerate software-defined vehicle innovation. We also further extended our strategic partnership with Dassault Systems, integrating our AI-driven PCB solution with Dassault's 3DEXPERIENCE Works portfolio, enabling up to a 5x reduction in design turnaround time for solid work customers. Now let's talk about our key highlights for Q1. Increasing system complexity and growing hyperconvergence between the electrical, mechanical, and physical domain is driving the need for tightly integrated co-design and analysis solutions. Our System Design and Analysis business delivered steady growth as our AI-driven design optimization platforms integrated with our physics-based analysis solution, continued delivering superior results across multiple end markets. Over the past six years, we have methodically built out our system analysis portfolio. And with the signing of the definitive agreement to acquire BETA CAE, are now extending it to structural analysis, thereby unlocking a multi-billion dollar TAM opportunity. BETA CAE is leading solutions have a particularly strong footprint in the automotive and aerospace verticals, including at customers such as Stellantis, General Motors, Renault, and Lockheed Martin. Our Millennium supercomputing platform, delivering phenomenal performance and scalability for high fidelity simulation is ramping up nicely. In Q1, a leading automaker expanded its production deployment of Millennium to multiple groups after a successful early access program in which it realized tremendous performance benefits. Allegro X continued its momentum and is now deployed at well over 300 customers. While Allegro X AI, the industry's first fully automated PCB design engine, is enabling customers to realize significant 4 times to 10 times productivity gain. Samsung used Celsius Studio to uncover early design and analysis insights to precise and rapid thermal simulation for 2.5D and 3D packages, attaining up to a 30% improvement in product development time. And a leading Asian mobile chip company use optimality intelligence system explorer AI technology and Clarity 3D Solver obtaining more than 20 times design productivity improvement. Ever-increasing complexities in the system verification and software bring-up continue to propel the demand of our functional verification products. With hardware accelerated verification, now a must have part of the customer design flow. On the heels of a record year, our hardware products continue to proliferate at existing customers, while also gaining some notable competitive wins, including at a leading networking company and at a major automotive semiconductor supplier. Demand for hardware was broad-based with the particular strengths seen at hyperscalers and over 85% of the orders during the quarter included both platforms. Our Verisium platform that leverages big data and AI to optimize verification workloads, boost coverage and accelerate root cause analysis of bugs saw accelerating customer adoption. At CadenceLIVE Silicon Valley, Qualcomm said that they used Verisium [Stem AI] (ph) to increase total design coverage automatically while getting up to a 20x reduction in verification workload runtime. Our Digital IC business had another solid quarter as our digital full flow continued to proliferate at the most advanced nodes. We had strong growth at hyperscalers, and over 50 customers have deployed our digital solutions on three nanometer and below design. Cadence Cerebrus, which leverages Gen.AI to intelligently optimize the digital full flow in a fully automatic manner now has been used in well over 350 tapeouts. Delivering best in class PPA and productivity benefits, it's fast becoming integral part of the design flow at marquee customers, as well as in DTCO flows for new process nodes at multiple foundries. In custom IC business, Virtuoso Studio, delivering AI-powered layout automation and optimization continued ramply, strongly, and 18 of the top 20 semi have migrated to this new release in its first year. Our IP business continued to benefit from market opportunities offered by AI and multi-chiplet based architecture. We are seeing strong momentum in interface IPs that are essential to AI use cases, especially HBM, DDR, UCIe, and PCIe at leading edge nodes. In Q1, we partnered with Intel Foundry to provide design software and leading IP solutions at multiple Intel-advanced nodes. Our TenSilica business reached a major milestone of 200 software partners in the Hi-Fi ecosystem, the de facto standard for automotive infotainment and home entertainment. And we extended our partnership with one of the top hyperscalers in its custom silicon SOC design with our Xtensa NX controller. In summary, I'm pleased with our Q1 results and the continuing momentum of our business. [Piling] (ph) chip and system design complexity and the tremendous potential of AI-driven automation, offer massive opportunities for our computational software to help customer realize these benefits. In addition to our strong business results, I'm proud of our high-performance inclusive culture and thrilled that Cadence was named by Fortune and Great Place to Work as one of the 2024's 100 best companies to work for, ranking number 9. Now I will turn it over to John to provide more details on the Q1 results and our updated 2024 outlook."
},
{
"speaker": "John Wall",
"content": "Thanks, Anirudh, and good afternoon, everyone. I am pleased to report that Cadence delivered strong results for the first quarter of 2024. First quarter bookings were a record for Q1 and we achieved record Q1 backlog of approximately $6 billion. A good start to the year coupled with some impressive new product launches, sets us up for strong growth momentum in the second half of 2024. Here are some of the financial highlights from the first quarter starting with the P&L. Total revenue was $1.009 billion. GAAP operating margin was 24.8% and non-GAAP operating margin was 37.8%. GAAP EPS was $0.91 and non-GAAP EPS was $1.17. Next, turning to the balance sheet and cash flow, cash balance at quarter end was [$1.012 billion] (ph). While the principal value of debt outstanding was $650 million. Operating cash flow was $253 million. DSOs were 36 days and we used $125 million to repurchase Cadence shares in Q1. Before I provide our updated outlook, I'd like to share some assumptions that are embedded in our outlook. Given the recent launch of our new hardware systems, we expect the shape of hardware revenue in 2024 to weigh more toward the second half, as our team works to build inventory of the new system. Our updated outlook does not include the impact of our [pending] (ph) BETA CAE acquisition and it contains the usual assumption that export control regulations that exist today remain substantially similar for the remainder of the year. Our updated outlook for fiscal 2024 is revenue in the range of $4.56 billion to $4.62 billion. GAAP operating margin in the range of 31% to 32%. Non-GAAP operating margin in the range of 42% to 43%. GAAP EPS in the range of $4.04 to $4.14. Non-GAAP EPS in the range of $5.88 to $5.98. Operating cash flow in the range of $1.35 billion to $1.45 billion. And we expect to use at least 50% of our annual free cash flow to repurchase Cadence shares. With that in mind, for Q2 we expect revenue in the range of $1,030 million to $1,050 million. GAAP operating margin in the range of 26.5% to 27.5%. Non-GAAP operating margin in the range of 38.5% to 39.5%. GAAP EPS in the range of $0.73 to $0.77. Non-GAAP EPS in the range of $1.20 to $1.24. And as usual, we've published a CFO commentary document on our investor relations website, which includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations. In summary, Cadence continues to lead with innovation and is on track for a strong 2024 as we execute to our intelligent system design strategy. I'd like to close by thanking our customers, partners, and our employees for their continued support. And with that operator, we will now take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Joe Vruwink with Baird. Please go ahead."
},
{
"speaker": "Joe Vruwink",
"content": "Great. Hi everyone. Thanks for taking my questions. Maybe just to start with your outlook for the year. Can you perhaps provide maybe your second half assumption before this quarter versus where it stands today in terms of just recalibrating around delivery schedules and maybe a good way to frame it, I think in the past you gave a share of this year's revenue that was going to come from upfront products. Is that still the right range? But if it is the right range, you can obviously see more is going to end up landing in the second half. And so that kind of puts to your original views or how is that, I guess, skewed relative to what might have been the expectation a quarter ago?"
},
{
"speaker": "John Wall",
"content": "That's a great question, Joe. And I think you've hit on the main point there that upfront revenue is driving a lot of the quarter-over-quarter trends this year. That -- when I look at last year, you recall that we had a large backlog of hardware orders and we dedicated 100% of the production, hardware production in Q1 to deliver that hardware in Q1 2023. As a result, in Q1 2023, 20% of our Q1 ‘23 revenue was from upfront revenue sources. That in contrast, Q1 this year, it's only 10% of the total revenue for this Q1 is coming from upfront revenue. But again, last year, and to reflect on where we thought we were this time last quarter, that we still expect that upfront revenue will probably be 15% to 20%. I mean, around the midpoint there is 17.5% in expectation for upfront revenue this year. And a midpoint of say 82.5% for recurring revenue. That's still the same as what we thought this time last quarter. That contrast with last year was I think 16% of our revenue was upfront last year. And to put dollar terms on it, last year $650 million of our revenue was upfront. This year, we're expecting roughly $800 million to be upfront. But the first half versus first half, last year, we had $350 million in the first half and $300 million in the second half because we had prioritized all those shipments in hardware and it skewed the numbers toward the first half last year. So $350 million and $300 million ending with the $650 million of upfront revenue last year. This year it looks more like $250 million and $550 million at the back end. But I know that's largely as a result of, we had a record backlog, our record bookings quarter in Q1. We've got a substantial backlog in IP that we're scaling up to deliver, a lot of that revenue falls into the second half. And also we launched these new hardware systems last week. Hardware revenue is expected to be more second half weighted now, because based on what we've heard, and I'll let Anirudh chime in here on the technical aspects of the new hardware systems, but we expect them to be so popular that a lot of demand will shift to those new hardware systems and we'll have to ramp up production to be able to deliver that demand. So it shifts some of the upfront revenue to the second half. So I think upfront revenue is really driving a lot of the skewed metrics. Anirudh, do you want to talk about Z3?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, absolutely. So we are very proud of the new systems we launched. As you know, we are a leader in hardware-based emulations with Z2 X2. And last time we launched them was in 2021. So that was like a six-year cycle. You know Z1 X1 was 2015 and then Z2 X2 was 2021. So what I'm particularly pleased about is, we have a major, major refresh, you know, it's a game-changing product, but it was also developed in only three years. So in 2024, we have a new refresh and it's a significant leap in terms of capacity. And even last week at our CadenceLIVE conference, Nvidia and Jensen talked about how they use Z2 to design their latest chip like Blackwell. And it's also used by all the major silicon companies and system companies to design their chips. But what is truly exciting about Z3 and X3 is this a big leap, it’s like Z3 is 4 times or 5 times more capacity than Z2. It's a much higher performance. So it sets us up nicely for next several years to be able to design the several generations of the world's largest chips. So that's the right thing to do. And the reason we can do it in three years versus six years is, we use our own design internally in Cadence for TSMC advanced node. So we're using all our latest tools, all the latest AI tools, we are using all our IP. There's a very good validation of our own capabilities that we can accelerate our design process, but really sets up hardware verification and overall verification flow for using the new systems. Now, as a result, normally there is a transition period when you have a new system and we went through that twice already in the last 10 years. And the customers naturally will go to the new systems and then we build them over next one or two quarters. But that is the right thing to do for the business long-term. The time -- it's good to accelerate the -- because these AI chips are getting bigger and bigger, right? So the demand for emulation is getting bigger and bigger, and I can give you more stats later. So we felt that it was important to accelerate the development of the next generation system, to get ready for this coming AI wave for next several years, and we are very well positioned. As a result, it does have some impact on quarter-to-quarter, but that's well worth it in the long run."
},
{
"speaker": "Joe Vruwink",
"content": "That's all very helpful, Thank you. Second question, I wanted to ask how -- some of the things you just spoke of, but also AI, start to change the frequency of customers engaging with you, how they approach renewals. So you just brought up how the [Harbor] (ph) platforms, the Velocity, there has improved from first generation to next six years. Now we're down to a three year new product cycle. When I listened to your customers last week talk about AI, they're not just generating ML models that can be reused, but then, of course, each run becomes better if you're incorporating prior feedback. So it would just seem like AI itself not only creates stickiness, but there would be an incentive to deploy it maybe more broadly than a customer traditionally would think about deploying new products. Does that mean the average run rates of a renewal ends up becoming much bigger and we'll start to see that flow in the backlog?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, that's the correct observation. You know, like as you know, what we have said before, AI has a lot of profound impact to Cadence, a lot of benefit to our customers. So there are three main areas. One is, you know, the build out of the AI infrastructure, whether it's Nvidia or AMD or all the hyperscalers. And we are fortunate to be working with all the leading AI companies. So that's the first part. And in that part, as they design bigger and bigger chips, because the big thing in AI systems is they are parallel. So they need to be bigger and bigger chips. So the tools have to be more efficient, the hardware platform have to support that. And that's why the new systems. Now, the second part of AI is applying AI to our own products, which is the Cadence.AI portfolio. And like you mentioned last week, we had several customers talking about success, you know, with that portfolio, including Intel, you know, like I mentioned Intel, Broadcom, Qualcomm, Juniper, Arm, and the results are significant. So we are no longer in kind of a trial phase of whether these things will work. Now we're getting pretty significant improvements. Like we mentioned, MediaTek got like 6% power improvement. And one of the hyperscale companies got 8% to 10% power improvement. These are significant numbers. So it is leading to deployment of our AI portfolio. And I think we mentioned like the AI run rate on a trailing 12 months basis is up 3x. And I think design process already was well automated. EDA has a history of automating design over the last 30 years. So AI is in a unique position because you need the base process to be somewhat automated to apply AI. So we were already well automated and now AI can take it to the next level of automation. So that's the second part of AI which I'm pretty pleased about, is applying to our own product. And then the third part of AI proliferation is new markets that open up, which things like data center design with reality that we announced or Millennium, which is designing systems with acceleration or digital biology. Those are like a little, they take a little longer to ramp up, but we have these three kinds of impact of AI. The first being direct design of AI chips and systems. Second, applying AI to our own products. And third being new applications of AI."
},
{
"speaker": "Joe Vruwink",
"content": "That's great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line at Charles Shi with Needham & Company. Please go ahead."
},
{
"speaker": "Charles Shi",
"content": "Thanks. Good afternoon. I just wanted to ask about the China revenue in Q1. It looks pretty light. I just wonder whether that's part of the reason that's weighing on your Q2. I understand you mentioned that you're going through that second-gen to third-gen hardware transition right now. Maybe that's another factor, but from your geographical standpoint, is what's the outlook for China for the rest of the year and specifically Q2. Thanks."
},
{
"speaker": "John Wall",
"content": "Hi Charles, that's a great observation. If you recall this time last year we were talking about a very strong Q1 for China for functional verification and for upfront revenue. I think those three things are often linked. You contracted with this year, China is down at 12%. Upfront revenues is lower at 10% compared to 20%. And functional verification, of course, is lapping those really tough comps when we dedicated 100% production to deliveries. I think when you look at China, we're blessed that we have the geographical diversification that we have across our business. But -- what we're seeing in China is strong design activity. And while the percentage of revenue dropped to 12%, it pretty much goes in-line with a lower hardware, lower functional verification, lower upfront revenue quarter would generally lead to a lower China percentage quarter. But we have good diversification. While China is coming down, we can see other Asia increasing and our customer base is really mobile. That geographical mix of revenue is based on consumption and where the products are used. But as we do more upfront revenue in the second half, we'd expect the China percentage to increase."
},
{
"speaker": "Charles Shi",
"content": "Thanks. I want to ask another question about the upcoming ramp of the third generation hardware. Where exactly is the nature of the demand? Is it the replacement demand, like your customers replacing your Z2 X2 with the Z3 X3, or you expect that lot more great deal of customers adopting Z3 X3 and more importantly I think you mentioned about 4 times to 5 times capacity increase they can design a larger -- much larger chips with a lot more transistors. How much of an ASP uplift you are expecting from the Z3 X3 versus Z2 X2?"
},
{
"speaker": "Anirudh Devgan",
"content": "Charles, all good observations. So let me try to answer that one by one. So, I mean, in terms of your last point, normally if the system has more capacity like this one has, it can do more. So it produces, it gives more value to our customers. So we are able to get more value back. So typically newer systems are better that way for us and better for the customer. And to give you an example, I mean, these things are pretty complicated. So, we'll just take Z3 for example. So Z3 itself, we designed this advanced TSMC chip by ourselves and this is one of the biggest chips that TSMC makes. And one rack will have like, more than a hundred of these chips. And then we can connect like up to 16 racks together. So if you do that, you have thousands of full radical chips emulating -- that's, and these are all liquid cooled connected by optical and InfiniBand interconnect. So this is like a truly a multi rack supercomputer. And what it can do is just emulate very, very large systems very, very efficiently. So even Z2, like Nvidia talked about it last week, even Blackwell, which is the biggest chip in the world right now with 200 billion transistors, was emulated on few racks of Z2. Okay, so now with 16 rack of Z3, we can emulate chips which are like 5 times bigger than Blackwell, which is already the biggest chips in the world, right? So that gives a lot of runway for our customers because with AI, the key thing is that is the capacity of the chip needs to keep going up, not just a single chip. Look at Blackwell, they have two full radical chips on a package. So as you know, you will see more and more, not just big chips on a single node, but multiple chips in a package for this AI workload and also 3D stacking of those chips. So what this allows is not just emulating a single large chip, but multiple chips, which is super critical for AI. So I think this is what I feel that this puts us in a very good position for all this AI boom that is happening, not just with our partners like Nvidia and AMD, but also all the hyperscalers companies. And so that will be the primary demand is more capacity chips require more hardware. And then X3 will go for that with the software prototyping which is used on FPGA. And then we have some unique workload capabilities apart from size of these big systems being, the capacity being much better and performance, there are new features for low power, for analog emulation that helps in the mobile market. So we talked about Samsung, working with us, especially on this four state emulation, which is a new capability in emulation over the last 10 years. So I think it's just -- it's a combination of new customers, a combination of competitive win, but also continuing to lead in terms of the biggest chips in the world which are required for AI processing now and you know years from now. I think the size of these chips as you know is only going to get bigger in the next few years and we feel that Z3 X3 is already set up for that."
},
{
"speaker": "Charles Shi",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Lee Simpson with Morgan Stanley. Please go ahead."
},
{
"speaker": "Lee Simpson",
"content": "Great, thanks. And thanks very much for squeezing me on. Just wanted to go back to what you said last quarter, if I could. It did seem as though you were saying that there was an element of exclusivity around your partnership with Arm, your EDA partnership around Arm total design. I wondered how that was developing, if indeed you're collaborating to accelerate the development of custom SoCs using Neoverse. It looks as though it's pulled in quite a lot of work or continues to pull in quite a lot of work around functional verification. And I guess as we look at now third generation tool sets for Palladium and Protium, leaving aside some of the rack scale development that we're seeing out there, whether or not Arm’s total design, I guess development work is pulling in or is likely to pull in some of that second half business. That means not just hyperscalers, but perhaps in AI PCs and beyond. Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, thank you for the question. I mean, we are proud to have a very strong partnership with Arm and with our joint customers, Arm and Cadence customers. I think we have had a very strong partnership over the last 10 years, I would like to say, and it's getting better and better. You know, and yes, we talked about our new partnership on Total Compute. Also, I think this quarter we talked about our partnership with HARMAN Automotive. Because what is interesting to see, which of course you know this already, but Arm continues to do well in mobile, but also now in kind of HPC server and automotive end markets. So we are pleased with that partnership, you know, and they are also doing more subsystems and higher order development and that requires more partnership with Cadence in terms of the backend, Innovus and Digital Flow and also verification with hardware platforms and other verification tools."
},
{
"speaker": "Lee Simpson",
"content": "Great, maybe just a quick follow up. You know, we've seen quite a bit of M&A activity from yourselves of late, you know, including the IP house acquisition of Invecas. You've had Rambus bought, you've now acquired BETA in the computer-aided emulation space for the car. There's been quite a lot of speculation in the market about the possibility of a transformative deal being done. I guess, given that we have you on the mic here, maybe if you get a sense from yourself, what would be the sort of thing that a business like Cadence could look for? Would you look for a high value and a contiguous vertical to what you've already addressed, let's say in automotive, or would it be something more waterfront, a business that spans several verticals, maybe being more relevant across the industrial software space? Could that be the sort of ambition that Cadence would have given the silicon to systems opportunities that are emerging? Thanks."
},
{
"speaker": "Anirudh Devgan",
"content": "Well, thank you for the question. And a lot of times there are a lot of reports and we don't normally don't comment on these reports and people get very creative on these reporting. But What I would like to say is that our strategy hasn't changed. It's the same strategy from 2018. First of all, I want to make sure that we are focused in our core business, which is EDA and IP. And, yes, I launched this whole initiative on systems and it's super critical, you know, chips silicon to systems. But what is one thing that I even mentioned last time, what is different from 2018 to now, is that EDA and IP is much more valuable to the industry. You know, Our core business itself has become much more valuable because of AI. So our first focus is in our core business. We are leading in our core business. Our first focus is on organic development. That's what we like. We always say that's the best way forward. Now, along with that, we will do some, we have done, like you mentioned, some opportunistic M&A, which is usually, I would like to say, the tuck-in M&A in the past. And that adds to our portfolio, it helped us in system analysis. We also did it in IP because I'm very optimistic about IP growth this year. And we talked about our new partnership with Intel Foundry in Q1. Also, we acquired Rambus IP assets, which are HBM. And HBM is of course a critical technology in AI. And we are seeing a lot of growth in HBM this year. Now, if we have booked that business, the deliveries will happen towards second half of the year, as John was saying earlier. But so that's the thing. Now in terms of BETA, it made sense because it is a very good technology. It's the right size for us. And we are focused on finishing that acquisition, and also integrating that -- that will take some time. So that's our primary focus in terms of M&A. And it's a very good technology. They have very good footprint in automotive and aerospace vertical. So just to clarify, we have the same strategy from ‘18, and that's doing working as well. It's primarily organic with very synergistic computational software, mostly tuck-in acquisitions."
},
{
"speaker": "Lee Simpson",
"content": "That's great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ruben Roy with Stifel. Please go ahead."
},
{
"speaker": "Ruben Roy",
"content": "Thank you. Anirudh, I had a follow up on the Z3 X3 commentary that you had. And one of the things I was thinking about, especially as you talked about the InfiniBand low latency network across the multiple racks of Z3, you had mentioned that you're up to 85% attach rate of both systems with the Z2 X2. I would imagine that would continue to go up and if you can comment on if the new systems incorporate InfiniBand across Z3 and X3 and if so, do you expect that to be sort of a selling point for your customers that are designing these big chips, which in many cases these days have software development attached to the design process. Do you think that the attach rates continue to move higher for both systems?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes, absolutely. I think I started this in, I forget now, 2016, I think, in a Dynamic Duo are ‘15 and ‘16, which is we have a custom processor for palladium and we use FPGA for Protium. So this is what we call dynamic duo, because then palladium is best in class for chip verification and RTL design, and Protium is best-in-class for software bring up and with the common front end. So as a result, over the years, this has become the right approach. And our customers are fully embracing both these systems as they invariably do both chip development and software development. I mean, perfect example is of course, our long-term development partner, Nvidia. I mean, Nvidia is no longer doing just chip development. They have a massive software stack. And that's true for all the hyperscalers. So we see that trend continuing. And now we do use, you know, Nvidia's products like InfiniBand in our systems on Z3 to your question, which is, because Z3 is a very unique architecture. So it requires very, very high speed interconnect. So it's almost like a super computer. So then it requires optical and InfiniBand in Z3. Now in X3, we are using AMD FPGAs, which are fabulous, but it does not require that tight interconnect speed. So InfiniBand is more used in Z3 versus X3. But X3 is a great system too, we're using the latest AMD FPGAs, it has 8x higher capacity than X2, and all kinds of innovation on the software side as well. So we are very pleased -- I'm very confident that we have true leadership in these hardware platforms, both Palladium and Protium. And we're also pleased, like I said earlier, that we are able to refresh it much sooner than the market expected, given our track record. And then we are seeing a lot of demand for both of these systems together going forward."
},
{
"speaker": "Ruben Roy",
"content": "That's helpful. Thank you, Anirudh. And then a follow up for John. Anirudh mentioned HBM IP business, booked and shipping in second half. I was wondering if you can kind of give us a bigger picture update on how you're viewing IP in general in terms of bookings relative to sort of ramps of those IP sales. Is it sort of the entire segment sort of a second half? Should we think about the second half ramping at a heavier weight than first half or any update there would be helpful?"
},
{
"speaker": "John Wall",
"content": "Yeah, thanks Ruben. I mean Q1 IP performance and bookings were ahead of our expectations. And everything remains on track there for a very strong growth year for 2024 for the IP business. Of course, the timing of revenue recognition depends on the timing of deliveries, but we had a tremendous bookings quarter in Q1 and we're preparing to scale for a number of deliveries of IP in the second half, but we expect the IP to have a very strong year this year. We're pleased with the overall business momentum, but we need to scale up some headcounts to prepare to deliver on some of the larger backlog orders."
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah, 1 thing, I want to highlight, I think you may have seen this, I just want to highlight our partnership with Intel and IFS. That was concluded in Q1. And so it's really good to see, you know, [Pat] (ph) and Intel investing more in the foundry business and also working more closely with us. So that's also a key contributor to IP, but like John said, we have to hire the people, do the -- we need to port our portfolio to the Intel process, okay? And that takes some time. So that's more will come towards the end of the year and next year. But we are pleased with that new partnership on IP."
},
{
"speaker": "Ruben Roy",
"content": "Very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Thank you. For you -- John, first, and then Anirudh. So for John, thinking back to a recent conversation we had, could you comment as a measure of EDA market health or dynamics, what you're seeing or expecting in terms of intra-contract new or expansion business. You know, this is an ongoing phenomenon in EDA, maybe talk about what you're seeing in that kind of business beyond the customer renewals schedule. And then relatedly, how are you thinking about pricing for this year given that EDA generally has substantially better pricing capacity than you might have had years past. And then my follow up for Anirudh."
},
{
"speaker": "John Wall",
"content": "Sure, thanks, Jay. Great question. I think what you're getting at there is what we would call add-ons. Typically, we have the very predictable software renewal business. And you'll see in the recurring revenue part of our business, I think we're at double digit revenue growth. But over the past few years, I think that's been at low teens. But we're seeing that a number of customers that have adopted AI tools are maybe not coming back and purchasing add-ons as frequently, but right now we're focused on proliferating those AI tools into accounts. I think there's an opportunity to increase pricing there, but maybe now is not the right time. I think we have such strong momentum on the upfront revenue business. We're preparing for scale into the second half there. But we'll have plenty of revenue growth in the second half of the year. We can continue to focus on proliferating our AI tools and technology into accounts. And pricing is something certainly we can focus on more intently in future years, but right now the focus is on proliferation. Anirudh, do you have anything to add to that?"
},
{
"speaker": "Anirudh Devgan",
"content": "No."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Okay, Anirudh so [piggyback] (ph) to your conference last week, particularly the Gen AI track, it was interesting of course to hear the adoption presentations by Renesas, Intel and so forth. But what seemed to be taking place is a heavy focus on Cerebrus which makes sense, it is the one longest end-market. So perhaps you could talk about how you are thinking about the adoption curve for the other brands aside from Cerebrus? And are there any critical parts of the design flow that might not necessarily be amenable to AI enablement. We hear a lot about implementation, analog, verification but we don't hear a lot about AI as being applicable to synthesis, for example. So maybe talk about those areas where it makes a lot of sense and knows where perhaps it will remain more or less conventional technology."
},
{
"speaker": "Anirudh Devgan",
"content": "Yes. Thanks, Jay for the question. So as you know, we have five major AI platforms with Cerebrus and Digital implementation being the one that has been out the longest and Cerebrus is doing quite well, like you noted. And we also commented on more than 350 tapeouts, lot of PPA improvement. But all the other ones are doing well, too. Sometimes we have like too many products, we don't talk enough about the others, but like verification, like Verisium is doing quite well. And I mentioned Qualcomm last week talked about pretty impressive results because verification, as you know is an exponential problem, because as the chips get bigger, the verification task gets exponentially bigger. So the benefit of AI can be significant in verification. So I think, you will see that in the next few quarters and years that verification will be as important as implementation in terms of benefits of AI. And then the other area I’d like to highlight is PCB and Allegro and Packaging because that area hasn't seen that much automation. And PCB – and Allegro is a leading-platform for packaging and PCB, but really proud of Allegro X AI. And we talked about several customers, including Intel last week talked about 4x to 10x improvement using X AI in PCB. So apart from Digital, I think the next two ones, I feel are verification and Allegro and PCB and then the areas that haven't done as well, I mean is more not in design optimization is like design generation. And I think, there -- this LLM based models do provide a lot of promise. So historically, we haven't done as much design-generation, which is -- this is like almost pre-RTL, right going from Spec to RTL. That's the -- truly the creative part of the design process. And then once you have RTL, it is more optimization part in digital and verification. So I think that's where we have to see, but some initial results, which we haven't talked but I think mentioned last week. But we work with a -- but we have to see it still in early stages, but we work with one or two customers in which we took like a 40, 50 page Spec document, this English document, and able to automatically generate RTL from it, okay? And the RTL quality is pretty good. So again we have to see how that goes, but that requires these really advanced LLM capabilities. So that's something to be seen. But if that works well, that could be another kind of very interesting kind of application of Gen AI."
},
{
"speaker": "Jay Vleeschhouwer",
"content": "Okay, very good. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gary Mobley with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Gary Mobley",
"content": "Hi guys. Thanks so much for taking my questions. John, I appreciate the fact that China revenue in the first quarter was down against a tough year-ago comp on the hardware verification side as you work on backlog. And I assume that you still expect China to be dilutive to overall company growth in the fiscal year. Could you speak to whether or not you are starting to see US export controls begin to impact your ability to do business there, whether that be a function of restrictions around gate-all around or certain China customers added to the entity list."
},
{
"speaker": "John Wall",
"content": "Hi, Gary, thanks for the question. And just to clarify, I think last quarter, I said I expected China revenue to be flat to down this year. I think, we still expect that. And that's because last year was such a strong year and there was a lot of -- there was kind of an oversized-portion of that hardware catch-up that we had that was delivered to China. So I think, it skewed the China number higher last year. So we are lapping pretty tough comps. But the design activity in China remains very strong, though. And -- we have a lot of diversification. There is strength in other parts of the world -- but we're very comfortable with the 2024 outlook and we factored all the impact of geopolitical risk in there to the best we can and try to derisk China, as much as we can in our guide."
},
{
"speaker": "Gary Mobley",
"content": "Okay. The follow up, I want to ask about bookings trends for the balance of the year. You obviously highlighted better than seasonal Q1 booking trends. How would you expect the bookings to play out for the balance of the year? And to what extent will Z3 and X3 factor into that for the balance of the year? Thank you."
},
{
"speaker": "John Wall",
"content": "Yes. I mean, it's hard to predict in terms of Z3 and X3 that we definitely need another quarter to see that. I expect -- we expect strong demand and we expect strong revenue growth into the -- that we are preparing for scale into the second half on the hardware side, but we need to at least see another quarter of demand. And normally with hardware, I don't like taking up the year for hardware until I see the pipeline in the summer. So we are trying to be conservative there. But generally on the hardware side, yes we are basically preparing for scale we’re trying to build -- we'll build those systems as quickly as possible. We expect strong demand there."
},
{
"speaker": "Gary Mobley",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jason Celino with KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Jason Celino",
"content": "Hi, thanks for [heading] (ph) me. And Anirudh, congrats to your R&D team. [I] (ph) -- Impressed that they reduced the cycle there, all while designing that among [box] (ph), too, right? So -- maybe first, just how many of the -- for the Z3 and X3, does it become available in Q3? I guess when can customers start putting orders in for that?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yes. First of all, thanks. And yes, they become available now, okay? But it will ramp Q3 and then Q4. But we already have them running at several early customers. So I mean, normally when we announce something, as you know, like and one of our lead partners, they have been running for three months already and very stable. But in general, it will be more Q3 and then Q4 in terms of -- because normally, in any system, there is like a three months to six months kind of overlap. So we will still sell Z2 X2, and then move to Z3 X3, so that's a natural part. And that's also contributing to this quarter-by-quarter variation a little bit, but it will ramp. And Q3 will be bigger and then Q4 should be bigger than that."
},
{
"speaker": "John Wall",
"content": "Yeah, we try to derisk the guide -- with the assumption that there is going to be strong demand for the newer systems. But it will give us the opportunity to put some of the older systems into the cloud because we have a large underserved community that want to use our emulation capacity. But we haven't had a lot of capacity to share with them through our cloud offering. To the extent we do that, that will lead to ratable revenue though, because I think when it is used in the cloud, you get revenue over time, whereas when we deliver and they use it on-prem, we take revenue upfront."
},
{
"speaker": "Anirudh Devgan",
"content": "But the demand it -- takes like one to two quarters to ramp…"
},
{
"speaker": "Jason Celino",
"content": "Okay. Because that's kind of -- what I was going to ask next is I think last time in 2021, you had like a six month period where you are selling both. And I think, you were trying to clear inventory for the Z1 and X1. It doesn't sound like you will be trying to do that again. Because when I think, about this Q2 air pocket, is it a function of customers waiting for Z3 X3? Or is it a function of they might not want to buy the older version?"
},
{
"speaker": "John Wall",
"content": "Well, the guide -- we've de-risk the guide on the assumption that many customers might wait. But we intend to sell them side by side. But to the extent the customers wait, it will shift some hardware revenue into the second half of the year. And we have anticipated that. So that's within the guide. To the extent the customers continue to buy Z2. And we're not putting those into the cloud, but selling those outright as well. Well, then that will change the profile of the shape of revenue. But we expect that this new system, the strength of this new system will trigger a lot of demand for it."
},
{
"speaker": "Jason Celino",
"content": "Okay, perfect. Thank you both."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Vivek Arya with Bank of America Securities. Please go ahead."
},
{
"speaker": "Vivek Arya",
"content": "Thank you for taking my questions. I think you mentioned second half growth will be driven a lot more by hardware. Do you think you will see all the benefit of the hardware refresh within this year? Will it be done? Will it continue into 2025. I guess my bigger question really is that if I exclude the upfront benefit from last year and this year, your recurring business is expected to grow about 10%. And I'm curious, Anirudh, is that in-line with the kind of recurring revenue growth you are expecting or we should be expecting going forward, right along with periodic hardware refreshes -- or is that not the right way to interpret your core recurring part of your business?"
},
{
"speaker": "Anirudh Devgan",
"content": "Very good question. First of all in non-recurring, it's not just hardware, but it's also IP in terms of the second half because like we mentioned, we have new IP business driven by HPM and AI and also by Intel IFS. So that is also back-end loaded along with hardware. And then hardware, hardware normally when we launch a new system, it takes one years or two years for it to fully. So even though we are not commenting about next year, I would be surprised if this time, it's only a six month impact. So I expect like these things is built for to be used in design for next five years, seven years. So the impact will be also not just this year but following years. And in terms of recurring revenue, I think the best way like we have said is to look at a three year CAGR basis because there could be some fluctuation in all. And overall, we are pleased with the recurring revenue growth and we go from there."
},
{
"speaker": "John Wall",
"content": "Yes. And Vivek if I could -- I'd like to kind of take -- carry in some of Gary's question earlier that I don't think I addressed because he was asking about the bookings profile for the year. Q2 for software renewals, I think is our [latest] (ph) software renewals quarter for the year. But I think, we explained last quarter that we expect the weighting of bookings first half to second half to be about 40-60 this year. But the recurring revenue right now in the guide is about double digits -- above 10%. And in the past, it's been about 13%. Now we are not really anticipating a huge number of add-ons, but to grow that above 10%. To the extent that, that comes through, it will be upside to the guide. But what we try to do when we do the guide is de-risk for the risks that we can see."
},
{
"speaker": "Vivek Arya",
"content": "Thank you. For my follow-up question on incremental EBIT margin. Do you think this greater mix of hardware is impacting the incremental EBIT margin. I think, if I calculate it correctly, the new guidance is still below the 50% incremental, right, or right about -- which is lower than what you have had the last two years, three years. Is that the right interpretation? And what can change that?"
},
{
"speaker": "John Wall",
"content": "Yes, Vivek, I think what you are referring to really is that, I mean, for what, seven years in a row now, we think we've been achieving over 50% incremental margins. It's a matter of pride here, we try to achieve that every year -- we'll certainly be trying to achieve that this year. I think we are in the high 40s. It's probably about 47% when you look at this guide right now. I think, one of the biggest challenges with something like that is you know, we do small tuck-in M&A, but I don't want to go over Lee Simpson – answer Anirudh gave to Lee Simpson, but organic is delicious here. At Cadence, we focus on innovation and growing with organically driven products and then with small tuck-in M&A. But to the extent that we do some larger M&A and of course, we have BETA CAE, which apparently is the gold standard in structural simulation. So that's a big acquisition for us. But -- now I think the size of that probably still qualifies as a small tuck-in. But when you do something like that -- that those M&A transactions typically are headwinds to that incremental margin calculation in the short-term, they will be beneficial in the long-term. But in the short-term, M&A can be -- dilutive pretty much in the first year and then becomes accretive later. When we look at our incremental margin that's a headwind. But we try to overcome that headwind because normally, all we do with these small tuck-in M&As So I haven't given up on 50% incremental margin for this year. It's a challenge, but we'll do our best to achieve this."
},
{
"speaker": "Vivek Arya",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your final question will come from the line of Harlan Sur with JPMorgan. Please go ahead."
},
{
"speaker": "Harlan Sur",
"content": "Good afternoon. Thanks for taking my question. After a strong 2023, SDA is starting the year relatively flattish and down about 5% to 6% sequentially. I think, like -- it's an unusual starting point for SDA, especially given all of the drivers that you guys have articulated. Is SDA expected to also be more second half loaded? And do you expect SDA, this is ex BETA CAE, but do you expect SDA to grow in-line or faster than your overall corporate growth target for the full year?"
},
{
"speaker": "John Wall",
"content": "Yes, Harlan. That's a great question. And thanks for highlighting that -- because I had that on my list of things to say. I think there's something funny going on with the rounding on when you kind of apply the growth rates for SDA for Q1 over Q1, the actual growth rate is probably high single digits Q1-over-Q1. I know, that's lapping tough comps against Q1 '23. I think, if you look on a two year CAGR basis, I think it's up about 17% per annum on a two year CAGR basis for SDA. But we're expecting strong SD&A growth again this year, and it will be higher than the Cadence average. That's our expectation."
},
{
"speaker": "Harlan Sur",
"content": "Great. Thanks for that. And then Anirudh lots of new accelerated compute AI SoC announcements just even over the past few weeks where we saw flagship Blackwell GPU announcement by one of your big customers Nvidia. But we've actually seen even more announcements by your cloud and hyperscale customers bringing their own custom [ASIC] (ph) to the market with Google with TPU V5, Google with their Arm-based CPU ASIC; Meta unveiled their Gen 2 TPU AI classes of chips as well. And in addition to that, like their road maps seem to be accelerating. So can you give us an update on your systems and hyperscale customers? I mean are you seeing the design activity accelerating within this customer base? And is the contribution mix from these customers rising above that sort of roughly 45% level going forward?"
},
{
"speaker": "Anirudh Devgan",
"content": "Yeah Harlan, that's a very good observation. And the pace of AI innovation like is increasing and not just in the big semi companies, but of course, in these system companies. And I think several announcements did come out, right, including, I think now Meta is public that Meta is designing a lot of silicon for AI, and of course, Google, Microsoft, Amazon. So all the big, really hyperscaler companies, along with Nvidia, AMD, Qualcomm, all the other kind of Samsung had AI phone this year. So I mean, there is a lot of acceleration both on the semi side and on the system side. And we are involved with all the major players there, and we are glad to provide our solutions. And I do think -- and this is the other thesis we have talked about for years now, right, five years, seven years that the system companies will do silicon because of a lot of reasons for customization, for schedule and supply chain control for cost benefits, if there is enough scale. And I think, the workload of AI, like if you look at I think some of the big hyperscaler and social media companies, they are talking about using like 20,000, 24,000 GPUs to train these new models. I mean this is immense amount. And then the size of the model and the number of models increased, so that could go to a much, much higher number than right now that is required to train these models and of course, to do inference on these models. So I think, we are still in the early innings in terms of system companies developing their own chips and at the same time, working with the semi companies. So I expect that to grow and those that -- our business with those system companies doing silicon, I would like to say is growing faster than Cadence average. But the good thing is the semi guys are also doing a lot of business. So I don't know, if that 45% will -- because that's a combination of a lot of companies. But overall, the AI and hyperscalers, they are doing a lot more than so are the big semi company."
},
{
"speaker": "Harlan Sur",
"content": "Perfect. Thank you."
},
{
"speaker": "Operator",
"content": "I'll now turn it back over to Anirudh Devgan for closing remarks."
},
{
"speaker": "Anirudh Devgan",
"content": "Thank you all for joining us this afternoon. It is an exciting time for Cadence as our broad portfolio and product leadership highly positions us to maximize the growing opportunities in the semiconductor and systems industry. And on behalf of our employees and our Board of Directors, we thank our customers, partners and investors for their continued trust and confidence in Cadence."
},
{
"speaker": "Operator",
"content": "Thank you for participating in today's Cadence first quarter 2024 earnings conference call. This concludes today's call, and you may now disconnect."
}
] |
cdw | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning all, and thank you for joining us for the CDW Fourth Quarter 2024 Earnings Call. My name is Carly, and I'll be coordinating your call today. [Operator Instructions] I'd like to turn over to your host, Steve O'Brien, from Investor Relations. The floor is yours."
},
{
"speaker": "Steve O'Brien",
"content": "Thank you, Carly. Good morning, everyone. Joining me today to review our fourth quarter and full year 2024 results are Chris Leahy, our Chair and Chief Executive Officer; and Al Miralles, our Chief Financial Officer. Our earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the call. I'd like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K we furnished to the SEC today and in the company's other filings with the SEC. CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You'll find reconciliation charts in the slides for today's webcast and in our earnings release and Form 8-K. Please note, all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2023 with net sales growth rates described on an average daily sales basis, unless otherwise indicated. Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company. With that, let me turn the call over to Chris."
},
{
"speaker": "Christine Leahy",
"content": "Thank you, Steve. Good morning, everyone. I'll begin our call with an overview of our fourth quarter and full year performance and share some thoughts on our strategic progress and expectations for 2025. Then I will hand it over to Al, who will take you through a more detailed review of the financials as well as our capital allocation strategy and outlook. We will move quickly through our prepared remarks to ensure we have plenty of time for questions. For the fourth quarter, the team continued its exceptional level of customer commitment and delivered net sales of $5.2 billion, 5% above 2023 on an average daily sales basis. Gross profit of $1.16 billion, flat as reported and up 2% on an average daily sales basis -- on an average daily basis. Non-GAAP operating income of nearly $500 million, 4% below 2023 and non-GAAP net income per share of $2.48, down $0.09 year-over-year or 4%. The fourth quarter delivered a solid finish to a challenging year. During the quarter, as we have seen all year, customer priorities remains laser-focused on operating efficiency and expense elasticity and continually met with as a service and ratable solutions like cloud and SaaS and consultative services in order to optimize spend and minimize capital expenditures. At the same time, customer focus on mission-critical and must-do priorities drove interest in resuming projects with clear short-term returns on investment. This led to an uptick in demand across several hardware categories. Despite this shift in our mix, our durable and stable gross margin held strong and in fact, reached its highest quarterly level in 2024. Looking back on the full year, the team's ability to deliver as a service and service offerings helped partially offset the impact hardware de-prioritization had on our top line, which declined by 3%, and we delivered full year consolidated gross profit roughly 1% below 2023. Sustaining the resources needed to deliver exceptional service to our customers and support future growth drove slight expense deleverage in both 2024 non-GAAP operating income and non-GAAP net income per share declined by 5% and 4%, respectively. Although 2024 P&L results were not consistent with our record of performance, we once again generated more than $1 billion of adjusted free cash flow. We stayed the course on our capital allocation priorities and commitment to shareholders and returned $832 million to shareholders via dividends and share repurchases. A commitment that was reinforced with today's Board of Directors' action to increase our share repurchase authorization by $750 million. Now let's take a closer look at our fourth quarter performance. As always, there are three main drivers of our results: our balanced portfolio of customer end markets; breadth of our product solutions; and services portfolio and relentless execution of our 3-part strategy for growth. First, the balanced portfolio of our diverse customer end markets. As you know, we have five U.S. sales channels: Corporate; Small business; Healthcare; government; and Education. Each channel is a meaningful $1-billion-plus per year business on its own. Within a channel, teams are further segmented to focus on customer end markets, including geographies and verticals. We also have our U.K. and Canadian operations, which together delivered sales of USD 2.5 billion. The benefit of our diverse end markets was clear during the fourth quarter. Commercial markets showed signs of stability in the quarter and returned to growth. While customer behavior remained cautious and we did not experience traditional year-end budget flush, we did see greater willingness by some customers to spend their remaining budgets. Corporate and Small Business increased their top line, both up by 4%. International or other increased by 5% and public increased 6% driven by Healthcare's standout performance, up 30%. Within public unique end market factors continue to influence Education and government. Education declined 2% as high ed strong performance was more than offset by declines in K-12. As expected, the K-12 market experienced the impact of the first full period without any stimulus-based government funding programs. Government's decline was driven by federal end market uncertainty where we saw spending pauses as agencies awaited clarity around priorities from the incoming administration, clearly, a quarter of varied end market performance. The second driver of our performance this quarter was our broad and deep portfolio of solutions and services. Hardware increased top line by 4%, with client devices, NetComm and storage all increasing mid-single digits or better in the U.S. Client Devices growth was primarily driven by normal refresh of aging units. Software net sales were up 5% as robust double-digit SaaS and IAS growth continued to be impacted by the market transition away from licenses. Customer spend and gross profit both increased mid-single digits. Cloud remained an important driver of performance across the business and once again was a meaningful contributor to gross profit. Cloud profit increased by mid-teens. Security was a top contributor to cloud and software results and delivered high single-digit top line and profit growth. Customers continue to leverage our growing services capabilities as part of their strategies and services top line increased 10%. Overall services delivered double-digit profit growth. CDW Managed Services increased more than 20%. As you can see, our deep and broad portfolio of solutions enable the team to address customers' most pressing priorities, and that leads to our third driver of results, relentless commitment to our growth strategy. During 2024, we maintained our strategic fortitude and patients. We continue to build upon our productivity and efficiency work and further strengthen our relevance to our customers, coworkers and partners. One way we are strengthening and differentiating our relevance is by deepening our technical and industry expertise. We know more than anything that customers value our unbiased, highly informed point of view. A point of view that enables our ability to architect and implement full stack multi-branded solutions, which cuts through the noise and deliver outcomes that address each customer's unique needs. Sitting side-by-side with the C-suite at the table, CDW industry experts add value to the decision process and move us up the stack. CDW Healthcare offerings showcase this expertise, our deeply experienced Healthcare subject matter experts include more than two dozen former industry executives. These former CIOs, CTOs and practitioners have been crucial in developing and launching solutions only possible by combining very deep industry-specific expertise with our extensive portfolio and capabilities. Solutions like our proprietary patient room next AI and IoT-based solution and innovative Healthcare transformation centers located across the U.S. Healthcare transformation centers are collaborative spaces equipped with the latest technology and staffed by experts where Healthcare organizations can explore new content, develop strategies and test customized solutions. Solutions that improve patient care and clinical workflows across the care continuum. One center is capable of running a 2,000 bed hospital complete with a stand-alone isolated data center and simulation lab, and another center is focused on exploring scalable and evolving technologies for enhancing quality of life for those aged 50 and older. These transformation centers deliver measurable clinical outcomes. Outcomes like reduced readmission rates, where real-time access to patient data is combined with advanced analytics, so providers can identify at-risk patients and intervene before they are readmitted, and outcomes like enhanced patient satisfaction, where mobile communication tools and solutions deliver greater engagement and streamlined care coordinations, driving higher patient approval scores. Outcomes all made possible by our strategic focus on enhancing our expertise and our capabilities in the fastest growth, highest relevance cloud and software vectors. During 2024, we maintained a patient and opportunistic stance towards capital investment. When the target and the timing was right, we leveraged our cash position and strong free cash flow. And on November 27, we closed our acquisition of Mission Cloud Services a premier AWS partner and leader in driving cloud adoption and migration. Mission complements recent investments we have made to drive greater scale in our services and -- as a service offerings. Investments and capabilities that include cloud migration, full stack and cloud-native software development, DevOps engineering, robust consulting and cloud-based workflow automation expertise and resources. Mission expands our AWS Connect opportunities and delivers a compelling managed service offering that can be purchased through AWS Marketplace, allowing customers to burn down their cloud commits. We know how powerful this can be. Let me share an example of a solution that combined professional and managed services with AWS Connect and AI. It's an example of how we help a customer drive efficiency find cost savings and improve the customers' experiences and outcomes in today's challenging environment. A financial solutions company's on-premise contact center needed an upgrade. After careful evaluation, the CDW team designed a flexible custom solution that improved both customer service and streamlined operations. The solution includes cloud-based compute database and business intelligence that uses AI-driven analytics and natural language understanding. The project began with a multi-hundred-thousand-dollar initial investment in CDW delivered technical and implementation services that provided strong ROI to the customer. The Solution represents a significant monthly spend commitment to CDW for cloud-based customer service agent access to customer data and managed services for continuous performance monitoring. This integrated hardware, software and services solution reduces high maintenance costs, improve scalability, agent performance, customer experience and enables innovative customer service solutions from a data-driven insight. It's an excellent example of the power of integrating managed and professional services with our full portfolio of cloud and AI offerings. Solutions made even more compelling with mission in the family. While we have more to do our investments in high relevance, high-growth areas over the past five years have positioned us well to deliver value to our customers, however they need us. That leads us to our view for 2025. We currently look for the U.S. IT market to grow by low single digits in 2025 on a customer spend basis and for us to outpace market growth by 200 to 300 basis points. This outlook factors in expected impact from unique market dynamics on the public spending side, particularly in federal and Education as well as expected intensified pressure for our U.K. and Canadian operations, given their market face increased uncertainty driven by macro factors and political change. As always, we base our view of IT growth and what we are seeing in the market and what our customers are telling us about their plans and priorities for 2025. Right now, our commercial and public customers' decisions remain deliberate with ongoing project scrutiny, pursuit of short-term ROI and continued large project buying hesitancy. While our market view recognizes the potential for meaningful exogenous factors to impact demand, including policy uncertainty, the level inflation, the impact of tariffs and other potential disruptors, it does not weigh these wildcards too heavily. For now, we are comfortable with our prudent outlook. As we always do, we will provide an updated perspective on business conditions and refine our view of the market as we move through the year. In the meantime, we will continue to do what we do best, out-execute the competition. Whatever the conditions, we will use all of our competitive advantages to outperform the market. Our customers face proliferating data and ever-expanding cybersecurity needs. They face expanding workloads and hardware obsolescence. At the same time, they face the potential and promise of AI and other exciting innovative technologies. With our broad and deep portfolio of solutions and services and capabilities, we will be there for our customers as their trusted adviser, today and tomorrow, wherever their priorities lie. Now let me turn it over to Al, who will provide more detail on the financials and outlook. Al?"
},
{
"speaker": "Albert Miralles",
"content": "Thank you, Chris, and good morning, everyone. I will start my prepared remarks with details on our fourth quarter performance. provide a brief 2024 full year summary, move to capital allocation priorities and then finish with our 2025 outlook. Fourth quarter gross profit of $1.2 billion was roughly flat year-over-year, but up 2% compared to the prior year factoring in 1 less day. This was above our original expectation of low to mid-single-digit declines as our teams captured increased demand for cloud, security services and certain hardware products. In-line with our expectations, gross margin of 22.3% was up 50 basis points on a quarter-over-quarter basis, the highest margin quarter of the year but below the record level of 23% achieved in the fourth quarter of 2023. Compared to the prior year, the decline in gross margin was due to a higher contribution from notebook and desktop sales and a modest contraction in margin rate across a few product categories. Netted down revenues represented a strong 35.8% of our gross profit compared to 35.4% in the prior year fourth quarter. We continue to meet customers where they need us most. The netted down category of solutions represents an important and durable trend within our business. While we expect netted down revenue streams to outgrow the rest of the portfolio over time, driven by consistently strong cloud and SaaS growth we may see variance in growth from some of the other netted down categories, including warranties and software assurance as we did this quarter. Moving to a quick review of our channels for the quarter. On an average daily sales basis, the commercial business, achieved top line growth for the first time in two years, alongside firm gross margins. In the public space, Education was roughly seasonal and its sequential decline. And while government remained challenged, the sequential decline was less than historical levels. Healthcare was a standout performer this quarter as our team outperformed in a challenging end market, reflecting the strategic investments we've made in this space. International net sales grew for the quarter, driven by product volume growth but will behind historical fourth quarter sequential growth rates due to a lack of budget flush activity. We still expect volatility in the international end markets as customers in these regions face ongoing economic and political uncertainty. Overall, I want to credit our teams for delivering above our expectations in a tough environment. Turning to expenses in the fourth quarter. Non-GAAP SG&A totaled $656 million, up 3.3% year-over-year. Compared to our prior expectation for SG&A to be roughly flat year-over-year. This increase was mostly due to higher gross profit achievement. The efficiency ratio of non-GAAP SG&A to gross profit was 56.8%. Coworker count at the end of the year was approximately 15,100. While customer-facing coworker count was approximately 10,900, both down 300 coworkers from the third quarter and flat to last year. These numbers take into consideration both our acquisition of Mission Cloud Services and the actions taken in the fourth quarter to align our expenses to market conditions. Our goal is to balance growth, expansion of capabilities and exceptional customer experience with greater efficiency and cost leverage from our broader operations. Non-GAAP operating income was approximately $500 million, down 3.8% versus the prior year, driven by lower gross margins year-over-year combined with higher expenses. Non-GAAP operating income margin of 9.6% was down from the record 10.3% in the prior year. Our non-GAAP net income was $333 million in the quarter, down 4.7% on a year-over-year basis, impacted by slightly higher interest expense following our debt refinancing and lower interest income due to modestly lower rates. With fourth quarter weighted average diluted shares of $134.4 million, non-GAAP net income per diluted share was $2.48, down 3.7% versus the prior year. Shifting gears to briefly review full year results. 2024 was the second consecutive year we experienced a challenging environment. Demand was below what we initially anticipated and customer sentiment was cautious throughout the year with more deliberation and decision-making and elongated sales cycles. Net-net, this led to a 1.8% decline in net sales and a 1.1% decline in gross profit. Despite these declines, gross margins held firm year-over-year at 21.9% versus 21.8%, showing that even when client devices are stronger, and solution hardware is weaker, our margins remain resilient. Our strategy investments are working. Investments like the recent acquisition of Mission Cloud Services which brings capabilities which should position us well for growth in the future. As always, we will continue to pivot to meet customers where they need us, no matter of the environment. Down the P&L, we saw higher year-over-year non-GAAP expenses as we pivoted to adjust our fixed cost base to align to an uneven demand environment and made judicious investments in support of our strategy. This led to year-over-year decline of 4.5%, 4.4% and 3.6% and our non-GAAP operating income non-GAAP net income and non-GAAP net income per diluted share, respectively. Moving to the balance sheet. At period end, net debt was roughly $5.1 billion, up roughly $253 million from the third quarter and approximately $69 million since year-end 2023. This was driven by our use of cash during the quarter, notably to fund our acquisition of Mission Cloud Services. Liquidity remains strong with cash plus revolver availability of approximately $1.7 billion. The 3-month average cash conversion cycle was 18 days, up 1 day from the prior year and at the low end of our targeted range of high teens to low 20s. This cash conversion reflects our effective management of working capital, including proactive management of our inventory levels. As we've mentioned in the past, timing and market dynamics will influence working capital in any given quarter or year. We continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Adjusted cash flow -- free cash flow was $315 million in the quarter, consistent with our expectations. For 2024, in total, adjusted free cash flow was a healthy $1.1 billion and 84% of our non-GAAP net income, achieving our stated rule of thumb of 80% to 90% of non-GAAP net income. For the quarter, we utilized cash consistent with our 2024 capital allocation objectives, including returning approximately $146 million in share repurchases and $83 million in the form of dividends. For the year with $332 million of dividends and $500 million of share repurchases, we exceeded our target of returning 50% to 75% of adjusted free cash flow to shareholders finishing the year at approximately 77%. That brings me to our capital allocation priorities. Our first capital priority is to increase the dividend in line with our non-GAAP net income growth. We announced on our last earnings call, an approximately 1% increase of our dividend to $2.50 annually, our 11th consecutive year in increasing the dividend. We will continue to prudently manage our dividend with respect to the growth environment and target a roughly 25% payout ratio versus non-GAAP net income going forward. Our second priority is to ensure we have the right capital structure in place. We ended the fourth quarter at 2.5x net leverage within our targeted range of two to 3x. We will continue to proactively manage liquidity while maintaining flexibility as evidenced by our 2024 debt refinancing and redemption actions. Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. We continually evaluate M&A opportunities that could accelerate our 3-part strategy for growth as shown by our recent acquisition of Mission Cloud Services. Likewise, we remain committed to our target to return 50% to 75% of our adjusted free cash flow to shareholders via the dividend and share repurchases. As such, we are pleased to announce an additional $750 million share repurchase authorization program approved by our Board of Directors. On top of the approximately $588 million of authorization remaining under our current program for 2025 and beyond. And that leads us to our outlook. Customer sentiment remains cautious across end markets. We expect these conditions to persist in the near term but are cautiously optimistic about 25 as an inflection point for the demand cycle. Customers still have a compelling need to address priorities such as workload growth, increasing security threats and aging client devices. And while uncertain macroeconomic conditions and a complex technology landscape, may continue to weigh on customer demand for solutions hardware, we anticipate leveling demand for these products, including in areas like NetComm that saw depressed growth rates in 2024, driven by product digestion and after lapping tough 2023 compares. With these factors in mind, our full year 2025 expectation is for the IT market to grow low single digits. We target market outperformance of 200 to 300 basis points on a customer spend basis. Based on the anticipated mix of products and solutions, we expect low single-digit gross profit growth. We also expect gross margin to remain relatively stable and within the range of 2024 levels as we continue to scale up our cloud, SaaS and services businesses, while balancing the prospect of a return to growth in solutions hardware. We expect first half gross profit to be slightly lower than the second half, reasonably in line with our historical seasonal splits of 48% versus 52%. Finally, we expect our full year non-GAAP earnings per diluted share to grow low single digits year-over-year as we focus on profitable growth, exceptional customer outcomes and an effective execution of our capital allocation priorities. Please remember, we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. On that note, we expect currency to be a slight headwind to reported growth throughout the year. Moving to modeling thoughts for the first quarter. We anticipate mid-single-digit gross profit decline sequentially and relatively in line with historical levels, leading to low single-digit year-over-year growth, and we expect gross margin to be similar to overall 2024 levels. Moving down the P&L. We expect first quarter operating expenses to be similar to both the first quarter and fourth quarter of 2024 on a dollar basis. As we've seen in the last few years, this will result in the first quarter being the highest level of non-GAAP SG&A as a percentage of gross profit for the year. Finally, we expect first quarter non-GAAP earnings per diluted share to grow in the low single-digit range year-over-year. That concludes the financial summary. As always, we will provide updated views on the macro environment and our business on our future earnings calls. And with that, I will ask the operator to open it for questions. [Operator Instructions]. Thank you."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Amit Daryanani of Evercore ISI."
},
{
"speaker": "Amit Daryanani",
"content": "Thanks a lot. Good morning, everyone. I guess just to start with Chris, when I think about the calendar '25 guide that folks just provided, how are you thinking about different parts of the public vertical kind of stack having the growth profile? And I guess, really, given the focus on efficiencies and the impact on Dodge, how do you see that kind of playing out for CDW in the near to medium term? That would be really helpful."
},
{
"speaker": "Christine Leahy",
"content": "Yes. On the public sector side, we've taken into consideration those areas that we can in our typical seasonality and some of the the unique factors that we're facing in terms of Education being at the end of that large funding cycle, et cetera. But here's what I would say. I'd say, look, it's too early to tell where all these things are coming out. We've got a lot of lack of clarity. Things are moving fast. They're very fluid. And so we're basically taking it and analyzing as we go, and we'll update as we go through the year. I would say that when it comes to dose, there are going to be puts and takes. Any time you reduce workforce that tends to slow things down in the government space, and we have factored that in. But on the other side, anything driving efficiency is positive for technology over the long run. So we've tried to be prudent and cautious in our federal approach knowing full well that we just don't have all the clarity and we're going to continue to assess and update you as we go through the year. On Education, we're getting news every single day around the Education side. And so we're just going to be very measured. We're going to stay aware. We're going to stay tuned, but not be overly reactive and we're going to continue to assess funding sources and policy changes across the board. As I said, there are going to be puts and takes. There's going to be -- you'll have reductions, but you'll also have a realignment, and it will be our job to figure out where the opportunities and risks are. And we got a strong -- we've got a very strong federal, state and local and Education business. We have 40 years of finding where the funds are and helping our customers actually work their way through and understand changes, and we're right in the middle of doing that right now. There's a lot of discussion with customers. There's a lot of analysis. They really are turning to us to understand on a daily basis and longer term. Certainly, I think you're going to see some air pockets as people figure things out. But over the long run, we think that technology is going to be a winner across the federal and Education landscape."
},
{
"speaker": "Amit Daryanani",
"content": "Got it. That's really helpful. If I could just follow up. When I think about the low single-digit gross profit dollar guide for the year, you're expecting the broader IT spend and see that this top line to be somewhat better than that. So what's kind of driving a bit more muted gross profit dollar growth, if you make? Is it mix? Or are there some other factors that we should be aware about? Just help us think about that low single-digit profit dollar growth would be helpful."
},
{
"speaker": "Albert Miralles",
"content": "It's Al. I would say, look, as you think about our outlook and down the P&L, the actual variance between the line items from customer spend, gross profit all the way down to EPS. The variance in those growth rates are not significant. So that's number one. So there's nothing there too meaningful to report beyond maybe a little bit of a shifting of mix. So -- and I maybe would just note that with that shifting in mix. We would probably continue to see a little bit of compression in net sales as we continue to lead in lean into netted down, which will bolster gross profit. a little bit of a continued pressure on the expense line that would depress non-GAAP operating income a bit, but then you pick up some leverage as you get further down into EPS. So the variance between those categories, not too meaningful overall."
},
{
"speaker": "Operator",
"content": "Our next question comes from Samik Chatterjee of JPMorgan. Samik your line is now open."
},
{
"speaker": "Samik Chatterjee",
"content": "Thanks for taking my question. I guess maybe to start off on the 4Q results, you had a strong end to the year, but it also seemed like within the verticals that you called out, Healthcare was particularly strong, up, I think, close to 30% on a day adjusted basis. Can you just go through sort of what drove that? Was it a lot of transaction business or any sort of anything else that drove that number to be that strong and I have a quick follow-up."
},
{
"speaker": "Christine Leahy",
"content": "Yes, sure. Look, Healthcare was a standout and Healthcare has been performing for several quarters now. The net sales number reflected the mix that we saw a really nice number there. But at the end of the day, it's been a very balanced success over the last couple of quarters with Healthcare, which is a reflection of our strategy and how we bring value to our customers. The broadened portfolio, particularly around cloud, when you couple that with our deep Healthcare expertise. Those enable the Healthcare teams to be real trusted partners and help our Healthcare customers on their cloud journeys. We've made a number of investments behind Healthcare in the capabilities and technologies and partners, frankly, that we bring to bear. And that is just bearing fruits. Now I would say that we are overlapping a couple of very difficult years. So the number, it does seem high. But at the end of the day, very, very proud of the Healthcare team and the focus and execution that they're bringing to bear for Healthcare organizations that are really earlier in their journey on cloud, and we're right there to help them along the way."
},
{
"speaker": "Albert Miralles",
"content": "And maybe, Samik, I'll just add on that. Chris' point about the comps. As we think about overcoming the comps on Netcomm, Healthcare would be a big one in that regard. It also adds that business, as we've invested behind it has built a nice client base, including some larger transactions. So while we are definitely pleased with the execution and the outcomes there, there is an element there of transactions that may not be fully recurring. . And then finally, I would just note, while that the business is really strong in Healthcare, it tended to somewhat offset some of the declines from government Education. So that would be round out kind of that overall public sector."
},
{
"speaker": "Samik Chatterjee",
"content": "Got it. And probably this one, the follow-up is for you. Just following up on my last question. You mentioned the mix sort of on the net sales side. And I think what you're referring to, which you referred in your prepared remarks is the change in practices from like some Microsoft on the subscription of the on the cloud subscriptions. I think a lot of investors are curious sort of what that magnitude of exposure looks like and how you're sort of navigating through those changes and policies from some of these sort of cloud companies."
},
{
"speaker": "Albert Miralles",
"content": "Sure, Samik. I think we mentioned that last call on some of the Microsoft changes or we got the question with respect to that. Look, we see program changes and change incentive from partners very commonly. This one was telegraphed for quite a while. And so the impact on '25 from that is not material to our overall results. We had been seeing that coming. We were contemplating that. And as usual, we are pivoting to both the other opportunities for growth with Microsoft but also with other partners."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from Harry Reid of Redburn. Harry, your line is now open."
},
{
"speaker": "Unidenified Analyst",
"content": "Just checking up on a comment made helping clients run down that annual commit on AWS. I'm just thinking about the moats in the business and if there's any threat of disintermediation is the by nature of the value-added service of the reseller essentially protecting that moat and why our clients wouldn't procure directly from AWS marketplace for some of their software? Just any comments there would be very helpful."
},
{
"speaker": "Christine Leahy",
"content": "Yes, it's great to have you on. I would characterize it this way, the moat that CDW has is all of the services that we wrap around the market place purchases. In fact, we were just named AWS Marketplace Partner of the Year. And our customers really turn to us because marketplace is another complexity, if you will, in the procurement chain. And CDW brings to bear all the input and expertise that customers make good decisions. The other thing to remember is that our clients are really squarely hybrid cloud, meaning multi-cloud and on-prem and while cloud is obviously growing very quickly. We have many customers who are also repatriating back to on-premise and have particular reasons that they want to stay on premise, including some of the advances in AI and efficiency around models, et cetera. So the interconnectivity that our customers have across their entire hybrid infrastructure is critically important to have knowledge around. And the only ones who could do that are folks like us who understand the customers' full estate and how things work together. So we are investing behind that. Mission Cloud is a great example of a strategic investment to continue to build our differentiation and we're pleased to have them as part of the family and they're -- they've joined us and taken off well."
},
{
"speaker": "Operator",
"content": "Next question comes from Ruplu Bhattacharya of Bank of America. Ruplu, your line is now open."
},
{
"speaker": "Ruplu Bhattacharya",
"content": "First one for Chris. In the past, SMB has been a bellwether for a change in end market demand. It looks like revenues in that segment this quarter grew about 3% year-on-year. and that's after essentially two years of weakness. So Chris, was there any onetime in this quarter? And do you think that, that segment can now grow year-on-year? And should we think this as a positive indication for overall market demand? And I have a follow-up for Al."
},
{
"speaker": "Christine Leahy",
"content": "Yes. I would say, look, our small business and corporate businesses both showed signs of stabilization this past quarter. And we've said before that we saw small business kind of bumping along the bottom and now in Q4, a little bit of stabilization. We are seeing -- when I say stabilization, I want to be clear that what I mean is the rhythm of the business. We're seeing less unevenness, more stability in the rhythm of the business. the activities in the business, et cetera. So we find that really encouraging. At the same time, Ruplu, I'd just say that customers remain cautious. And we are taking that into account as we think about our outlook and being very prudent, particularly with everything that's happening in the environment. It's unclear what's going to happen with inflation. Clearly, interest rates is an issue out there and then just add all the policy uncertainty and impact -- downstream impact and uncertainty, I think we're going to see small businesses continue to be cautious. But the good news is, is they're cautious and they're optimizing for cost and cost efficiency we've been helping them significantly using cloud and ratable and subscription offerings. So I wouldn't call it a rebound just yet with small business, but we are cautiously optimistic."
},
{
"speaker": "Ruplu Bhattacharya",
"content": "Okay. Al, if I can ask you a question on margins. specifically, if we look at the gross margin of the core business, ex the netted down items, looks like fiscal '24 overall came in at 15.4%. So it was down about 40 bps year-on-year. But the fourth quarter, I think, came in the core business margins 1.5%, so that grew sequentially. The question -- my question to you is fiscal '25 should see an improvement in some end market or end device products like PCs. So how are you thinking about core business margins trending in fiscal '25?"
},
{
"speaker": "Albert Miralles",
"content": "Sure. Thanks, Ruplu. A couple of things I would note. You are right. For the quarter, our non-netted down margin was 15.5%. That sequentially was up about 30 basis points. but it was down year-over-year, and I think for the full year, down about 40 basis points, you might have mentioned that. As we think about 2025, I would say net-net, Ruplu would expect that margin to hold reasonably firm. And the reason for that would be while we expect that client will continue to move along a path. We wouldn't expect significant acceleration, but move along the pad, it's been on. We would also expect modest growth of solutions, which we think will aid those non-netted down margins. And then we are cautiously optimistic as hardware comes back that you will see more services attached, which certainly will aid that margin as well. So all things considered, we would expect that non-main margin to hold pretty firm during '25."
},
{
"speaker": "Operator",
"content": "Our next question comes from Keith Housum of Northcoast Research. Keith, your line is now open."
},
{
"speaker": "Keith Housum",
"content": "Chris, just a little bit more on the Mission Cloud Services acquisition. Perhaps can you provide a little bit of context about what it provides to you guys in terms of the financial statements. I mean you do a good job explaining the business. But in terms of -- is it accretive to your gross margins into the bottom line? And do you guys require a significant investment to kind of make it more of a CDW type integrated product that you guys have?"
},
{
"speaker": "Christine Leahy",
"content": "Yes. Sure, Keith. Let me start and then I'll hand it over to Al. We're really excited about Mission Cloud. It's in a fast-growth mode. It's a profitable business. It brings incredible AWS expertise and reputation in the market. And we're really excited to bring that to there across our customer base. As you know, they are focused on mid-market and small business, which is a sweet spot for us, but extensible into the rest of our segments. In terms of accretive, the price we paid and we won't see much addition to the bottom line profitability this year because of the foregone interest. And as a result, we're not going to see a big impact. That said, we do expect Mission Cloud to have a significant impact on our strategy and growth rates going forward."
},
{
"speaker": "Albert Miralles",
"content": "Yes. Thanks, Keith. The only thing I would add is, look, Mission is a company that is in growth mode, but notably is profitable. So we deemed it and deem it as a high-quality asset, but we are in the formative stages of integration, so to Chris' point, the materiality at the gross profit and the non-GAAP operating income line would be not substantial in '25, and then really pretty much flat down to EPS when you think about the interest income. And again, Chris hit this, as we fully integrate in '25, and we open the aperture to our vast customer base. We think the upside in the accretion possibilities for Mission are really significant."
},
{
"speaker": "Keith Housum",
"content": "Great. I appreciate it. And then earlier on, you mentioned a little bit of gross margin pressure from some price in the end markets. I just want to make sure I understood that correctly. And two, what's the expectation that would continue going forward?"
},
{
"speaker": "Albert Miralles",
"content": "Sure, Keith. Yes, in kind of walk of the gross margin components and the puts and takes, one of the things that I mentioned was like-for-like, we saw a bit of a compression, particularly in the product side of the house. Now I just recall, Keith, that we've had now several years of product margins holding up really, really strong. And I think we've called out that at some point, you could see an impression. I would not note what we saw in the quarter as material. And probably the most notable area where we saw a little bit of compression was clients. So when we factor in all of the elements on the margin front for 2025, Certainly, we've made some space for a little compression, but we would not call that an outsized contributor."
},
{
"speaker": "Operator",
"content": "Our next question comes from Erik Woodring of Morgan Stanley. Erik, your line is now open."
},
{
"speaker": "Erik Woodring",
"content": "Chris, if I look back over the last call it, decade plus, 2024 was the first year that your earnings growth did not outpace your revenue growth. And as I look to 2025, you are guiding kind of as Al referenced, EPS growth, largely in line with gross profit and revenue growth. And so when I take a step back, I'm just -- I'm wondering why maybe we aren't seeing as much leverage in the model as you've seen historically, even including past periods where there was macro uncertainty or a dynamic market. Can you maybe just help us understand maybe why we're not seeing that leverage materialize. And anything that's unique about this environment that truly is different than we look at the past CDW? And then I have a quick follow-up."
},
{
"speaker": "Christine Leahy",
"content": "Yes, sure. I'd characterize it this way. We're -- our goal is to balance growth investments in our capabilities with efficiency across the broad base of our operations. And when you look at the investments we've made over the last several years, they've been significant and producing very good results. But we've been doing this in an environment that exacerbates the kind of deleverage. And that is one where we aren't growing. And we've taken a number of measures, as you know, to ensure we rightsize the business for the current environment for demand, but also, Erik, ensure that we are positioned for growth going forward. I think we've been investing very judiciously. We've been investing very deliberately. And I think in areas that are high growth, high relevance. And Healthcare is a great example of seeing that strategy pay off. Our cloud and SaaS business growth in our security business growth, those are great examples of that strategy paying off. but the deleveraging has to do with the confluence of factors, I'd say, which is investing while we've got initiatives going on for productivity and efficiency in an environment that is low to no growth. Eric, that said, we do expect, obviously, as we move forward for operating leverage to come back over the next year and beyond. I mean that is our goal as well, provided that we are in an environment that supports that."
},
{
"speaker": "Erik Woodring",
"content": "Okay. sorry for cutting you off there. And maybe, Chris, just a quick follow-up is, I could probably make the case for leaning more into M&A in this environment given the change in administration your historical comments about where you see workloads shifting and how that might impact clients by the CDW. Is your appetite for M&A higher today than when we look back over the last, call it, two to three years? And besides just consolidating a fragmented market, where are the specific product gaps you believe are most critical for CDW to address today?"
},
{
"speaker": "Christine Leahy",
"content": "Yes, Erik, it's a really interesting question. What I would say is we always have a large appetite for M&A. We are in a different position today because we do have scale and foundation in those areas that we've been driving growth. So when we think about our cloud capabilities, we think about security capabilities. We think about data capabilities. We've been growing those now over five years and have a really good base of scale. I think that puts us in a position that could be really opportunistic to add to those capabilities and fortify them while at the same time identifying tuck-ins that might be more specific to an industry or specific to a particular emerging technology. Our focal areas, frankly, have not changed at dramatically or at all from an M&A perspective. But I would say that we are adding a lens around industry capabilities specifically. You've seen us buy companies specific to Education, specific to federal. This has been a very good strategy for us, and we see that work quite a bit. So I'd just look for us to do more of that. But all said and done, we are patient. We are opportunistic, and we look for great assets."
},
{
"speaker": "Albert Miralles",
"content": "And maybe, Erik, I'd just add. Look, I think 2024 is a great example where we did bring the full array of capital allocation priorities. So during a tough period where we would have deemed our stock to be at more attractive levels. We did lean in more to share repurchases, but behind the scenes, looking actively at what is the next acquisition opportunity that could fuel our operating income and really compounding of earnings. So we will continue with that drumbeat and continue to look at opportunities that fulfill our capability needs, but also drive earnings power."
},
{
"speaker": "Operator",
"content": "Our next question comes from George Wang of Barclays. George, your line is now open."
},
{
"speaker": "Dong Wang",
"content": "Maybe to just -- maybe if you can impact kind of fourth quarter kind of in the prepared remarks, you guys talked about underlying hardware, including NetComm and the storage up mid-single digit. Just curious if you can impacted despite the channel, whether that's all driven by corporate and SMB or whether some from the health care upfront? And also, can you give more color in terms of the full year outlook on the net comp. It seems like you guys are seeing some green shoots. Just curious if we should expect some sort of inflection particularly just on the NetComm side, consider we are probably testing some of the digestion."
},
{
"speaker": "Albert Miralles",
"content": "Okay. George, just take a crack at that, that was a lot. So first, just starting with the quarter, on the end market side. I think the punch line would be the most significant element that exceeded our expectations would be on the commercial side. And we saw as Chris suggested, signs of stabilization on corporate and small business. That was reasonably balanced, George, across different categories of growth. in that area. And then the other end markets that I'd point out, and we've talked about it is health care, again, exceptional performance driven by an array of categories if you will, and really a good reflection of our investing behind that strategy. George, as we look out in '25, some of the elements of what we saw from a category perspective in we would expect to continue. That is on the client side, mid-single-digit growth or better is what we experienced in Q4. We think that's a reasonable glide path for 2025. And then we have a modest expectation on solutions hardware. We saw 3%, 4% in the quarter. And in that realm, I think, is quite reasonable. Where will that come from? Probably some contribution from NetComm and again, we're cautious on the demand there, but we think there could be some continued growth in NetComm. Storage was a strong performer for us in Q4. And then going the other way, servers have been challenging. And so we are cautious that may continue in that space. So that would be how it would round out on the hardware product category side of things."
},
{
"speaker": "Dong Wang",
"content": "Okay, great. If I can squeeze a follow-up. Last quarter, you guys talked briefly on some of the slight increased competition/pricing pressure. I just want to make sure of the transitory in nature kind of completely went away in the December quarter and going forward. So maybe you can address if you guys are still seeing some increased competition or that was really sort of completing the rearview mirror?"
},
{
"speaker": "Albert Miralles",
"content": "Sure, George. I'll take that. First, I would say those comments were not just specific to Q3. It was really a reflection on the broader range of the last two years and the challenged environment we've been in. We've been in a tough down cycle of hardware. And with that competition, quite fierce. That's continued. I wouldn't point anything out differently in Q4, and we continue to fight the good fight in that regard. And I think we came out quite well versus our expectations in that regard. I would not point to when we talk about margins, George, that the competition is having any meaningful impact on our margins in that regard."
},
{
"speaker": "Operator",
"content": "Thank you very much. At this time, I'd like to hand the call back to CDW for closing remarks."
},
{
"speaker": "Christine Leahy",
"content": "Okay. Thank you, Carly. I appreciate that. Let me close by recognizing the incredible dedication and hard work of our coworkers around the globe their ongoing commitment to serving our customers, it's what makes us successful. Thank you to our customers for the privilege and opportunity to help you achieve your goals. And thank you to those listening for your time and continued interest in CDW. Al and I look forward to talking to you next quarter. ."
},
{
"speaker": "Operator",
"content": "As we conclude today's call, we'd like to thank everyone for joining. You may now disconnect your lines."
}
] |
cdw | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning all, and thank you for joining us for the CDW Third Quarter 2024 Earnings Call. My name is Carly, and I'll be coordinating your call today. [Operator Instructions] I'd now like to hand over to your host, Steve O'Brien of Investor Relations to begin. Steve, the floor is yours."
},
{
"speaker": "Steve O'Brien",
"content": "Thank you, Carly. Good morning, everyone. Joining me today to review our third quarter 2024 results are Chris Leahy, our Chair and Chief Executive Officer; and Al Miralles, our Chief Financial Officer. Our earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the call. I'd like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K we furnished to the SEC today and in the company's other filings with the SEC. CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You'll find reconciliation charts in the slides for today's webcast and in our earnings release and Form 8-K. Please note, all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2023 with net sales growth rates described on an average daily sales basis, unless otherwise indicated. Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company. With that, let me turn the call over to Chris."
},
{
"speaker": "Chris Leahy",
"content": "Thank you, Steve. Good morning, everyone. I'll begin today's call with a brief overview of our third quarter performance and view for the balance of the year. Al will provide additional detail on our results, our capital allocation priorities and our outlook. We'll move quickly through our prepared remarks to ensure we have plenty of time for questions. Market conditions in the third quarter were challenging. While demand for cloud solutions remained strong, and we continue to see a pickup in client device growth. Hardware solutions remained under pressure and the firmer footing we anticipated for our corporate channel did not materialize. Within this complex environment, the team delivered gross profit of $1.2 billion, 2% lower than last year and gross margin of 21.8%. Net sales of $5.5 billion, 3.5% lower on an average daily sales basis, non-GAAP operating income of $534 million, down 4% year-over-year; non-GAAP net income per share of $2.63, down 3% year-over-year; adjusted free cash flow of $261 million. While our success meeting customer priorities with cost-effective software and cloud solutions as well as services led to a resilient gross margin and strong cash flow, results did not meet our expectations as lower-than-projected solutions hardware drove a shortfall in volume. This shortfall in volume reflects both external factors and CDW-specific dynamics. Let's take a look at each of these and most importantly, the actions in place to mitigate future impacts. First, the macro and IT spending environment remain challenging. Technology complexity combined with persistent economic and geopolitical uncertainty has led to large project delays and further extension of sales cycles. Layered on top was the uncertainty around the outcome of the U.S. election, which has dampened not only government spending, but also other public sector end markets, as well as spend from commercial customers. And finally, this limited demand environment has heightened competition and increased pricing intensity across all end markets. Beyond the current environment, market conditions continue to reflect the secular shifts we've experienced over the past several years, shifts that impact how customers consume IT and how customers pay for IT. Consumption shifts driven by as-a-service and pay-as-you-go public and private cloud focus have contributed to market pressure on hardware solutions. And while our conviction toward a hybrid cloud approach for IT is unwavering, market demand continues to reflect unprecedented hardware cyclicality, cyclicality that resulted from pandemic-driven demand for work and learn from anywhere on endpoint, collaboration and netcomm solutions, which resulted in an off-cycle demand boom, a period of supply chain volatility and subsequent digestion. All of these external factors have clearly impacted our results in the quarter and over the past year. The impact has been further amplified by three CDW-specific dynamics. The first dynamic relates to our long-standing financial discipline. While our North Star is to provide value to our customers in highly competitive markets, we maintain our discipline when competitors pursue transactions at uneconomic terms. While this contributed to lower third quarter sales and gross profit, our gross and operating margins held firm even while we mixed into lower-margin client devices. We have seen this market behavior before and expect it to dissipate as the demand environment improves. Second, our exposure to larger deals. As we have deepened and broadened our strategic capabilities, including through the addition of Sirius, our ability to deliver large, full stack, full outcome projects has expanded, projects at the higher dollar tier that can be pushed for any number of reasons. This can drive year-over-year performance lumpiness and depending on the size and timing of decisions, impact results. Impact that is more acute during periods of low demand. You see this in commercial and federal this quarter where larger deals expected to close were deferred or reduced. And the third specific item pertains to our cloud and SaaS-based business. While we have grown this business significantly during the past several years, we have not yet achieved the scale we desire relative to our overall portfolio. As such, when demand for hardware softens, it has a more outsized impact on our financial results. I hope this perspective helps contextualize how CDW-specific dynamics amplified the impact of the low market demand environment and created a near-term growth challenge that we have not yet been able to overcome. These are not excuses. We own our results. So let's turn to what's important. What are we doing? As always, our continuous improvement in seller effectiveness is ongoing. This means delivering repeatable solutions and further streamlining the sales processes to maximize sales professional productivity. I'd like to highlight three additional focus areas. First, we are organically and inorganically growing our capabilities in the fastest growth, highest relevance cloud and software vectors to increase scale in both our services and as-a-service offerings. This will deliver greater choice and value to our customers and lead to greater recurring and reoccurring revenue streams. Second, we are further driving exceptional and differentiated customer experience in our core business. We are aligning our digital capabilities to serve customers in the way they want to plan, buy, consume and manage technology. And finally, we are enhancing our agility and accelerating pipeline growth. We are building on our customer growth engine by opening new lanes with both existing and new customers, and we are deepening our technical and industry expertise across all end markets. We know more than anything, customers value our unbiased highly informed point of view, a point of view that enables our ability to architect and implement full stack multi-branded solutions, which cut through the noise and deliver the outcomes our customers need. These are not new efforts, but we have ramped up intensity. Work is underway and progress is on track. Some actions will have fairly immediate impact and some will take more time to produce results. In the meantime, we remain laser-focused on finding pools of profitable growth and converting sales with rigor and speed. Now let's take a deeper look at quarterly results. Third quarter corporate net sales decreased 4% as sales cycles further elongated, most notably for large infrastructure investments. netcomm storage and servers all declined by significant double digits. We helped customers with client refresh, driving growth of high single digits. ASPs remained strong as customers' preference continued to drive higher-end devices. Cloud solutions was a priority and gross profit from cloud increased by double digits. Small business continued to bounce along the bottom with net sales down 2%. Cloud solutions remained strong given their low upfront commitment and customers continue to sweat data center assets. Unlike other channels, client refresh continues to be pushed out as customers remain in a cash preservation mode. Security was strong as cyber threats increased for lower profile businesses. The team's success delivering services drove strong double-digit growth in both professional and managed services. Public performance was less than seasonal and sales decreased 5% year-over-year. Health care was a bright spot in the quarter, delivering top line growth of 3%. The team continued its success helping health systems adopt managed services and cloud solutions to better control expenses, and they delivered strong double-digit growth in services and cloud spend. Similar to corporate, netcomm storage and servers all declined meaningfully. Client was strong, up double digits for the second quarter in a row. Government declined 12% with both state and local and federal government performance below seasonal in the quarter. Market conditions were challenging for the federal team. Demand impact was felt most acutely in large hardware solutions deals with federal posting double-digit declines in both netcomm and servers. Several agencies moved ahead with refresh and for the third quarter in a row, client devices increased by double digits. Cloud Solutions posted a double-digit increase in cloud gross profit. State and local sales declined by low double digits. Delays due to increased scrutiny and multiple approvals impacted large infrastructure hardware deals with netcomm storage and servers all posting significant declines. Security remained a top priority, posting a strong double-digit increase in gross profit. Services performance was strong, up high double digits, driven by professional services. Education sales declined 5%. Higher ed's top line declined high single digits. Client devices were flat and slow project materialization and budget constraints and cutbacks at some public universities contributed to double-digit declines in netcomms and servers. The team's success helping institutions implement cloud solutions to drive cost elasticity delivered double-digit growth in cloud spend and gross profit. K-12 net sales declined by low single digits, largely driven by declines in audiovisual and netcomm as school systems digested investments made over the past few years. The team continued to help refresh aging Chromebooks and delivered high teens client device growth. Cloud delivered double-digit gross profit growth. Services adoption was also up double digits, driven by our managed client device life cycle solution, which streamlines the configuration, deployment, management and a refresh process so school systems can focus on what really matters, their students. Other, our combined U.K. and Canada business performed above our expectations, up 5%. Both markets experienced stronger demand, albeit off depressed results in the prior year and prior quarter. Both the U.K. and Canada increased by similar amounts in local currency. As you can see, end market performance was mixed during the quarter. Let's take a look at how this translated to category performance. Portfolio performance reflected our ability to meet customers where and how they want it with client device, cloud and software and services growth, growth that was more than offset by hardware solutions decline. A low single-digit increase in transactions was more than offset by solution sales decreases of double digits. Hardware decreased 7%. High single-digit client device growth was more than offset by declines in netcomm storage and servers. Software increased 3.5% with healthy gross profit growth. Cloud was an important driver of this performance, up double digits in gross profit. Services increased by 13%, driven by managed services and warranties. As you can see, while demand varied, the diversity and completeness of our portfolio enables us to meet our customers where and how they need us. And that brings us to our expectations for the rest of the year. Given current conditions, we do not anticipate market demand to improve for the balance of the year, and we now look for the U.S. IT market to be roughly flat with 2023. We expect our results to continue to reflect the market and CDW-specific dynamics I referenced with gross profit growth challenged, given our mix of hardware and the pronounced cyclicality the market is experiencing. As we always do, we will provide our view on 2025 market conditions in our next call. There's no denying that we are operating in a tough environment, but we are confident that growth will return. The demand drivers are there, workload expansion and data explosion, increased security threats, client device obsolescence and adoption of AI-powered assistance and applications. And when demand picks up, we will be there to profitably capture these opportunities. In the meantime, we are doubling our efforts to drive profitable growth. While this past year has been challenging for us, it has also been challenging for our customers. As they're a trusted adviser, customers need us now more than ever. Our relationships are bolstered by our commitment to deliver value to our customers regardless of the demand environment. Now let me turn it over to Al, who will provide more detail on our financials and outlook."
},
{
"speaker": "Al Miralles",
"content": "Thank you, Chris, and good morning, everyone. I will start my prepared remarks with details on our third quarter performance, move to capital allocation priorities and then finish with our updated 2024 outlook. Third quarter gross profit of $1.2 billion was down 2.2% versus the prior year. This was below our original expectations of low single-digit growth as strength in cloud and client devices across most channels was offset by lower demand for solutions hardware. Gross margin of 21.8% was flat year-over-year and quarter-over-quarter and broadly in line with both full year 2023 levels and our expectations for 2024. Third quarter margin was aided by a higher mix into sales or CDW act as agent, also known as netted down revenues. This category grew by 7.1% on a reported basis, once again outpacing overall net sales growth and representing 35.7% of our gross profit compared to 32.6% in the prior year third quarter. Year-over-year expansion came from our teams continuing to successfully serve customers with cloud and SaaS-based solutions. This led to our highest quarterly netted down revenues we've seen as a company as we met customers where they needed us most. The netted down category of solutions continues to represent an important and durable trend within our business. Third quarter gross profit was up 1.5% sequentially compared to the second quarter of 2024 on a reported basis. Net sales were up 1.7% sequentially as well. Higher year-over-year demand in the health care and international channels alongside a sequential increase in government drove growth over the second quarter. However, this growth is below both historic seasonal levels and our own expectations as the firmer footing in the corporate space that we saw at the end of the second quarter did not persist through the later months of the third quarter. We experienced deals getting pushed out and downsized as customers deliberate on where and when to spend and primarily in the solutions space. While international outpaced the U.S. business in the third quarter, we still expect volatility in this space as customers face economic and political uncertainty. Overall, we're competing in a challenging low-growth environment, and we are focused on achieving profitable growth. We acknowledge that we have work to do to better calibrate market conditions and deliver on our own expectations. Turning to expenses for the second [ph] quarter. Non-GAAP SG&A totaled $667 million, down 0.7% year-over-year. Expenses were down year-over-year and quarter-over-quarter, and the efficiency ratio of non-GAAP SG&A to gross profit of 55.5% was relatively in line with our expectations. We continue to look to align our cost structure with demand and have taken actions early in the fourth quarter to better align expenses to market conditions. Coworker count at the end of the third quarter was approximately 15,400, up slightly over the second quarter and modestly above year-end. Customer-facing coworker count was also up slightly at approximately 11,200. Our goal is to balance growth and exceptional customer experience with greater efficiency and cost leverage from our broader operations. Non-GAAP operating income totaled $534 million, down 4% versus the prior year, driven by our volume shortfall, offset by slightly lower expenses year-over-year. Non-GAAP operating income margin of 9.7% was down from 9.9% in the prior year, but up from 9.4% in the second quarter. Our non-GAAP net income of $355 million in the quarter, down 3.9% on a year-over-year basis. With third quarter weighted average diluted shares of 134.9 million, non-GAAP net income per diluted share was $2.63. Moving ahead to the balance sheet. At period end, net debt was roughly $4.9 billion. Net debt is down $91 million from the second quarter and has decreased by approximately $184 million since year-end 2023. During the quarter, we issued $600 million of 2030 senior notes and $600 million of 2034 senior notes. We issued the combined $1.2 billion to settle the tender offers of both the 2024 and 2025 senior notes and for general corporate purposes that will maximize strategic flexibility. Since Q3 end, we have fully redeemed the 2024 notes. Liquidity remains strong with cash plus revolver availability of approximately $2.2 billion. The 3-month average cash conversion cycle was 17 days, up 2 days from the prior year and at the lower end of our targeted range of high teens to low 20s. This cash conversion reflects our effective management of working capital, including active management of our inventory levels. As we've mentioned in the past, timing and market dynamics will influence working capital in any given quarter or year. We continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Adjusted free cash flow was $261 million in the quarter, roughly consistent with our expectations. Year-to-date, adjusted free cash flow was a healthy $764 million and 80% of our non-GAAP net income within our stated rule of thumb of 80% to 90% of non-GAAP net income. We are on track to meet our 2024 objectives. For the quarter, we utilized cash consistent with our 2024 capital allocation objectives, including returning approximately $100 million in share repurchases and $83 million in the form of dividends. We remain committed to our target to return 50% to 75% of adjusted free cash flow to shareholders via the dividend and share repurchases in 2024. That brings me to our capital allocation priorities. Our first capital priority is to increase the dividend in line with our non-GAAP net income growth. We're announcing an approximate 1% increase of our dividend to $2.50 annually, our 11th consecutive year of increasing the dividend. We will continue to prudently manage our dividend with respect to the growth environment and target a roughly 25% payout ratio of non-GAAP net income going forward. Our second priority is to have the right capital structure in place. We ended the third quarter at 2.3 times net leverage within our targeted range of 2 to 3 times. We will continue to proactively manage liquidity while maintaining flexibility as evidenced by our recent debt financings. Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. We continually evaluate opportunities that could accelerate our 3-part strategy for growth. Year-to-date, we've utilized over $350 million of cash on share repurchases and have over $730 million of authorization remaining under our current share repurchase program. And that leads us to our outlook. The uncertain market conditions we operated under throughout 2023 have persisted well into 2024. Demand has been below what we originally anticipated and customer sentiment remains cautious across the majority of end markets. Last quarter, we spoke about the slow start to the year for 2024 IT spending and shared our expectations for tough conditions to persist in the near term. That was the case and was moderately worse than we even expected in the third quarter. Customers still have a compelling need to address priorities such as cloud workload growth, increasing security threats, aging client devices, but uncertain macroeconomic conditions and a complex technology landscape continue to weigh on customer demand for solutions hardware. Given these conditions, our updated 2024 expectation is for a low single digit gross profit decline. This implies seasonality slightly below historical levels for the fourth quarter and second half gross profit and net sales. We maintain our expectation for 2024 gross margin to be similar to the full year 2023 and much like we've seen year-to-date in 2024. Finally, we expect our full year non-GAAP earnings per diluted share to be down mid single digits year-over-year. Please remember, we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. Moving to modeling thoughts for the fourth quarter. We anticipate low to mid single-digit gross profit declines compared to the prior year, with gross margins slightly above the first three quarters of 2024, but below the fourth quarter 2023 level. This leads to a slightly worse than seasonal sequential fourth quarter. Traditionally, the fourth quarter is meaningfully lower than the third quarter, principally due to seasonally lower demand from education and government customers. But this first fourth quarter, we also do not anticipate this being offset by seasonally strong demand from corporate and small business customers. Moving down the P&L. We expect fourth quarter operating expenses to be similar to the level of fourth quarter of 2023 on a dollar basis. Finally, we expect fourth quarter non-GAAP earnings per diluted share to decline in the high single-digit range year-over-year. That concludes the financial summary. As always, we'll provide updated views on the macro environment and our business on our future earnings calls. And with that, I will ask the operator to open it for questions. We'd ask each of you to limit your questions to one with a brief follow up. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'd now like to open the lines for Q&A. [Operator Instructions] Our first question, excuse me. Our first question comes from Adam Tindle of Raymond James. Adam, your line is now open."
},
{
"speaker": "Adam Tindle",
"content": "Okay, thanks. And good morning. I just wanted to start, as we analyze this quarter, I understand tough macro to predict volumes. But I really wanted to ask about the negative operating leverage down the P&L. And taking a step back, I think what investors really like about CDW is the variable cost model and ability to kind of flex up and down with volumes. I understand some of the rationale in the prepared remarks, but this seems to be a pattern for the past few quarters. So I guess the question would be twofold. One for Chris. If you could maybe just assess what is changing and why the negative drop-through is increasingly severe down the P&L. It sounds like you decided to implement some restructuring. So maybe you can tie in some of the rationale for that. And then secondly, for Al, on that restructuring, if you could just help us with the size and what it does to the model in 2025. I think it's about a 10% to 15% of headcount based on the reports that we've seen. So just trying to rightsize how we should think about OpEx moving forward. Thank you."
},
{
"speaker": "Al Miralles",
"content": "Yeah, Adam, actually, this is Al. I will start just to give you a little bit of commentary on the quarter and operating leverage, and I'll let Chris jump in thereafter. So first - on the quarter, first, I would just say, Adam, we continue to hold strongly to our variable cost model and the impact therein. For the quarter, if you actually look at our non-GAAP SG&A expenses relative to GP, we came in just about at that 55% range, which we've talked about that being kind of the target that we would have. It's maybe slightly higher than we would have anticipated for the quarter, but that was more of a, I'll call it, denominator factor that is the GP was lower than expected. So in the quarter, we did get the movement in our variable expenses as we would expect. I think the challenge there otherwise, Adam, is that we have a fixed cost base. And while the demand environment has moved pretty dramatically, we certainly have taken action on our fixed cost to try to align with what we were seeing in current demand and what we were seeing as we go forward, it becomes a matter of just the timing therein on that fixed cost base. That said, as you know, going into the fourth quarter, we did take some actions that would reduce our fixed cost base, and that included a reduction in our workforce. Just to size that for you, Adam, it was about 2% of our workforce. So it was not at the level that you quoted there. But certainly, that would align us more closely with where we think we need to be from a fixed cost base perspective."
},
{
"speaker": "Chris Leahy",
"content": "Yeah. And Adam, I would just add that we're being very prudent as we look at where we rightsize the business while we continue to invest behind areas that we see will be pockets of growth. So a lot of focus on the demand environment, preserving profitability and also delivering exceptional customer experience for our teams."
},
{
"speaker": "Adam Tindle",
"content": "Got it. Thank you. Just a quick clarification since I know that was a long one. When you're talking about the increased pricing intensity and competition, just to clarify, is that higher competition between VARs? Or is that higher competition in pricing amongst the OEM vendors? Thanks."
},
{
"speaker": "Chris Leahy",
"content": "Yes, Adam, it's a little of both. It's a little of both."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from David Vogt of UBS. David, your line is now open."
},
{
"speaker": "David Vogt",
"content": "Great. Thanks, guys, for taking the question. And maybe one for Chris to start. So Chris, I think I heard in your prepared remarks that you'd expect sort of the U.S. IT market to be flat in 2024 and yet you're confident that you can continue to outgrow it. But obviously, the macro has been tough and it looks like you're going to undergrow the market this year. Did I hear that correctly? And how should we think about what that means going forward? I know you're not giving 2025 guidance, but I think that's a little bit disappointing relative to where investors might have been thinking given the challenging backdrop. Is it just really a reflection of where the hardware solutions are ending up? And then along those lines, we're hearing from some of our checks that networking and even to a lesser degree, storage and servers is getting a little bit better. Maybe what are you seeing a little bit differently than maybe what we're picking up and what others are maybe communicating in the marketplace? Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Yeah. Let me just start with the market share. That was the beginning of the question. Look, we continue to hold ourselves accountable for delivering a premium to the IT market rate of growth. And looking at this year and this quarter, given the low hardware demand and taking into account our mix, I'd say we're holding serve and feeling very confident that we've performed extremely well in certain areas, take cloud, Software as a Service, services as an example, but other areas have been challenged for us. And our view is that hardware will come back. It's a matter of when will that inflection point take place, and we'll be well positioned to help our customers in those circumstances. You asked specifically about networking and storage. Look, what we are seeing is we're seeing traction in clients pick up. And I wouldn't yet call it the inflection point, but we do think we're outperforming in that area. Data center has really been the area where customers have paused, have moved spend to the cloud and are taking longer time to make decisions. That means we're seeing storage, networking and servers all quite muted. But once we see the client refresh start, one would expect to see data center begin to pick up again. As I said before, the catalysts are all there. Explosion in data, the need for massive bandwidth for networking, digital transformation isn't going anywhere. Security continues to get more and more focused. So the catalysts for growth are all there. I think we just got to get to the other side of the uncertainty that we sit. And certainly, after we get through the election, there'll be a little more certainty."
},
{
"speaker": "Al Miralles",
"content": "And David, maybe I'll just add there."
},
{
"speaker": "David Vogt",
"content": "And maybe just - sorry, go ahead, Al."
},
{
"speaker": "Al Miralles",
"content": "It's okay. Just to add a couple of data points there. So obviously, all of those categories, Chris mentioned in the solutions space have been softer. We also have the tough comps from a netcomm perspective. Q3 is the last quarter with those tough comps. So while we would not say that demand is picking up meaningfully on netcomm, at least the comps get a bit easier. And then the other data point I would just give you is from our vantage point, just hardware overall, we've now seen eight quarters of declines on hardware. And so again, Chris noted some of the catalysts we think ultimately will play out. We've seen a pretty prolonged period of hardware cyclicality."
},
{
"speaker": "David Vogt",
"content": "Great. And just as a quick follow-up. So when we think about looking at the recovery or the potential recovery around the timing of the recovery? I know you're not giving '25 outlook. But what are some of the milestones that you're looking at that gives you increased confidence heading into '25? I know obviously, the election is coming up and hopefully, that kind of changes maybe customer conversations. Anything else sort of maybe at a high level that you're thinking about in your conversations that give you some degree of maybe a leading edge or a leading indicator in terms of what you're thinking about for 2025?"
},
{
"speaker": "Chris Leahy",
"content": "Yeah. I think about the things that are creating the current environment and whether or not those change. So uncertainty around the economic environment and geopolitical will have an impact. Obviously, the election policy outcomes of the election are going to be very different. That will have an impact most likely. Those are the things that are at the forefront of our mind, how the economy is doing, frankly, how it's perceived to be doing, going to be doing in the future and the volatility across the world are the two things that we look at most closely. Now the complexity in IT is not going anywhere. So the requirement now to have more business and IT leaders involved in decision-making. It's our new norm is kind of longer decision cycles for these larger complex projects. And so we're getting used to that, but we don't see that going away anytime soon. That's what we focus on."
},
{
"speaker": "David Vogt",
"content": "Great. Thank you, guys."
},
{
"speaker": "Al Miralles",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you very much. Our next question comes from Erik Woodring of Morgan Stanley. Eric, your line is now open."
},
{
"speaker": "Erik Woodring",
"content": "Great. Thank you so much for taking my questions. I have two as well. Chris, if we could just go back to some of your comments on product demand. Obviously, lots of commentary about challenges in Infrastructure Solutions, double-digit declines with many customers across netcomm, servers and storage. I just want to make sure I understand, are those rates of declines that you're referencing reflective of the broader market? Or are you seeing those declines simply because you are walking away from some lower profitability deals and therefore, you are underperforming in those specific end markets. And maybe at the end market, they aren't declining nearly as much as maybe you're seeing. I'd just love to get a better understanding of this is kind of CDW's view or if this is the broader market view? And then I just have a follow-up. Thanks."
},
{
"speaker": "Chris Leahy",
"content": "Yeah, sure. I would say it is the broader market view, possibly tempered a bit by CDW not racing to the bottom because we are walking away from economic deals. It's important to keep - protect profitability, et cetera. So I would say it's a bit of both. I would say it is market and consistent with market, but also we are not racing to the bottom."
},
{
"speaker": "Erik Woodring",
"content": "Okay. All right. That's helpful. And then maybe just on the second question, I'd love if you could maybe elaborate a bit on the market competition comments because you're highlighting market competition, which I can't necessarily remember you citing explicitly before. And to be fair, you guys have encountered several challenging and competitive market environments in the history of the company and still managed to materially outperform peers over those years. And so maybe my question is just what has changed with competition that is new? And really why would that competitive intensity ever go away even in a period of stronger demand? Thanks so much."
},
{
"speaker": "Chris Leahy",
"content": "Yeah. It's a great question, and we do reflect on that. We are used to highly competitive environment. What I would say we're feeling right now and this quarter and the past couple of quarters, in particular, is irrational pricing. And we know how to compete in the market, but we are seeing deals at below margin, low margin, et cetera, and that just is not our business model. The last time I saw intensity in pricing like this was years ago. So it has been a little bit more unique over the last couple of quarters, and we're very good with our discipline around financials. So we're holding firm. That's really the answer here. It's a little unique over the last couple of quarters. We've seen it really tick up."
},
{
"speaker": "Erik Woodring",
"content": "And just to clarify, that is rational pricing from VARs, from distis or from both?"
},
{
"speaker": "Chris Leahy",
"content": "I would say it's up and down the value chain. So competitors who are value-added resellers, direct competitors, distributors, I wouldn't perceive as in that chain as much."
},
{
"speaker": "Erik Woodring",
"content": "Okay. Thank you so much, Chris."
},
{
"speaker": "Chris Leahy",
"content": "Yes, the behaviors that are going on, every competitor is feeling the elongation in the sales cycle. The chunking up agreements to make them smaller, the deferrals, the reductions, the different ways they want to go at saving money or deferring spending, short-term ROIs. That is a market dynamic right now that everybody is feeling."
},
{
"speaker": "Erik Woodring",
"content": "Understood. Thank you, Chris."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our next question comes from Amit Daryanani of Evercore. Your line is now open."
},
{
"speaker": "Amit Daryanani",
"content": "Good morning. I have two as well. I guess, Chris, just to conclude this discussion you had, you folks are on track to have 2 years of consecutive gross profit declines at the company. And it's something you haven't seen at CDW, I think, historically, even if I go back to '03, '04 or '07, '08 time frame. I understand all the macros that you're talking about, but it feels like the way CDW is navigating this macro uncertainty volatility is worse than what you've seen before. And why do you think that's happening? And what's changed perhaps in the company that you've had multiple years of gross profit declines, which frankly, you haven't had historically?"
},
{
"speaker": "Chris Leahy",
"content": "Yeah, Amit, fair question. I'll tell you, we're a company in transformation, and we have been in transformation for several years now. So when you think about the CDW - CDW-specific factors I mentioned, they have been having a real impact on results, amplified by the muted hardware demand environment. So if we just think about the third one I mentioned, which is our cloud and SaaS business, we've been investing behind that business and growing it incredibly rapidly over the last 5 years. All of our acquisitions have had a cloud services hook to them. Nonetheless, given the full portfolio that we have, we have not yet attained the scale that we want to be at relative to the full portfolio. So when hardware is muted, it now has even more of an outsized impact because of the secular movement towards cloud. And we're growing that, but we still have a very high mix of hardware. The other thing is the strategic investments that we've made over the year have been incredibly fruitful in developing broader and deeper strategic capabilities so that we can deliver full stack, full outcomes projects. These now we're seeing at much larger, higher dollar tier levels, and those are the kind of projects that are lumpy. We used to talk about this with our federal contracts all the time. The very big deals become lumpier. And depending on when decisions are made, they can get deferred, they can move around, the size can change, and therefore, it can impact results. And we saw that with commercial and federal this quarter. And the last one is what I just talked about in the prior question, which is our financial discipline. We're going to continue to maintain our gross margin discipline as we move forward. And we've hit a couple of quarters where we're seeing behavior that is extreme - pricing behavior that's extreme. So I just - Amit, I'd say it is a combination of our strategic investments that are working incredibly well vis-à-vis value to the customer and growth in fast-growing high-relevance areas in an environment where hardware has been and continues to be muted on a persistent basis. It's a bit of a double whammy for us. But I'm confident in the growth as hardware turns around. Go ahead, Amit."
},
{
"speaker": "Amit Daryanani",
"content": "No, I'll let you finish."
},
{
"speaker": "Chris Leahy",
"content": "No, I was just going to say..."
},
{
"speaker": "Amit Daryanani",
"content": "You know, growth."
},
{
"speaker": "Chris Leahy",
"content": "Go Amit."
},
{
"speaker": "Amit Daryanani",
"content": "I was going to say, Chris, would it be fair to say that as growth resumes presumably in '25 that you should start to see gross profit dollars increase back to the way it normally does? I think that would be a fair way to think about it. And then maybe my clarification was going to be, we've heard from Cisco and Microsoft, some of your bigger vendors and how they're changing their channel pricing and the channel strategy for 2025. Do you see that being a bit of a driver for you as you think about your growth, especially the agent sales piece of the business into next year and beyond?"
},
{
"speaker": "Chris Leahy",
"content": "Yeah. As I think about the changes, I think about investing behind our cloud business and really the cloud flywheel where we are trying to - we are delivering a seamless experience from professional managed services to consumption and transaction-based services to managed services around the cloud. And by doing that, delivering higher value to our customers, but that's precisely aligned with what our vendors are the CSPs, the Ciscos of the world exactly aligned with what they - what they're incenting and what they want. So we think we're well positioned, and that will be a positive benefit for us as we move into 2025 and beyond because it aligns with our strategy and our value that we can deliver to customers. And frankly, it drives - because of the services wraparound, it drives better economics for CDW and a stickier relationship with the customer."
},
{
"speaker": "Operator",
"content": "Thank you very much. Our next question comes from Matt Sheerin of Stifel. Matt, your line is now open."
},
{
"speaker": "Matt Sheerin",
"content": "Yes. Thank you. Good morning, everyone. Just another question regarding the comments on client device growth. I think you said mid single-digit growth, but it sounds like that was skewed more toward the public markets and not so much corporate and SMB. And you talked about macro. Is the expectation for AI PCs? Is that another reason why we're seeing that push out? And are you seeing any kind of growth in corporate SMB versus enterprise there?"
},
{
"speaker": "Chris Leahy",
"content": "Yeah, Matt, thanks for the question. On the client side, we're actually seeing - we're seeing growth across almost all of the end markets. Corporate was - we saw growth in corporate. It small business is where we are seeing our customers kind of in a cash preservation mode and so pushing off the client device. But we really have seen a nice pickup in client across almost all the end markets. So that's been positive."
},
{
"speaker": "Al Miralles",
"content": "Yeah. And Matt, I'll just add the - what has been driving it has been more refresh of aging fleets and need for customers to get on with this activity. It's been less in the way of Win 11 drivers and less in the way of AI PCs."
},
{
"speaker": "Chris Leahy",
"content": "So next year, as AI PCs do come on board, that will be another nice accelerant for PC refresh."
},
{
"speaker": "Matt Sheerin",
"content": "Okay. Great. Thank you. And then relative to your guidance on gross margin, Al, for Q4, which is down year-over-year, and you had a big bump last year. Is that because you're expecting sort of a lower percentage of the advanced hardware solutions, which carries higher margins or services? What are the other reasons behind that?"
},
{
"speaker": "Al Miralles",
"content": "Yeah. Great question, Matt. It anticipates that we'll continue to see softness in the solutions side of the business, which comes at moderately higher gross margins. It assumes that client will continue to tick along, not in an outsized way, but that client would continue to move along. And then we would expect that we would get your typical pickup in more of the netted down revenues in the fourth quarter. I'll just note the delta versus Q4 of 2023 is that maybe a little bit modest pick there on the netted down revenues versus last year because it was quite outsized at the end of the year."
},
{
"speaker": "Matt Sheerin",
"content": "Got it. Okay. Thank you."
},
{
"speaker": "Al Miralles",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Keith Housum of Northcoast Research. Keith, your line is now open."
},
{
"speaker": "Keith Housum",
"content": "Thank you. Two questions as well, if I could. Chris, just trying to reconcile something here. CDW has always tied itself as being a relationship driven company providing value for its customers. But yet we're hearing about transactional competition and losing deals that way. Perhaps can you break it out for us like how much of the business is more transactional where people are just going with the lowest price versus how much of your business is really driven by that relationship and the value you provide?"
},
{
"speaker": "Chris Leahy",
"content": "I would say that when you look at our portfolio and the spectrum of our relationships with our customers, that over 90% of those relationships and those customers would tell you that they buy from CDW because of the value we deliver, the access to a full portfolio, the expertise that we bring to bear, the ease with which they can do business, the agility with which we deliver that is what every customer says to me when I meet with them. Regarding the pricing and the transaction issues, there are times when there are large rollouts, for example, that - where the economics just gets lower and lower and lower. And those are transaction purchases that don't typically have the value wrapped around, and those are the ones that we are less interested in pursuing."
},
{
"speaker": "Keith Housum",
"content": "Okay. Appreciate it. And then you talked about like the move to the as-a-service model. I guess as I think about that, it's still relatively in its infancy, but it's only going to grow as we go from here. So how much of, I guess, a challenge or a headwind does that present to hardware sales as we kind of think about just the future?"
},
{
"speaker": "Chris Leahy",
"content": "I didn't hear the whole question. I'm sorry."
},
{
"speaker": "Al Miralles",
"content": "I think I got it, Keith. Here's what I would say. Obviously, we've seen pronounced cyclicality in hardware, and that would typically be pretty significant upfront spend. Think about that as kind of CapEx from a customer's perspective. What we've seen kind of counteracting that in some respects is an increase in our netted down revenues, including SaaS and cloud. Now Keith, historically, a lot of that business would be what we would call reoccurring where we are both seeing that business upfront and recognizing that upfront. But I would say that over the last year or 2, more of that business has been moving to a recurring nature. And that is where customers are more making judgments on what they want to spend on cloud, but they're consuming it as they go. And therefore, that shows up over time for us. Now I wouldn't call that a material dollar amount at this point, but it is growing. And therefore, I would say that is part of the calculus of kind of the air pocket when you have pronounced cyclicality of hardware and more business that starts to come on as we go. Certainly, as we continue to grow that sector in that category, we'll report more on kind of that split in details with respect to reoccurring business versus recurring. Hopefully, that's helpful."
},
{
"speaker": "Keith Housum",
"content": "Yeah. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you very much. Our next question comes from Samik Chatterjee of JPMorgan. Samik, your line is now open."
},
{
"speaker": "Samik Chatterjee",
"content": "Hi. Thank you for taking my questions. I guess if I can start with one. Chris, you mentioned in your prepared remarks and in some of the responses as well, the exposure to large projects that you have on account of the capabilities that you've invested in over the years. I mean, as you outlined some actions you're taking on the cost structure side. But as you look at the business and the lumpiness that, that drives in terms of exposure to large projects, are there any changes you're contemplating on that side in balancing out the business between larger projects or transactions versus do you still - or do you still believe that's the right sort of balance or margin mix to have in the portfolio and really just wait for the market to come back on that front? And I have a follow-up. Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Yeah. The way I'd answer that question is kind of yes and yes. In other words, we do have actions underway. Look, we're looking at this quarter in 2025 as an opportunity to accelerate the most important parts of our strategy that we've been working on for several years. But one of them, for example, would be our digital work. We've done a lot of foundational work in digital, and we just need to go faster. And that really means aligning our digital capabilities and our people to deliver personalized recommendations that match how customers want to buy, plan, consume and manage their assets. So think about this in terms of large deals and perhaps smaller deals as an intersection of our sales professionals moving up a value chain and being available to learn and enabled by digital tools to sell at the highest point of the value chain while creating a seamless digital experience for our customers, a flywheel, if you will, so that we can deliver both velocity in that digital flywheel and serve customers how they'd like to be served, self-serve, et cetera, and value with our account managers and sales professionals working together. So that's one area, as an example, where we - our intention is to drive velocity in deals at all sizes, lower-tier levels while we continue to build engagements at high value, high levels."
},
{
"speaker": "Samik Chatterjee",
"content": "Okay. Got it. And, thank you for that. Quickly for my clarification question. I know you mentioned the election-related uncertainty and some of the slower spend on the public sector federal side as well. I mean we've seen elections in the past as well. Have you had instances or are you looking at any scenarios in which you do end up getting like a budget flush post the election outcomes? Are there any sort of scenarios or any indications of that happening in the fourth quarter? Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Yeah, hard to tell. I would say this election cycle, I wouldn't - I would say there's nothing really normal about it. So hard to tell. I mean, right now, what's happening with the federal government is we've got the knock-on effects from the delayed budget previously. And now we've got - while we saw strong spending in the Department of Defense, we're seeing less than we'd hoped because they're waiting to see what the administration's priorities are. So we - right now, we just see the federal government paused. One would hope we'll have some more clarity post election, but then the timing comes down to Congress and the President in getting a budget passed."
},
{
"speaker": "Al Miralles",
"content": "And maybe, Samik, I'll just add on the back end there. Obviously, we play all of the different scenarios and how things could play out when we look at the quarterly outlooks. I would say our Q4 outlook has the appropriate level of caution baked into it based on all the factors that we've talked about, the external factors, TDW specific, and certainly, that would include any political uncertainty."
},
{
"speaker": "Samik Chatterjee",
"content": "Got it. Got it. Thank you. Thanks for taking the questions."
},
{
"speaker": "Al Miralles",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you very much. We currently have no further questions. So I'd like to hand back to Chris Leahy, Chair and CEO, for any closing remarks."
},
{
"speaker": "Chris Leahy",
"content": "Okay. Thank you, operator. Let me close by recognizing the incredible dedication and hard work of our 15,000 coworkers around the globe. It's their ongoing commitment to our customers in this challenging environment that makes us successful over the long term. Thank you to our customers for the privilege and opportunity to help you achieve your goals, and thank you to those listening for your time and continued interest in CDW. Al and I look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"content": "As we conclude today's call, we would like to thank everyone for joining. You may now disconnect your lines."
}
] |
cdw | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, all. Thank you for joining us for the CDW Second Quarter 2024 Earnings Call. My name is Carly and I'll be the call coordinator for today. [Operator Instructions] I'll now hand over to Steve O'Brien of Investor Relations to begin."
},
{
"speaker": "Steve O'Brien",
"content": "Thank you, Carly. Good morning, everyone. Joining me today to review our second quarter 2024 results are Chris Leahy, our Chair and Chief Executive Officer and Al Miralles, our Chief Financial Officer. Our earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the call. I'd like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K we furnished to the SEC today and in the company's other filings with the SEC. CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures and you will find most directly comparable GAAP measures in accordance with SEC rules. You'll find reconciliation charts in the slides for today's webcast and in our earnings release and Form 8-ks. Please note all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2023 unless otherwise indicated. Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company. With that, let me turn the call over to Chris."
},
{
"speaker": "Chris Leahy",
"content": "Thank you, Steve. Good morning, everyone. I'll begin today's call with a brief overview of our performance, strategic progress and view on the second half of the year. Al will provide additional detail on our results, our capital allocation priorities and our outlook. We'll move quickly through our prepared remarks to ensure we have plenty of time for questions. Second quarter market dynamics played out roughly as we expected. Cautious customer behavior once again, elongated sales cycles and drove prioritization of needs over wants and cost savings over expansion. Capital investment in complex solutions, particularly those tied to data center and network modernization continued to be downsized or put on hold, and there was growing refresh activity in client devices. What was not expected were two end-market specific dynamics, a worsening in the UK environment and further federal funding challenges. Within the limited demand environment, we continue to help our customers build out technology roadmaps and our pipeline remains solid in the solution space. Conversion remains challenging with uncertainty weighing on our customers' appetite to spend. The team's value as a trusted adviser and ability to deliver solutions that met our customers' most pressing priorities drove excellent performance across cloud, security and services. Performance that contributed to strong profitability and cash flow, performance made possible by the strategic investments we have made over the past five years to bring full stack, full lifecycle solutions to our customers. For the quarter, the team delivered gross profit of $1.2 billion, flat year-over-year with a gross margin of 21.8%, up 80 basis points, net sales of $5.4 billion, which were down 3.6%, non-GAAP operating income of $510 million, down 3.7% with a non-GAAP operating income margin of 9.4%, which was flat and non-GAAP earnings per share of $2.50, which was down 2.6%. Let's take a look at this quarter's performance drivers. First, our balanced portfolio of end markets. Recall, we have five sales channels, corporate, small business, healthcare, government and education, each a meaningful business on its own with 2023 annual sales ranging from $1.6 billion to $9 billion. Channels are further segmented to focus on customer end markets including geography, verticals, customer size and spend. Teams are similarly segmented in our UK and Canadian operations, which together delivered US$2.6 billion dollars in 2023 sales. These unique customer end markets are typically uncorrelated given the different economic and external factors that impact each of them. Our second quarter results provide a good example of this. Corporate posted a net sales decline of 2%. Robust increases in cloud and security supported profitability with a meaningful increase in gross margin. Client devices increased for the second quarter in a row and posted both year-over-year and sequential sales increases of low double digits. Notably, client device ASPs held firm with a mix into higher value, higher functionality units. Once again, servers and netcomm declined as customers continue to undergo technology transitions in its real capacity. Storage was a standout category increasing double digit driven by upgrades of legacy systems. Small business net sales declined 3%. The team's ability to help customers address mission critical priorities around security and productivity with cost-effective software and cloud solutions contributed to improvements in both gross profit and margin. Small business did not see significant refresh activity and while increasing mid-single digit sequentially, client devices declined slightly year-over-year in the quarter. Consistent with corporate ongoing postponement of infrastructure investments in netcomm and servers drove low double-digit declines. Public sales declined 2% in the quarter with mixed performance by end market. Government decreased 6% as growth in state and local was more than offset by a decline in federal. Federal results were further impacted by the delayed fiscal 2024 budget authorization as several key customers did not receive funding releases until late June, weeks later than expected. These released funds face processing delays from the normal gears of government as hardware and software orders require solicitation, competitive bids and evaluation. We know that ongoing projects will eventually move forward, but some agencies may pause new projects as they await the clarity around the next administration's priority. In light of these layers of friction and uncertainty, we do not expect a federal catch up in the back half of 2024. The state and local team had another solid quarter, up mid-single digits. Security remained a key performance driver. Client devices increased by mid-single digits both year-over-year and sequentially. While early state and local budget dollars are being allocated to improving citizens experience at state and municipal agencies, including enhanced AI-powered automated response and messaging platforms. Healthcare net sales were flat. Security remained a key focus area and the team delivered robust customer spend and gross profit growth, led by security assessments for cloud migration and identity management. Driven by refresh, client devices increased by double digits. The team's ability to deliver cloud migration, including moving applications out of hospital data centers, drove excellent cloud performance and contributed to both increased gross margin and profitability. Education sales declined roughly 1%. K-12's top line was roughly flat year-over-year while profitability grew. For the second quarter in a row, client device sales increased up mid-single digits as school systems refreshed aged Chromebooks. Security and cloud remain top priorities, both delivering strong growth and gross profit. Once again, collaboration hardware, primarily smart whiteboards and interactive flat panels, declined meaningfully as schools continue to digest significant purchases made over the past several years. With the sunsetting of ETF funds and upcoming deadlines for ESSER funds of September 30th, the team is focused on helping their customers pivot to refresh programs funded through traditional mechanisms. Consistent with recent quarters, higher ed institutions remained focused on investments to enhance student experience to drive enrollment, while doing more with less, and the team posted a mid-single-digit top-line decline. Cost elasticity continued to drive strong double-digit growth in cloud. Security remained a top priority, up strong double digits and client devices returned to growth in the quarter, up high single digits driven by refresh. Our UK and Canadian international operations, which we reported other, declined 13%. While both teams continue to execute well, the demand environment, particularly in the UK, worsened during the quarter as the early general election amplified already challenging conditions. UK sales declined high teens in US dollars and Canada declined 4% in US dollars. Given current conditions, we expect the UK market to remain volatile and under pressure through the back half of the year. As you can see, the diversity of our end markets results is fundamental to the first driver of our performance, our balanced portfolio of customer end markets. Category performance demonstrates the benefit of our second performance driver, our broad and deep portfolio of products and solutions. Transactions categories increased during the quarter while solutions categories declined. Both transactions and solutions increased sequentially in the quarter. At the portfolio level, hardware decreased 5%. High single-digit client device growth and mid-single-digit steward growth was more than offset by meaningful declines in netcomm and collaboration. Software customer spend increased mid-single digits while net sales were impacted by our strong mix into netted down revenue and decreased by 1%. Services increased by 6% driven by cloud and security-related services. Once again, cloud was an important performance driver, contributing double-digit gross profit growth across software, services and security. Profitable growth that was enabled by the strategic investments, both organic and acquired, we have made in solutions and services capabilities over the past five years. And this leads to the final driver of our performance in the quarter, our three-part strategy for growth, which is; first, acquired new customers and capture share; second, enhanced our solution of capabilities; and third, expand our services capabilities. Each pillar is crucial to our ability to profitably advise, design, orchestrate and manage the solutions our customers want and need in any environment. Let me share an example of our strategy and action as we delivered on a customer's priority in today's challenging demand environment. An insurance company faced early end of life for its hyperconverged infrastructure equipment, something not contemplated in their already tight budget. Armed with our broad and deep cloud portfolio, our cloud, hybrid infrastructure and services group collaborated to architect a cloud subscription-based solution that delivered cost elasticity, the customer's budget could absorb. The multi-faceted solution seamlessly moved on-premise workloads and data to the public cloud, delivered cloud compute, migrated custom and off-the-shelf applications, created a virtual desktop infrastructure and delivered security measures with virtual firewalls. Plus, it optimized workloads to ensure the customer effectively managed CPU usage, memory and storage, further mitigating costs. This comprehensive solution generated more than $1 million in product revenue and a multi-million dollar CDW professional services engagement. After seeing our cloud expertise in action, the customer engaged us for additional cloud solutions, including identity management and unified cloud call center ongoing managed services. Today, we were one of the customers' most valued strategic partners. A great example of how we're delivering value to our customers both for today and for the future. And that leads me to our expectations for the balance of the year. You will recall that on the last quarter's conference call, we shared our expectations for 2024 U.S. IT market growth in the low single digits. And our target to grow 200 basis points to 300 basis points above market. This factored in a modest improvement in demand conditions in the second half of the year. Given real-time feedback from our large and diverse customer base, we now expect current market conditions to persist throughout the year, not get worse, but not get better. Given the market's slow start to the year, without a second-half demand pickup, we now look for U.S. IT market growth up towards the lower end of a low single-digit range. We continue to maintain our target to grow 200 basis points to 300 basis points above market. Growth will return. The demand drivers are there. Workload and data growth, increased security threats, client device obsolescence, and adoption of AI-powered assistance and applications. But customers need greater clarity and confidence, clarity around economic conditions and clarity around the impact of AI on their tech roadmap, and confidence that investments made today will deliver the right foundations and economic returns in an AI-powered future. Improved demand conditions are a function of when, not if. Wildcards for the balance of 2024 include the potential of greater macro and geopolitical uncertainty, significant degradation of market conditions in the UK, as well as unusual uncertainty in the U.S. election. As we always do, we will provide an updated perspective on business conditions as we move through the year. Whatever the market conditions, we will remain focused on delivering exceptional value to our customers, gaining share and executing with the discipline and rigor that is CDW's hallmark. And we will continue to play the long game, holding steadfast in our commitment to executing against our growth strategy to ensure we have the solutions and services capabilities our customers need to achieve their mission critical outcomes. With that, let me turn it over to Al, who will share more detail on our financial performance."
},
{
"speaker": "Al Miralles",
"content": "Thank you, Chris and good morning, everyone. I will start my prepared remarks with details on our Q2 performance, move to capital allocation priorities and then finish with our updated 2024 outlook. Second quarter gross profit of $1.2 billion is roughly flat, up 0.1% versus the prior year. This is modestly below our original expectations for low single-digit growth for the quarter as the aforementioned strength in cloud, security and services was offset by lower demand for netcomm and collaboration hardware. Consolidated second quarter net sales of $5.4 billion were down 3.6% versus the prior year on both reported and average daily sales basis and up 11.3% sequentially, driven by seasonally higher demand in education channels and government channels and especially pursuant to client devices. Gross margin increased approximately 80 basis points year-over-year. Gross margin of 21.8% was flat quarter-over-quarter and broadly in line with both full-year 2023 levels and our expectations for 2024. Second quarter year-over-year margin expansion was primarily driven by the higher mix in the sales, where CDW acts as agent, also known as netted down sales. This category grew by 8.7%, once again, outpacing overall net sales growth and representing 33.2% of our gross profit, compared to 30.6% in the prior year's second quarter. Year-over-year expansion came from our teams continuing to successfully serve customers with cloud and SaaS-based solutions. The netted down category of solutions represents an important and durable trend within our business, contributing to our ability to deliver enhanced gross margins. It is important to note that netted down sales growth and its impact on our mix of business will fluctuate over time with customer priorities and product demand. Second quarter gross profit was up 11.3%, compared to the first quarter of 2024 on both reported and sequential average daily sales basis. While second quarter sequential net sales and gross profit growth were higher than the sequential growth rate seen in the last few years, they were very modestly behind our own expectations, as well as historical seasonal upturn we experienced in pre-pandemic years. This reflected two factors, longer-than-expected delays in spend from our federal customers related to the prior congressional budget impasse and lower performance by our UK business, which is impacted by volatility in the economic and political climate. Turning to expenses for the second quarter. Non-GAAP SG&A totaled $673 million, up 3.2% year-over-year. Expenses were roughly consistent with the expectation we shared on our last earnings call, including expense efficiency ratio more in line with normal levels. The improvement from the first quarter reflected higher gross profit attainment and relatively lower level expenses on a quarter-over-quarter basis. Coworker count at the end of the second quarter was approximately 15,200, up slightly over the first quarter and year-end. Customer facing coworker count was also slightly up at approximately 11,000. Our goal is to balance driving growth and exceptional customer experience with efficiency and cost leverage from our broader operations. Non-GAAP operating income totaled $510 million, down 3.7% versus the prior year, driven by the combination of roughly flat gross profit and moderately higher expenses year-over-year. Non-GAAP operating income margin of 9.4% was flat to the prior year and up from 8.3% in the first quarter. Our non-GAAP net income was $339 million in the quarter, down 2.9% on a year-over-year basis. The second quarter weighted average diluted shares of 135.6 million, non-GAAP net income per diluted share was $2.50. Moving to the balance sheet. At period end, net debt was roughly $5 billion. Net debt has declined by approximately $93 million since year-end 2023, primarily reflecting our increased cash position alongside modest debt repayment. Liquidity remains strong with cash plus revolver availability of approximately $1.9 billion. The three-month average cash conversion cycle was 17 days, up three days from the prior year, but still at the lower end of our targeted range of high-teens to low-20s. This cash conversion reflects our effective management of working capital, including active management of our inventory levels. As we've mentioned in the past, timing and market dynamics will influence working capital in any given quarter or year. We continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Adjusted free cash flow was $138.4 million in the quarter, consistent with our expectations and seasonal business trends. Year-to-date, adjusted free cash flow was a healthy $503 million, an 84% of non-GAAP net income within our stated rule of thumb of 80% to 90%. First-half performance puts us on track to meet our 2024 objectives. For the quarter, we utilized cash consistent with our 2024 capital allocation objectives, including returning approximately $202 million in share repurchases and $83 million in the form of dividends. We remain committed to our target to return 50% to 75% of adjusted free cash flow to shareholders via the dividend and share repurchases in 2024. That brings me to our capital allocation priorities. Our first capital priority is to increase the dividend in line with non-GAAP net income. Last November, we announced a 5% increase of our dividend to $2.48 annually, our tenth consecutive year of increasing the dividend. We will continue to target a 25% payout ratio in 2024. Our second priority is to ensure we have the right capital structure in place. We ended the second quarter at 2.4 times within our targeted net leverage range of two to three times. We will continue to proactively manage liquidity while maintaining flexibility. Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. We continually evaluate M&A opportunities that could accelerate our three-part strategy for growth. Year-to-date, we've utilized over $250 million of cash on share repurchases and have over $830 million remaining under our current share repurchase program. And that leads us to our outlook. The uncertain market conditions we operated under throughout 2023 have persisted well into 2024. Customer sentiment remains cautious and prudent across end markets, particularly in the commercial, international and federal channels. Last quarter, we spoke about the slow start to the year for 2024 IT spending and shared our expectations for tough conditions to persist in the near-term, but to modestly improve in the second half. At the same time, we noted a compelling need for our customers to address cloud workload growth, increasing security threats and aging client devices. These priorities continue to resonate with customers and were brighter spots in the second quarter, while uncertain macroeconomic conditions and a complex technology landscape weigh on customer demand for solutions hardware. Given these market conditions, our updated full-year 2024 expectation is for flat-to-low single-digit gross profit growth, a view that incorporates both our slower start to the year and our view that the mild recovery we anticipated in the second half is not likely to materialize. This leads to seasonality roughly in line with historical levels, with the first half contributing approximately 48% of net sales and gross profit. We maintain our expectation for 2024 gross margin to be similar to the full-year 2023 and much like we've seen throughout the first half of 2024. Finally, we expect our full-year non-GAAP earnings per diluted share to be flat to up slightly year-over-year. Please remember we hold ourselves accountable for delivering our financial outlook on a full-year constant currency basis. Moving to modeling thoughts for the third quarter. We anticipate low single-digit gross profit growth compared to the prior year with no change to our expectation that gross margin will be comparable to full-year 2023 and the first half of 2024. This leads to roughly normal seasonality, compared to historical levels and also the moderately lower second quarter base. We continue to expect the fourth quarter to be meaningfully lower, compared to the third quarter, principally due to seasonally lower demand from education and government customers. Moving down the P&L. We expect third quarter operating expenses to be moderately higher than the third quarter of 2023 on a dollar basis given the higher gross profit performance, but at a similar ratio relative to gross profit. We expect third quarter non-GAAP earnings per diluted share to grow in the mid-single-digit range year-over-year. For full-year 2024, we are maintaining our expectation for adjusted free cash flow to be in the range of 80% to 90% of our non-GAAP net income. We currently sit comfortably within that range. That concludes the financial summary. As always, we'll provide updated views on the macro environment and our business on our future earnings calls. And with that, I will ask the operator to open it up for questions. We would ask each of you to limit your questions to one with a brief follow-up. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you very much. [Operator Instructions]. Our first question comes from Amit Daryanani of Evercore ISI. Amit, your line is now open."
},
{
"speaker": "Amit Daryanani",
"content": "Good morning and thanks for taking my question. I guess maybe, just to start with, if I look at your core gross margin, the gross profits excluding netted down revenues, it was up fairly, nicely, sequentially and really flat year-over-year despite what seems like a much higher mix of PCs in the quarter. Could you just talk about what is enabling the sequential gross margin expansion in June for your core business and if there's a structural change to what PC margins may look like going forward?"
},
{
"speaker": "Al Miralles",
"content": "Yes. Thanks, Amit. Good morning. I'll take that question. Nothing too significant there to report, Amit. I would just say that, within the array of the product sectors, we did see strength in storage in a couple other categories that supplemented our client device margins. And then further, I would note that on the client device side of the house, we continue to see firm margins there including, and Chris alluded to this, kind of a higher mix in the kind of premium product, if you will. So, overall, we continue to see an environment, where product margins appear to be holding up. And obviously, as you pointed out, they are further supplemented by the growth that we continue to see on the netted down revenue stream side."
},
{
"speaker": "Amit Daryanani",
"content": "Got it. And then, yes, I guess, Chris, could you just talk about, if I think about it at the start of the year, the expectation was for gross profit dollars to be up mid-single digits and it kind of went to low single digits and now, it's kind of flat to low. Is this downward revision that you made, is it really around what's happening to the PC recovery and how that's become a bigger part of the mix. Or are there other factors Let me see. How do you weigh the downtick in revisions over the last couple of quarters? And is there any change in how you forecast your forecasting philosophy as you go forward related to that? Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Yes. Good morning, Amit. Thanks for the question. As we think about, let me start with the first part of that question, the outlook, and I'll just walk you through. I mean, at high level, that our outlook, incorporated a modest uptick in the second half demand of 2024. And that change really reflects, that we think current market conditions will persist. I think, I said not get worse, excuse me, but not get better. And that's just based on our market intelligence with our customers and our frontline coworkers. If you want to go through the puts and takes, look, when we start with corporate after a long period of fits and starts, and what I'll call uneven performance, corporate feels on more solid footing and is demonstrating a steadier rhythm to the business. That said, with signs of stability, it's still a bit too early to call and to bake that into the expectation in the back half of the year. Just need to see a couple more data points to build confidence on that one. Small business, I'd say not getting worse, not quite as volatile, but still bouncing along the bottom, so not seeing an uptick there. And then we've got these two end markets that had very unique impacts and we think will impact going forward. The UK, the degradation in the UK that I mentioned in the environment there, which impacted the second quarter and expecting impact the second half of the year. And then the federal gears of government, these two delays are just creating, frankly, a bottleneck that's not overcomeable at this point, on the federal side. And so, we don't expect to see a pickup back in the second half of the year in federal as we expected to. So, I just say that the outlook net-net reflects that there's no substantive change in the commercial market demand. It incorporates normal seasonality and it also includes, I guess, a moderate IT refresh across primarily client devices and some other solutions that can't be postponed. So, that's the way that we're thinking about the outlook. I think you asked a question on forecasting. And I would just say that on the forecasting, look, the team is doing a phenomenal job staying highly-engaged with our customers and pivoting, when needed. As you can see from our results, security cloud, software services results, it's very clear that we -- our portfolio and our people allow us to be the trusted adviser and support in the moment in the market type solutions. The forecasting is, yes, it's a little bumpier. because you've got lumpy - lumpy-big deals and they're all interrelated. There's no the example that I shared during the script. You see how interrelated and complex the solutions are. So, as those push, they push. but I think the team's doing a great job staying engaged with customers. And I would also say that our solutions pipeline is really quite strong. It's been the conversion given the market that is reflecting the appetite to buy, but the pipeline is really quite strong."
},
{
"speaker": "Operator",
"content": "Our next question comes from Matt Sheerin of Stifel. Matt, your line is now open."
},
{
"speaker": "Matthew Sheerin",
"content": "Yes. Thanks. Yes. Thank you. Good morning. I wanted to ask about the commentary regarding the continued slow demand for netcomm and servers, advanced solutions products. This is probably the third quarter that we're into that malaise. I know there was a lot of backlog that was worked down. Are you seeing any visibility of signs of pickup there. And then on the server side, we're hearing, particularly, SMBs and middle markets, where there's more an acceleration toward cloud instead of doing their own internal upgrade. So, any visibility into those markets?"
},
{
"speaker": "Chris Leahy",
"content": "Yes. I would say on the networking side, there's certainly interest from customers on network modernization. That is a high priority. but there is still significant digestion going on. The supply chain is normalized, but we still have customers that are digesting what they purchased or actually received, I should say, later in the cycle. I think as we get back to the back half of the year, the overlaps will look a little bit different and so the performance will likely look a little bit different. But I would just say it's high priority. There's just still a lot of excess at our customers that they're digesting. On the server side, on the mid-market server side, we are seeing some strength in that area. but again, it's subject to our customers really, being cautious about where they're spending and pivoting a little more to cloud and elastic advisable solutions at this time."
},
{
"speaker": "Matthew Sheerin",
"content": "Okay. Thank you. And then regarding the outlook for the government business, it doesn't sound like there's going to be that seasonal uptick in federal, yet you're guiding the overall company for a seasonality in the next couple of quarters. So, are there any offsets to that weakness in federal."
},
{
"speaker": "Al Miralles",
"content": "Good morning, Matt. I would just note, look, we are still going to see reasonably normal seasonality from the government business. And remember, there's significant strength there on the state and local side of things. So look, even in the quarter, state and local offsetted some of that compression from a federal perspective. So, I would say it's all in the realm of regular normal seasonality for government, with just a downtick a bit in federal for Q3 and Q4."
},
{
"speaker": "Matthew Sheerin",
"content": "Got it. Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Keith Housum of Northcoast Research. Keith, your line is now open."
},
{
"speaker": "Keith Housum",
"content": "Great. Good morning. Just one question really. In terms of the CrowdStrike debacle that happened recently, was that a positive or negative for you guys in terms of working with your customers."
},
{
"speaker": "Chris Leahy",
"content": "Oh, Keith. Thanks for the question. First of all, it was CDW didn't impact us that much, which was great. But I'll tell you, I'm really proud of this team. They were so quick to help customers do boot-refixes and workarounds and essentially, get after customers immediately. So, it just reinforced, I think, the fact that we have such strong relationships with our customers and that the trust adviser role is so important. Once you do a transaction with a customer, it's not one and done, but this just reflected the fact that the aftercare and the relationship ongoing is so important. So, it was a very unfortunate, obviously, circumstance across the world, but really proud of the team for stepping up and stepping in with our customers."
},
{
"speaker": "Keith Housum",
"content": "Yes. If I can follow-up on that, is that an opportunity for you guys to gain customers by showing exactly the experience and advisor leadership you guys have."
},
{
"speaker": "Chris Leahy",
"content": "Oh, absolutely. Yes. So, in circumstances like this, when we have been able to help, when there's a particular issue that's popped up that absolutely goes back and across the sales organization, we take it to other customers to help highlight potential vulnerabilities and then help them resolve those."
},
{
"speaker": "Keith Housum",
"content": "Great. Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Same in the security space. That's what we do."
},
{
"speaker": "Operator",
"content": "Our next question comes from Asiya Merchant of Citigroup."
},
{
"speaker": "Asiya Merchant",
"content": "Great. Thank you for taking my question. If I could -- if you could just double click a little bit on the OpEx intensity, where is CDW spending these U.S. -- spending these operational expense dollars on. and how we should think about the trajectory of those expenses as it relates to your overall revenue or gross profit dollar growth in the back half. Thank you."
},
{
"speaker": "Al Miralles",
"content": "Sure. Good morning, Assia. A couple of things that I would just note. Number one, remember when we started the year, we indicated that we would have expected the beginning of the year would reflect higher level of expenses than usual and a ratio of SG&A relative to GP would ease as the year played out. Asiya, some of that is a function of just timing and seasonality of certain expenses that we see in the first half, some of it a function of our lower GP production -- gross profit production in the first half. And then just from a compare perspective, I would just note for you that, that last year obviously was a pretty uneven year, if you will. And pretty early in the year, we saw indications that our outlook was coming down. So that has an impact on the timing and our judgments with respect to things like compensation accruals. So, because of that, when you add it all together, our first half, we look a bit more shifting towards deleverage from an expense perspective. And what you should expect in the back half is that, that would ease, that would balance out obviously as our gross profit attainment would be higher. but also, you get a bit kind of a pickup from a seasonality timing of our expenses as well. So, for the full year, we expect it would look reasonably normal. The back half is going to look a lot different than it did in the first half vis-à-vis operating leverage."
},
{
"speaker": "Asiya Merchant",
"content": "Okay. And if I may, just you've talked about a strong pipeline here for your customers. Help us understand how you think about that pipeline conversion to revenues. I understand it's the federal impact and the macro, and the UK. But if you could just as you think about more into, let's say, the next 12 months ahead post-calendar ‘24, how are you thinking about that pipeline conversion. And how would you think about CDW's trajectory of growth ahead. Thank you."
},
{
"speaker": "Chris Leahy",
"content": "Yes. well, we think about the pipeline -- excuse me, we think about the pipeline, starting first, in terms of engagement with our customers and staying very close to our customers and doing and suggesting solutions that are best for them. In a market now, where cost optimization is high and needs are prioritized over once. A CDW is very careful to help our customers accommodate that, which might mean that not new and not growth revenue, but revenue that is finding cost optimization for them. All that said, what we do in an environment like this is we work hard to increase the pipeline to ensure that when it's time to convert, it's sufficient to drive growth. We do all the things that we do with a lot of rigor. We inspect the pipeline. We grow the pipeline. We measure the pipeline. We drive conversations with our customers. It's really just the appetite to convert at this point that we're not seeing. Now as I said, what has been very positive is the rhythm of the business feels, feels more stable, feels a little more firmer footing. and I think that's a good indicator of moving to more solid footing, which means a pipeline converting it in the not-too-distant future, which will convert into growth."
},
{
"speaker": "Asiya Merchant",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ruplu Bhattacharya of Bank of America/Merrill Lynch. Your line is now open."
},
{
"speaker": "Ruplu Bhattacharya",
"content": "Hi. Thanks for taking my questions. Maybe, the first question I'll ask to Al and it's another question on gross margins. When you look at the core business margins, ex-netted down items, looks like in fiscal 2Q that grew by 40 bps to about 15.7%. Can core business margins continue to grow for the remainder of the year? I guess, Al, my question is the gross profit for the year is lower, is that because the mix of netted down items is lower, or do you think the gross margin of the core business is also lower?"
},
{
"speaker": "Al Miralles",
"content": "Sure. Thank you, Ruplu. Look, for the full year, we are calling for gross margins to look much like the first half did and frankly then much like 2023 in total. What you can expect there is continued durability and trending of our netted down revenues, which have been extremely strong. We would expect that would continue. And particularly, I'd say, in the year, we typically see more of that with renewals, of cloud and SaaS contracts et cetera. And that would be balanced with our regular mix of business, including expectation kind of a glide path of our client business. Now, on the non-netted down margins, I'll just note again, that product margins there have continued to help hold firm, and that's been quite a run, where they've been firm and we would expect that to continue. So, that's the sum of the different parts, Ruplu, to get us to that gross margin expectation very similar in the back half as what we saw in the first half."
},
{
"speaker": "Ruplu Bhattacharya",
"content": "Okay. Thanks for the details there. Maybe, as a follow-up, can I ask, Chris, how are you thinking about AI related spend in 2024. Did you have any AI-related revenues in fiscal 2023 and how do you see the impact of that on hardware and also on your services revenues in the year? Thanks."
},
{
"speaker": "Chris Leahy",
"content": "Yes. Yes. Thanks for the question, Ruplu. I'd answer it this way. Look, we're really in the very early innings of AI monetization, and CDW is investing behind and doing well frankly. We're investing primarily in people and enablement, and doing well in the areas that are kind of early stage, which I would say, are consultative primarily at this point. AI certainly opens conversations with customers extensively. But I would say our opportunity, the massive opportunity for CDW is full stack over the long run, and I would call this a long a long game. look, it feels very much, and we've said this before that AI is like any other kind of transformative technology of the past. and it plays to CDW's strengths. Complexity and choice always make it more difficult for our customers, and that helps us bring our knowledge, expertise and portfolio to bear. So, as I think forward, we do see it as an accelerant. We're investing behind it. Our customers are still at the stage of what's the art of getting this done and how's the sign what's the science of doing it. It's just a matter, frankly, Ruplu, of what the time frame of growth looks like over the long term. but I feel confident that we'll play it every -- at every layer of the stack. And it will be embedded in every layer of the stack."
},
{
"speaker": "Ruplu Bhattacharya",
"content": "Okay. Thanks for all the details. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question comes from George Wang of Barclays. George, your line is now open."
},
{
"speaker": "George Wang",
"content": "Hey, guys. Thanks for taking my question. Firstly, I just want to ask about AI, kind of wondering if you have a refresher thought in terms of potential uncertainty related to the AI, especially last quarter, you got called about right now, the CDW customers are still in the assessment, the experimentation stage. So, you have sort of air pocket, if you will, before so the ARRI is further validated. Just curious are you seeing a slightly different behavior right now with the customers as they sort of play into this elongation of sales cycle. Just wondering if you can give a little more thought on that compared to a quarter ago."
},
{
"speaker": "Chris Leahy",
"content": "Yes. George, I would just -- I would reiterate that we're still seeing that AI has put the architectural roadmap for compute storage and networking under reevaluation and flux, and we're still seeing that play out this quarter. I actually expect that to last for some period of time as we help customers sort through again, what the art of the possibilities. but then what's the actual return on investment dollars."
},
{
"speaker": "George Wang",
"content": "Okay. Great. Yes. Just a quick follow-up, if I can. Just CDW has pretty good reputation of share gains through the cycle, especially in the fragmented box space. Just curious, are you seeing additional evidence, especially given, sluggish macro, but you're probably seeing the overall, so the four-stack solutions Are you seeing sort of a stronger pickup in sort of a kind of fragmented shed kind of just maybe, you can talk about competition and the kind of the areas CDW is. So, we're doing much better versus the rest of the field."
},
{
"speaker": "Chris Leahy",
"content": "Sure, George. I would just say that we feel very confident that we continue to gain share in this low demand and limited demand market across virtually every category. You saw our results for security and for services, and cloud, client device refresh is starting to pick up. And this is validated both by, obviously, our own data, but equally our partner reviews. our partners validate that we are indeed taking shares that we're feeling very good about, where we're positioned in a limited growth environment."
},
{
"speaker": "George Wang",
"content": "Okay. Great. I'll go back to the queue."
},
{
"speaker": "Operator",
"content": "Thank you very much. Our next question comes from Samik Chatterjee of JPMorgan. Samik, your line is now open."
},
{
"speaker": "Samik Chatterjee",
"content": "Hi. Thanks for taking my question. I guess, maybe, Chris, if I could just start with the areas of strength that you're seeing from product perspective. And I think storage, you sort of highlighted that as an area of strength. And not going into every specific category, but in terms of the areas that you're seeing refreshes on, just how do you feel about sustainability of that base. Because it does sound a bit more contrast to when you say customers are not really looking to spend as much and there's sort of a stable environment that there would be sort of a longer-term sustainability of the areas of strength that you're seeing at the same time. Just can you help us think about what is giving you visibility on that front. And I have a follow-up."
},
{
"speaker": "Chris Leahy",
"content": "Yes. Sure. So, I'd say look, capital investment and complex solutions, especially those tied to data center and network modernization are the ones that I highlighted as areas of more caution right now, given the uncertainty and also the increasingly complex technology landscape. Compute, we did see some pickup. That's really because, it was put off for some quite some time by a number of customers. and so there was a need to upgrade for against legacy systems. And then on the client side, as I said, we started to see, what we think is the beginnings of a refresh. Obviously, given all the catalyst there, that's going to be sustainable. The aged devices, Win 11, AI PCs, et cetera. We expect that to be a real refresh. And then I say sustainability in the clouds, where you saw strength this quarter in particular, cloud security and services in particular, I don't see those slowing down anytime soon. They're a great opportunity to offset some of those capital investments. They're a great opportunity for cost optimization and optimization generally. So, our customers have turned to them and with our portfolio, the beautiful thing about our is whatever our customers are buying, whenever they're buying it, we can give them the solution they need. So, very well prepared to deliver today and as we start to see a recovery in the capital investment appetite."
},
{
"speaker": "Samik Chatterjee",
"content": "And for my follow-up, I know you mentioned the netted down revenue mix every quarter. but anything further that you can give us in terms of how to best think about that sort of part of the portfolio, how much of that is security versus some other sort of software, just to be able to sort of more closely sort of correlate with what we're seeing from the peers and how should we really be thinking about which part of sort of software is it more correlated to."
},
{
"speaker": "Al Miralles",
"content": "Sure, Samik. I'll take it. This is Al. So, just reminder what categories fall into netted down. You have software assurance. You have warranty. You have SaaS. You have cloud. Right. So, the big components, if you will. The strength that we've seen obviously has been substantially in the SaaS and cloud space. and that runs the gamut in terms of underlying workloads in those categories. Right That includes data, virtualization software, networking to some degree. So, it runs the gamut in those categories. They've been the leaders in that space. I should note, Samik, there, with that over the last year, categories such as software assurance and warranty obviously have lagged. because they are substantially attached to products, hardware and software -- licensed software that is. And so they've been laggards, which at some point as we talk about the catalyst and things beginning to turn from a hardware perspective, you could see some of those categories pick up. But in the meantime, as we are now saying, Hannah, we think that recovery is going to take a little bit more time, the most durable trends are in the SaaS and cloud space."
},
{
"speaker": "Samik Chatterjee",
"content": "Thank you. Thanks for taking my questions."
},
{
"speaker": "Operator",
"content": "Our next question comes from Adam Tindle of Raymond James. Adam, your line is now open."
},
{
"speaker": "Adam Tindle",
"content": "Okay. Thanks. Good morning. Al, I wanted to start on guidance. I know, I asked you last quarter on this and some of the explanation was for Q2 was that your modeling is below seasonal. It was off of a weak Q1 and that it seemed like this was sort of a conservative guidance estimate for Q2. and here we are this morning with effectively a miss. That's kind of become a pattern here a couple of quarters now below expectations, and the miss is beyond just the revenue line and mix. So, I just wonder if you might reflect on what has changed in the business to drive this trend; because prior to this period, CDW was kind of a bellwether for visibility into the business, execution on exceeding expectations. So, what has changed And then secondly, how to remediate this issue You know, what kind of changes can you make to your forecasting process or maybe internal analytics to better predict the business."
},
{
"speaker": "Al Miralles",
"content": "Sure. Thank you, Adam. Appreciate the question. First, look, no doubt it has been a pretty volatile period of time for now a number of quarters for sure. I would note a couple of things. Number one, when we talked about a Q1, what we were expecting going in Q2, you did ask the question about seasonality. I made the remark that we would expect it would be somewhat short of historical pre-pandemic seasonality and that it was. The delta there, Adam, was essentially the sum of federal business and international. So, two things that we had not factored in. When you actually add those back, we get pretty close to that historical seasonality. So now, so we scroll forward. We have an expectation Q2 leading to Q3, of mid-single-digit sequential growth. And really how we get there, Adam is, it's taken off some of the expectation of meaningful pickup in the business. and I would say it's following now a more normal glide path. Now, that's backed up by a couple things. One, in line or close to historical seasonality, but also just the split between first half, second half. And so, when you think about our 48/52 split between first half, second half, that's not only consistent with the history. but I also would say coming off of a softer Q1. And so, while we are definitely not anticipating an upturn, if you actually look at the trend lines, I would say it's a pretty natural glide path from where we've come from, and we think it's reasonable when you add it up to the back half of the year."
},
{
"speaker": "Adam Tindle",
"content": "Okay. Thank you. Maybe, just as a follow-up, Chris. Security is obviously a big growth driver for you and you've done well. I think you've even announced $1 billion in sales with CrowdStrike, some earlier this year. So, I guess the first question on that would be what you're seeing now at the end of July in that piece of the business given the global outage, the impact to the cyber business growth trajectory. And then secondly, beyond just the cyber business, there's an investor fear that this might have a ripple effect into other areas of spending and just cause pausing broadly. We're sitting here on July 31st. You're the largest reseller. What customer behavior are you seeing now in the month of July as that closes to indicate that might or might not occur. Thanks."
},
{
"speaker": "Chris Leahy",
"content": "Yes. Adam, I would say customer behavior is on high alert around cybersecurity, and we're having heightened and more conversations with our customers around that. It does not feel that, that is putting off or, delaying any other engagements and projects at all. But we are seeing heightened conversation around cybersecurity."
},
{
"speaker": "Operator",
"content": "We have no further questions. So, I'll hand back to chair and CEO Chris Leahy for closing remarks."
},
{
"speaker": "Chris Leahy",
"content": "Well, thank you very much. I want to recognize the incredible dedication of our coworkers around the globe and their extraordinary commitment to serving our customers, our partners and all CDW stakeholders. You show the power of execution excellence every day in every way. And thank you to our customers for the privilege and opportunity to serve you, to our investors and analysts participating in this call, we appreciate you and your continued interest in and support of CDW. Al and I look forward to talking with you again, next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's call. Thank you to everyone for joining. You may now disconnect your lines."
}
] |
cdw | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Welcome to the CDW First Quarter 2024 Earnings Call. My name is Carla and I'll be coordinating your call today."
},
{
"speaker": "",
"content": "[Operator Instructions]"
},
{
"speaker": "",
"content": "I will now hand you over to your host, Steve O'Brien, of Investor Relations to begin. Steve, please go ahead."
},
{
"speaker": "Steven O'Brien",
"content": "Thank you, Carla. Good morning, everyone. Joining me today to review our first quarter 2024 results are Chris Leahy, our Chair and Chief Executive Officer; and Al Miralles, our Chief Financial Officer. Our first quarter earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the call."
},
{
"speaker": "",
"content": "I'd like to remind you that certain comments made in the presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K, which we furnished to the SEC today in the company's other filings and in the company's other filings with the SEC."
},
{
"speaker": "",
"content": "CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules."
},
{
"speaker": "",
"content": "You'll find reconciliation charts in the slides for today's webcast and in our earnings release and Form 8-K. Please note all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2024, unless otherwise indicated."
},
{
"speaker": "",
"content": "Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company."
},
{
"speaker": "",
"content": "With that, let me turn the call over to Chris."
},
{
"speaker": "Christine Leahy",
"content": "Thank you, Steve. Good morning, everyone. I'll begin today's call with a brief overview of our performance, our strategic progress and view for the balance of the year. Al will provide additional details on our results, our capital allocation priorities and our outlook. We'll move quickly through our prepared remarks to ensure we have plenty of time for questions. Market conditions remained challenging, and first quarter results came in below our expectations."
},
{
"speaker": "",
"content": "For the quarter, gross profit was $1.1 billion, 2% lower than last year. Non-GAAP operating income was $404 million, down 7%, and non-GAAP net income per share was $1.92, down 6%."
},
{
"speaker": "",
"content": "In the first quarter, customers demonstrated caution and concern given heightened macro uncertainty, weighing on capital investment decisions. At the same time, the complexities of the tech landscape continued to ratchet up, particularly given the additional layer of AI and changes in the IT market landscape. This lengthened decision-making as customers deliberated on both how to navigate technology road map and when to spend on infrastructure in a challenging economic environment. While activity was reflected in a solid pipeline with deals being pushed out, our sales and gross profit lagged."
},
{
"speaker": "",
"content": "Results were also impacted by the federal budget stalemate, which led to a pause in our federal channel. Bottom line, while many of these factors are beyond our control, we are never satisfied. And as we do not expect decision cycles to improve in the near term, we remain focused on accelerating pipeline growth and using all of our competitive advantages to take share in this low-growth environment."
},
{
"speaker": "",
"content": "During the quarter, our teams maintained a high level of engagement, working with customers to implement mission-critical projects, help prioritize and evaluate options, develop multiyear plans and prove out use cases. You see the impact of this in our gross margin, which was a first quarter record and our excellent cash flow, which together reinforce the durability of our underlying profitability and integrity of our strategies. Whatever the market condition, we are laser-focused on delivering exceptional value to our customers. To ensure we continue to deliver on this commitment, we remain resolute in our strategy and continue to invest to ensure we have the capabilities to deliver full stack solutions and services."
},
{
"speaker": "",
"content": "Broadly speaking, customer priorities included cost optimization, data protection and workforce productivity. This drove focus on security, cloud and as a service as well as client demand and interest in AI. Let's take a look at how all of these priorities impacted performance."
},
{
"speaker": "First, customer end market performance. Recall, we have 5 sales channels",
"content": "corporate, small business, health care, government and education end markets, each a meaningful business on its own with 2023 annual sales ranging from $1.6 billion to $9 billion. Within each channel, the teams are further segmented to focus on customer end markets, including geography and verticals."
},
{
"speaker": "",
"content": "Our commercial operations are organized around geographies, verticals, customer size and spend. Teams are similarly segmented in our U.K. and Canadian operations, which together delivered USD 2.6 billion in 2023 sales. These unique customer end markets often act in a countercyclical way given the different macroeconomic and external factors that impact each of them. Corporate top line declined 3% year-over-year. Decision-making further elongated with heightened focus on ROI and a high level of project scrutiny, given interest rate expectations."
},
{
"speaker": "",
"content": "Cloud and security prioritization continued to drive excellent increases in customer spend and the team capitalized on client device demand and year-over-year client sales were up low double digits. Corporate saw declines in hardware categories undergoing transition and absorbing capacity notably servers and NetComm."
},
{
"speaker": "",
"content": "Storage, however, was a standout category up double digits, driven by data and workload growth as customers improve efficiency and capture savings from newer solutions. Small business posted a 7% year-over-year top line decline, but with sequential improvement versus the fourth quarter."
},
{
"speaker": "",
"content": "The team continued to help customers address mission-critical priorities around security and productivity which drove meaningful increases in cloud and software customer spend. Consistent with corporate NetComm and servers declined and storage increased. Small business continued to be accretive to overall margins. Client devices posted a sequential increase yet remained down year-over-year."
},
{
"speaker": "",
"content": "Public sales declined 5% from the prior year. Health care declined 2%, transactional performance was positive with an increase in client devices, while solutions declined. Health care performance was similar to commercial with customer caution given the significant focus on cost optimization. Security was also a major focus area, delivering double-digit increases in spend and gross profit."
},
{
"speaker": "",
"content": "State and local mid-teens increase was more than offset by a decline in federal top line and total government declined 1.5%. State and local performance was broad-based with strength across transactional and solutions categories. Client devices sales increased for the third quarter in a row, up high teens. Public safety remained a key focus area with security up substantially double digits."
},
{
"speaker": "",
"content": "Cloud adoption continued to gain traction. Federal's mid-teens decline was driven by the congressional budget impact, which was not resolved until late March. Some activity related to existing contracts continued, including client device refreshes, which drove a mid-teen increase, larger-scale network and data center projects paused. Engagement remains strong, and we expect to pick up and spend once agencies are able to allocate their appropriated funds."
},
{
"speaker": "",
"content": "It continues to be a challenging environment for education and the segment posted a 10% decline. Consistent with recent quarters, higher ed institutions remain focused on doing more with less, and the team posted a mid-teens top line decline. Hardware categories declined across the board, while ongoing focus on cost elasticity led to a strong double-digit increase in cloud."
},
{
"speaker": "",
"content": "K-12's top line decreased by high single digits. Client device sales increased by low single digits, with some school systems refreshing aged Chromebooks, several funded via normal operating budgets and not stimulus programs. Audiovisual solutions like smart whiteboards and interactive flat panels posted a substantial decline as schools continue to digest purchases from the past several years. Security remained a top priority in both top line and gross profit increased by mid-single digits. Our U.K. and Canadian international operations, which we report as Other continued to experience challenging market conditions and each declined by mid-single digits."
},
{
"speaker": "",
"content": "Both teams continue to execute well and are leveraging their capabilities to deliver great outcomes for our customers. For the most part, portfolio performance was consistent across customer end markets. Transactional product sales performed somewhat better than solutions and modestly increased sequentially. Both posted year-over-year declines with a greater decline in solutions from the fits and starts of decision-making."
},
{
"speaker": "",
"content": "At the portfolio level, hardware top line decreased by 4%. Services also decreased by 4% as weakness in services tied to hardware more than offset growth in managed services, which increased by low teens. Even though software net sales declined by 7%, gross profit increased slightly year-over-year. Top line performance was driven by declines in licensed software due to accelerated transitions to SaaS models."
},
{
"speaker": "",
"content": "Let's turn now to the topic that is getting a lot of attention, AI, and specifically what we are doing for our customers in this space. Right now, most of our customers are at the initial stages of the assessment process, developing and analyzing use cases and adopting data governance best practices to deliver insights and ensure end-to-end security."
},
{
"speaker": "",
"content": "Essentially, they are exploring the art of the possibility and working through the science of exactly how do we do this. This is exciting work for all of us and our customers. The complexity of adopting AI plays to our strength. We know how to bridge the gap between the promise of technology and transformational outcomes. And since deploying AI drives the need for technology investment across the full stack with entry points across the entire stack, we are uniquely positioned to serve our customers, and we are doing that today."
},
{
"speaker": "",
"content": "To support our customers as they navigate successful AI adoption, we offer 2 broad areas of consulting services. First, connecting AI to outcomes and ROI, which we call AI discovery, and second, a practical approach to implementing AI, including data governance and security, which we call Master Operational AI Transition, or MOAT. While still early innings, these services are gaining traction."
},
{
"speaker": "We scoped the broad AI opportunity around 4 areas of focus",
"content": "workforce productivity, notably end-use assistance and edge devices; high-value use cases; broad-scale vertical solutions; and full stack where customers rely on us to provide the infrastructure underlying applications and solutions. A great example of full stack is the corporate training and development, domain-specific large language model solution we shared with you last quarter."
},
{
"speaker": "",
"content": "Our broad-scale solutions are vertically based. As you know, we have expertise across many verticals, including health care, financial services in many key industry segments, expertise that enables us to deeply understand the unique needs and challenges faced by organizations in these sectors and tailor solutions and services that directly address their opportunities and pain points."
},
{
"speaker": "",
"content": "Let's take a look at a couple of the vertical AI examples. First, our AI offering for the K-12 market. AI presents an exciting opportunity to empower teachers and improve learning outcomes, but it must be done very carefully. Our education team has leveraged its expertise and relationships in this field to offer a safe AI platform that is specifically designed for K-12 classroom with a custom large language model that generates responses from embedded educational content, not the entire Internet."
},
{
"speaker": "",
"content": "The second example is a proprietary CDW health care solution, Patient Room 'Next'. While AI holds the promise of medical breakthroughs, our solution addresses the intense pressure institutions face to manage costs while sustaining high levels of patient outcomes. Our solution combines AI and connected devices to transform patient rooms, improve care delivery and enhance overall health care experiences."
},
{
"speaker": "",
"content": "The solution is HIPAA-compliant and runs on an end-to-end intelligent platform powered by GPUs, a platform that provides real-time insights from data and automated documentation. One current application serves over 300 beds and builds $4 million in annual licensing. Add to that, the services and equipment we provide for an end-to-end solution like cameras, network connections and servers, and you can see the opportunity this represents to deliver value for our customers and for CDW."
},
{
"speaker": "",
"content": "Of course, AI will take time to become embedded across our entire customer set, we know that, we have been here before as we've helped our customers adopt cloud. And while the hype cycle is much shorter than cloud, the adoption is very similar. Bottom line, we are here for our customers today and will be there for them in the future as they continue to ramp their efforts. And that leads me to our thoughts on the balance of 2024."
},
{
"speaker": "",
"content": "You will recall that on last quarter's conference call, we shared our expectations for 2024 U.S. IT market growth in the low single digits and our target to grow 200 to 300 basis points above market. Despite the slow start to the year, we still see potential for market growth. Let me be clear that we do not expect to demand hockey stick but do see potential for client device refresh and for improved solutions performance. Wildcards include further dampening of capital investment from sustained high interest rates, worsening of geopolitical issues as well as unusual election year uncertainty."
},
{
"speaker": "",
"content": "As we always do, we will update our view of the market as we move through the year. A hallmark of CDW is to serve our customers wherever their priorities lie. As we look ahead, our customers face a compelling need to address cloud workload growth, protect against increasing security threats, manage an aging client device base and navigate All Things Data as they build out their plans to leverage AI to capture insights and achieve their productivity aspirations. Armed with our full stack, full outcomes, full life cycle portfolio and unique vertical expertise, no one is more prepared to help our customers successfully navigate this period of unprecedented change."
},
{
"speaker": "",
"content": "With that, let me turn it over to Al."
},
{
"speaker": "Albert Miralles",
"content": "Thank you, Chris, and good morning, everyone. I will start my prepared remarks with detail on our first quarter performance, move to capital allocation priorities and then finish with our 2024 outlook."
},
{
"speaker": "",
"content": "Turning to the first quarter. We began 2024 experiencing the same uneven IT market conditions that we faced throughout last year. Caution on uncertainty range, high interest rates and growing pessimism towards the timing of rate cuts but deals under even greater scrutiny and ultimately led to the dampening of capital investment."
},
{
"speaker": "",
"content": "Customers are evaluating, optimizing their IT spending. And while we actively partner with them to build out tech road maps to support their strategies, the overhang of economic and financial uncertainties as the delay in deliberation and ultimate decision-making, exacerbating elongated sales cycles. During the quarter, we were able to capitalize on demand for client devices as some customers could no longer postpone refresh activity with sales of more complex solutions tied to digital transformation and network modernization were weaker."
},
{
"speaker": "",
"content": "Notwithstanding, we see the potential for both client device refresh activity to continue and for improved future conversion of our solid solutions pipeline. Moving on to the specific results. First quarter gross profit was $1.1 billion, down 2.4% versus prior year and below our original expectations for low single-digit growth for the quarter."
},
{
"speaker": "",
"content": "Consolidated first quarter net sales of $4.9 billion were down 4.5% versus prior year on a reported and average daily sales basis. Gross margin increased roughly 50 basis points year-over-year and partially offset the impact of lower net sales. Gross margin of 21.8% was a first quarter record and was broadly in line with both full year 2023 levels and our expectations for 2024."
},
{
"speaker": "",
"content": "First quarter margin expansion was primarily driven by higher mix in netted-down revenues. This category grew by 6%, once again outpacing overall net sales growth and representing 35.1% of our gross profit compared to 32.3% in the prior year first quarter as our teams were successful serving customers with cloud and SaaS-based solutions. While we continue to expect the mix of netted-down revenues to be an important and durable trend within our business, it is important to recognize that this mix may fluctuate with customer priorities and product demand."
},
{
"speaker": "",
"content": "However, even with a higher mix of client devices, margins remained firm in the quarter, consistent with our expectations. First quarter gross profit was down 7.8% compared to the fourth quarter on a reported basis. On a sequential average daily sales basis, first quarter net sales decreased 4.4%. While first quarter net sales and gross profit are typically lower than the fourth quarter, we had anticipated a more modest sequential decline as early 2024 customer engagement suggested more balanced spending across categories than we ultimately experienced."
},
{
"speaker": "",
"content": "Instead, the sequential decline this quarter was more in line with traditional seasonality, reflecting continued uncertain conditions impacting the spend of our corporate customers in addition to the congressional budget for laying spending of federal customers."
},
{
"speaker": "",
"content": "Turning to expenses for the first quarter. Non-GAAP SG&A totaled $660 million, up 0.7% year-over-year. Expenses were consistent with the expectation we shared on our last earnings call, with the first quarter higher than the fourth quarter as we reset some of our variable expenses for the year and accrue for other seasonally higher items. This played out as expected, but our expense efficiency ratio was further elevated due to our lower gross profit production for the quarter."
},
{
"speaker": "",
"content": "As we scroll forward, we continue to manage discretionary expenses prudently and diligently while balancing this against both our expectations for the year and the need to expand our capabilities and drive future growth. Our discipline was also reflected in our coworker count at the end of the first quarter, which was approximately 15,000 and down slightly relative to year-end 2023."
},
{
"speaker": "",
"content": "Customer-facing coworker count was also unchanged at approximately 10,900. As we expand our solutions and services capabilities, we are concurrently driving efficiency and cost leverage from our broader operations intended to fund these investments."
},
{
"speaker": "",
"content": "Following along on Slide 8, we delivered non-GAAP operating income of $404 million, down 7.1% versus the prior year driven by the combination of our gross profit shortfall and flat expenses year-over-year. Non-GAAP operating income margin of 8.3% was down 20 basis points from the prior year. As reflected on Slide 9, our non-GAAP net income was $261 million in the quarter, down 6.4% on a year-over-year basis. With first quarter weighted average diluted shares of approximately 136 million, non-GAAP net income per diluted share of $1.92 was down 5.5% year-over-year."
},
{
"speaker": "",
"content": "Moving ahead to Slide 10. At period end, net debt was $4.8 billion. Net debt declined by approximately $230 million from the fourth quarter, primarily reflecting our increased cash position alongside modest debt repayment during the quarter. Liquidity remains strong with cash plus revolver availability of approximately $2.1 billion."
},
{
"speaker": "",
"content": "Moving to Slide 11. The 3-month average cash conversion cycle was 16 days, down 2 days from the prior year and slightly below our target range of high teens to low 20s. Our cash conversion reflects our effective management of working capital particularly with respect to our inventory levels. As we've mentioned in the past, timing and market dynamics will influence working capital in any given quarter or year."
},
{
"speaker": "",
"content": "We continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Despite profit that was moderately lower than our expectations, effective working capital management drove strong adjusted free cash flow of $364 million, as shown on Slide 12. Over the last 12 months, adjusted free cash flow was 104% of non-GAAP net income, well above our stated rule of thumb of 80% to 90%. As we've mentioned in the past, timing will impact adjusted free cash flow throughout the year, but we're pleased with our first quarter performance, and we'll continue to update our outlook on this front as the year plays out."
},
{
"speaker": "",
"content": "For the quarter, we utilized cash consistent with our 2024 capital allocation objectives, including returning approximately $83 million to shareholders through dividends and $52 million in share repurchases. We remain committed to our target to return 50% to 75% of adjusted free cash flow to shareholders via the dividend and share repurchases in 2024."
},
{
"speaker": "",
"content": "That brings me to our capital allocation priorities on Slide 13. Our first capital priority is to increase the dividend in line with non-GAAP net income. Last November, we announced a 5% increase of our dividend to $2.48 annually, our tenth consecutive year of increasing the dividend. We will continue to target a 25% payout ratio in 2024 growing the dividend in line with earnings."
},
{
"speaker": "",
"content": "Our second priority is to ensure we have the right capital structure in place with a targeted net leverage ratio. We ended the first quarter at 2.3x, down from 2.4x at the end of 2023 and within our targeted range of 2 to 3x. We will continue to manage liquidity while maintaining flexibility."
},
{
"speaker": "",
"content": "Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. We currently have over $1 billion of availability under our share repurchase program. And that leads us to our outlook on Slide 14. The uncertain market conditions we operated under throughout 2023, have persisted into 2024, and customer sentiment remains cautious and prudent."
},
{
"speaker": "",
"content": "Last quarter, we spoke about a slow start to the year for 2024 IT spending, which has come to fruition and will likely continue in the near-term. However, as we look forward, we continue to see a compelling need to address cloud workload growth, increasing security threats, aging client devices and All Things Data, as we help our customers build out their plans to leverage AI and capture insights and achieve their productivity aspirations."
},
{
"speaker": "",
"content": "Our updated full year 2024 expectation is for low single-digit gross profit growth, reflecting the slower start to the year. We maintain our view that customers will spend their IT budgets in the upcoming quarters, but within the context of historical seasonality. With this also comes an unchanged expectation for 2024 gross margin to be similar to the full year 2023."
},
{
"speaker": "",
"content": "Finally, we expect our full year non-GAAP earnings per diluted share to be up low single digits year-over-year. Please remember that we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. Additional modeling thoughts for annual depreciation and amortization, interest expense and the non-GAAP effective tax rate can be found on Slide 15."
},
{
"speaker": "",
"content": "Moving to modeling thoughts for the second quarter, we anticipate low single-digit gross profit growth compared to the prior year. With no change to our expectation that gross margin will be comparable to full year 2023 and Q1 2024. Our first half/second half split is slightly more weighted to the second half than historical levels in keeping with our expectation for the market. However, we still anticipate seasonal quarterly patterns to reasonably hold, including a lower fourth quarter compared to the third quarter."
},
{
"speaker": "",
"content": "Moving down the P&L. We expect second quarter operating expenses to be moderately higher than the second quarter of 2023 on a dollar basis, but reflecting a more normalized ratio relative to gross profit than we experienced in Q1."
},
{
"speaker": "",
"content": "Finally, we expect second quarter non-GAAP earnings per diluted share growth to be in the low single-digit range year-over-year. For 2024, we're maintaining our expectation for adjusted free cash flow to be in the range of 80% to 90% of our non-GAAP net income, assuming a higher level of working capital investments to support growth."
},
{
"speaker": "",
"content": "That concludes the financial summary. As always, we'll provide updated views on the macro environment and our business on our future earnings calls."
},
{
"speaker": "",
"content": "And with that, I will ask the operator to open it up for questions. We would ask each of you to limit your questions to one with a brief follow-up. Thank you."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]"
},
{
"speaker": "",
"content": "Our first question comes from Adam Tindle from Raymond James."
},
{
"speaker": "Adam Tindle",
"content": "I just wanted to start one of the big themes during the tech earnings season is spending on AI as very, very strong and I appreciate all your comments in the prepared remarks. But it's hard not to dovetail that with CDW results here for Q1 that were a little bit weaker than expected and showing a decline in solutions where presumably AI would be reporting. Just figured I'd throw it out there to address any investor concerns that perhaps CDW is not participating in AI spending. What would that thesis be missing and if there's portions of that, that might be fair, things that you can do to capitalize more on AI spending, whether that's organic or inorganic?"
},
{
"speaker": "Christine Leahy",
"content": "If I could, let me zoom out first and then zoom back into AI. Let me just start with the environment that we experienced in Q1. There are a couple of factors that impacted results in complex solutions results. And look, we had a dynamic in a pretty complex environment that manifested in what I would call fits and starts of both the market and our customers who have lack of certainty and visibility."
},
{
"speaker": "",
"content": "You take the first economic and financial uncertainty. In other words, the interest rate and inflation environment and that was really the primary driver of the impact for our corporate team and our small business team. And that created an overhang in the environment, which drove what I'll call an uneven market condition situation pretty similar to the trends we saw in 2023."
},
{
"speaker": "",
"content": "And as a result, our customers remain cautious. They remain prudent, there is relentless scrutiny on deals across the board in the solutions space, in particular, as customers focused on cost optimization and short-term ROI and ultimately, that dampened capital investment in the period."
},
{
"speaker": "",
"content": "I'd also say to a lesser degree, AI considerations as an added complexity in the deliberation process enter the picture. We're at a real inflection point with AI, critical decision for all of our businesses, understanding what it means to their business and their workforce, what it means to their road map, technology road maps and what the implications for infrastructure are."
},
{
"speaker": "",
"content": "I just would highlight a couple of other pressure points during the quarter or a lesser impact, but we had some changes in the IT landscape with some consolidation and acceleration into -- as a service, which creates a natural interruption, I would say, in just the customer process. Fed budgets delayed and then the education market is transitioning really back to a more normalized funding mechanism. And the result of all of that was collectively, we had to spend deficits."
},
{
"speaker": "",
"content": "What I would say is our engagement overall is incredibly strong. I'm really pleased with the engagement, and we are seeing that our value continues to build as we help our customers manage the complex tech environment and a dynamic period, but what didn't happen is the solid pipeline that, that translated into did not then translate into invoicing in the solutions portfolio as it would in a normal operating environment."
},
{
"speaker": "",
"content": "Now while we have seen the pause on the complex solutions, we are helping customers who need to refresh client actually start doing that. And that's some positive signs in what I'll call a lower risk, lower-friction client [ story ]. But at the end of the day, right, it was solutions that impacted our results overall. Now if I flip to your question on AI, here's what I'd say."
},
{
"speaker": "",
"content": "Look, we're in the early innings. Some of our customers are advanced, but really most are in an assessment and experimentation stage, and it's going to unfold over time. CDW is uniquely positioned in the space to take advantage of what will be ubiquitous and a full stack opportunity. We know how to take customers on the journey. We've done it before, this art and science of new technologies. We've got the full stack and broad portfolio. So we can help customers at every entry point."
},
{
"speaker": "",
"content": "And we've got services against the entire part of the stack and across the life cycle. And so we've got the ability to deliver integrated solutions. We also understand our customers' pain points and opportunities given our deep vertical expertise and our intimacy with our customers. So we have created packaged solutions that can scale pretty quickly as well as customized solutions."
},
{
"speaker": "",
"content": "So you think about it in terms of the choice, we help them identify the best solution, compatibility, developing road maps for integration and cost and value analysis. Now in the areas of opportunity, there are 4 that I mentioned in the prepared remarks, and I'll just emphasize those, and then I'll talk about where we're seeing pick up now and what we anticipate going forward."
},
{
"speaker": "",
"content": "First, in workforce, think productivity tools and assistance. We're the leader here with regard to many of our partners, and there is much interest in workforce AI impact currently. High-value use cases, think horizontal and aligned personas, things like security and customer experience, chatbots that can be deployed horizontally across many of our customers. Think broad-scale vertical applications where they're deeply verticalized and multidimensional and then the full stack infrastructure to underpin the applications and solutions."
},
{
"speaker": "",
"content": "Now we are leveraging our deep partner relationships to understand and use our customer knowledge to influence our road maps, very similar to what we've done in the past, whether it's cloud or security and to bring to market products that are suitable for -- fit for certain customers. We're expanding our engineering and services capabilities. We're partnering with innovative AI start-ups. And we're developing our own internal experience, which helps us operationally but builds credibility with our customers."
},
{
"speaker": "",
"content": "Where we sit now, Adam, is primarily a services engagement. We have a lot of activity around those 2 solutions, MOAT discovery that I mentioned. And typically, in those we're finding that customers come to find that their data is not in the shape that it needs to be. And that leads to engagement around data and data governance and data security, et cetera. Over time, we would expect the arc of AI to move from the application layer and the services that we're providing through to inference at the edge and then into the data center."
},
{
"speaker": "",
"content": "But it's going to be a journey, and we're in the early innings. And we've seen this before play out. We certainly feel absolutely confident that it will be a full stack play and that our strategy and the strength of the partnerships is going to -- we're positioned and are already capturing the ability to navigate our customers through the journey."
},
{
"speaker": "Adam Tindle",
"content": "Yes. Complexity is typically good for CDW. That makes sense. Just a quick follow-up, Al, on guidance. The gross profit dollar for Q2 where you talked about low single-digit year-over-year growth. I think if I did the math on a sequential basis, it's like low double digits. And the last couple of years, it's been more like 6% to 8% sequentially, so above the last couple of years. Just given a little bit weaker-than-expected trends in Q1 and not wanting to get into that situation again in Q2, maybe just help us with how you thought about that gross profit dollar guidance in Q2? And is there anything that maybe underpins that sequential growth, whether it was maybe pushouts from Q1 or something like that?"
},
{
"speaker": "Albert Miralles",
"content": "Yes, sure, Adam. Happy to address that. A couple of things. First, I think we mentioned in our prepared remarks, look, we feel encouraged by the pipeline that we have and kind of what's out there from a customer spend perspective. And a lot of that would be more in the solutions category as we talked about. So that's number one. The thinking, Adam, is, look, if you look back over history of seasonality -- historical seasonality would be more in like the mid-teens level. And so when we take the sum of the catalysts that Chris mentioned upfront, that is the workload and data growth, the need on the security front and obsolescence of client devices."
},
{
"speaker": "",
"content": "We think that there's both catalyst there, but also kind of an existing tangible pipeline that we see. And so when you add that together and you think about the context of historical seasonality in the more mid-teens, our Q2 outlook would actually be short of that seasonality modestly, and we think that knowing that Q1 was a slower start, there's a decent pipeline there, and we know that ultimately, our customers have to get back to these critical spend items. We have confidence in ability to get to that level from a seasonality perspective in the second quarter."
},
{
"speaker": "Operator",
"content": "Our next question comes from Samik Chatterjee from JPMorgan."
},
{
"speaker": "Samik Chatterjee",
"content": "I guess, Chris, I sort of appreciate all your comments about what you're seeing in terms of a challenging sort of customer spending environment. I'm just more curious when I contrast this to last year. Obviously, the challenges or some of the scrutiny on budgets isn't new. But through last year, we did see sort of solutions remaining quite robust, and it was more the transactional business that was sort of impacted."
},
{
"speaker": "",
"content": "So as you now are starting to see the transaction business open up a bit with the solutions business pullback, any sort of insights or sort of read into -- sort of what the change in customer thinking is? Or what we might be able to see in terms of recovery in that solutions business from the insights you have from the transaction business as well? Just curious on that, and I have a quick follow-up."
},
{
"speaker": "Christine Leahy",
"content": "Yes. Let me start on that one. I think what we're seeing now is we talked about the macro environment and the added complexity now of AI as a consideration and as our customers this year are continuing on that kind of pause in deliberation added to it the AI factor, if you will. They are also faced with the need to refresh client devices. And so I tell you what I think we're seeing is a need to go ahead and spend budget on things that they really can't hold off on any more. They'd like to -- they have old devices. They'd like to get over to the new operating system. They want to make sure the devices are available as demand will start to pick up and there's some switching of the budget over to the devices right now. I think that's a behavior we certainly are seeing. In terms of the trend as we go through the year, I'll let Al speak to the outlook and our expectation regarding the outlook."
},
{
"speaker": "Albert Miralles",
"content": "Yes, sure. A couple of things I would mention. When we think about the parallel to 2023, look, a year later, a lot of the caution and concern that we experienced has persisted, and I would say, to some extent, in Q1, became even more heightened. And look, there is a mixed story on the economy, but when you think about the financial aspects intra-quarter, we went from an expectation in the market of a number of rate cuts to the potential of now just a few. So there's been quite the whipsaw effect just to give that kind of backdrop, if you will, that is the economic and financial environment continues to get more complicated, Samik, for sure."
},
{
"speaker": "",
"content": "The other element I would add is on the solutions front a year later, notwithstanding those comments about macro uncertainty persisting. We've got several categories that obviously have gone through pretty significant market transitions and digestion of capacity. And really, it all points back to as the clock moves forward, we get closer and closer to those catalysts that we talked about, that is need for network modernization, need to address workload and data growth and so our confidence on the solutions front is that ultimately, customers will have to act on those things. And I would say, our pipeline reflects a lot of those intended actions just the space that we're in right now is customers are deferring, taking longer, have more decision-makers to get to that solution spend but we know that it's out there."
},
{
"speaker": "",
"content": "So that would be how I compare the different periods. Look, hopefully, we'll get more economic and financial clarity that will assist. Hopefully, we'll get further down the path of customers thinking about what their IT road maps will look like in this era of AI. And then we do believe that we would see more balanced spending across both solutions and transactions."
},
{
"speaker": "Samik Chatterjee",
"content": "Got it. And Al, a quick follow-up for you. Just in terms of expectations for the gross margin as we progress through the year, you sort of get to 21.8% in 1Q, you're guiding to a similar number for the full year. Is it going to be pretty similar through all 4 quarters as you sort of see solutions spend improving maybe through the year, but client devices being a headwind on that margin? Like how should we think about progression here?"
},
{
"speaker": "Albert Miralles",
"content": "Sure, Samik. For the full year, I would say, we're holding to our expectation on gross margin that we gave, which was that it would be similar to 2023 all in. I think there's going to probably be some variability quarter-to-quarter. Obviously, most notably driven by mix, but at this juncture, we would hold to those expectations. Certainly, given that the mix has shifted a bit in Q1 and we saw stronger client device growth and less solutions, you'd expect that, that would have some impact on our gross margin. But I would say when we think about the contribution of netted-down revenue, which we think is durable that's helped to hold those margins. And so at this juncture, we're holding to that expectation of that kind of high 21s gross margin similar to 2023."
},
{
"speaker": "Operator",
"content": "Our next question comes from Amit Daryanani from Evercore."
},
{
"speaker": "Amit Daryanani",
"content": "I have, I guess, a question and a follow-up as well. When you folks talked about the hardware categories, one of the things that really stood out was storage performance was fairly good. I'm curious like historically speaking, the storage seems to be a leading indicator for what you see eventually with NetComm and servers or not. I'd love to kind of understand from a software perspective is storage is a better indicator. And then maybe related to that, the NetComm weakness, do you think it's more inventory digestion at this point? Or is it really demand is weak?"
},
{
"speaker": "Christine Leahy",
"content": "Amit, it's Chris. I think what we're seeing with storage right now are a confluence of 2 things. One, we had a number of customers who are investing in networking and implementing networking over the last few years and storage is kind of coming -- storage kind of what's the next investment, if you will. So we're seeing positive results there. The other thing is we've got some new exciting products out in the market, and that's always appealing to our customers. So that's really what I think is driving the storage growth in this period."
},
{
"speaker": "Amit Daryanani",
"content": "Got it. And then I guess, Al, just for you on capital allocation, the buybacks were fairly minimal in the quarter given how the free cash flow generation was and the fact that leverage is towards the lower end of the 2 to 3x range that you folks talk about. How do we think about buybacks for the rest of the year? And is the intent to perhaps show up some capital or cash for the debt paydown that you might have to do by the end of this year and early next year? Or would you use it for buybacks?"
},
{
"speaker": "Albert Miralles",
"content": "Look, we will continue to do what we've done in terms of balancing both the strategic and tactical elements on the capital allocation front. And I think, look, I think 2023 is probably a good guidepost for you in terms of what that looks like. At any given time, we're going to look at all the elements of the -- what's going to provide the best short-term return, how do we feel about the valuation front, and where do we get the most strategic value. I think the opportunity for us on it in 2024 is we'll continue to be patient and opportunistic. But with $800 million of cash on the balance sheet, I'd say, pretty consistent track record here of cash flow generation."
},
{
"speaker": "",
"content": "We feel like we've got plenty of opportunity and optionality to be able to create value across all 4 of the priorities in our capital allocation scheme."
},
{
"speaker": "Operator",
"content": "Our next question comes from Matt Sheerin from Stifel."
},
{
"speaker": "Matthew Sheerin",
"content": "Chris, I hope you can elaborate more on what you're seeing in the government sectors. You talked about budget-related pushouts in federal. So -- and I know there's obviously some seasonality, particularly in the September quarter. So what should we expect in terms of the seasonality across those markets?"
},
{
"speaker": "Christine Leahy",
"content": "Yes. On federal, I'd tell you that the federal budget delay, which was about -- pushes things out by about 6 to 8 weeks, creates a pretty much a complete pause. But once the budget was implemented, then the trickle-down effect starts to happen and the money is making its way to the agencies. We have seen, I'll call it, very strong activity in both projects and programs that were ready to go, and that's been a positive and very strong activity and those that will take a little while to get through the pipeline."
},
{
"speaker": "",
"content": "So what I would say, Matt, is as we think about seasonality back to the full year landing more on what you'd see as a federal seasonal year with it being more back-end loaded. And remember, sometimes when you get pushed out by a quarter or so in terms of the government decision-making, oftentimes, you just need to get the PON by the end of the year. So it's possible we see some of it pushed even into the following year that January sometimes happens. But what I would just tell you is, we knew it was coming. We've been working with the customers, poised to start moving the orders, and I feel quite good around federal playing out seasonally for the year."
},
{
"speaker": "Matthew Sheerin",
"content": "Okay. And then just as a follow-up, concerning the client device demand that you're starting to see pick up, are you seeing any interest or traction on AI-enabled PCs yet? Or is that still early?"
},
{
"speaker": "Christine Leahy",
"content": "Matt, I would say it's still early. And when we look at the units that we're selling now, really minimally AI PCs. They're the Win 11 and Apple next generation. And the impetus is really threefold. It's just refresh aging machines get to Win 11, frankly. And it's also an interest in getting ahead of any increasing demand. We are finding customers having longer memories when it comes to the pandemic and remembering that sometimes just in time doesn't work because you got to stay ahead of the supply. So that's also been a factor in the positive signs that we're seeing. I'd also say, look, I mentioned it before, it's a low-friction purchase and it's kind of no regrets. When you put together aging machines, the need for Win 11 with that kind of stable landscape, customers are just starting to move forward."
},
{
"speaker": "",
"content": "The AI PCs will come. There is interest. There's a lot of talk with customers, a lot of talk around which personas are they best going to be used for. But right now, what we're -- what our partners are providing have ample compute power to handle the AI that is in current form."
},
{
"speaker": "Operator",
"content": "Our next question comes from Erik Woodring from Morgan Stanley."
},
{
"speaker": "Erik Woodring",
"content": "Chris, maybe I'd love if you could maybe unpackage some of your pipeline comments a bit more. Outside of federal, if we put that to the side, you mentioned broad pushouts. But can you maybe clarify anything you're seeing in terms of customer set or products where you're seeing this behavior most acutely? Are you seeing any cancellations is to push up behavior this quarter, any more notable than past quarters? And is it as simple as the macro is the key factor here that can unlock this spend? Or are there any other factors that you see here when you speak to your clients, where they say, listen, we just have to refresh these devices, for example, where we have to modernize our data center infrastructure? And then I have a quick follow-up."
},
{
"speaker": "Christine Leahy",
"content": "Yes, sure. Thanks for the question. Let me just start with where you ended. And I would say, as we've suggested, the macro overhang really is the predominant factor in the extended and elongated sales cycles. What we're not seeing is we're not seeing cancellations. We're seeing just more deliberation and greater time and more involvement, frankly, by more business unit constituents in the decision-making process. And as I said, the AI consideration is a real thing. It's a bit of a pause. How do we think about this over the long term? As you know, the progress, the speed with which AI functionality is moving is really fast and they're taking that into consideration."
},
{
"speaker": "",
"content": "But I would say that the -- it feels very similar to 2023. And as Al mentioned, I mean, this quarter, we created more uncertainty in some ways than we saw in certain quarters last year. So it's not that dissimilar. And it really does have to do across what I'll call, complex solution sets. Remember, we don't really have customers buying point products per se. We are seeing in some areas of server, for example, refresh. We're just at the point where customers need to refresh, and we're figuring out how to do that or potentially starting to move some things to cloud. But I would just characterize it very similar to the trend from last year."
},
{
"speaker": "Albert Miralles",
"content": "And maybe, Erik, just adding on to that and to kind of stitch the story together. We talk about these catalysts. Within those catalysts are plenty of opportunities from a solutions perspective. I think that what we saw transpire is this kind of heightened caution and concern kind of the -- as you can see what's around the corner phenomenon, if you will, from a corporate perspective just caused more delay in deliberation."
},
{
"speaker": "",
"content": "And then to Chris' point, you add on AI and the complexity of the -- what is it ultimately going to mean for these customers' infrastructure environments, and it's just more impetus to say, let's take a little time. And I think the corollary there, Erik, would be that we had a pickup in client device, and it was literally across our end markets. And so we would have said that, that was a catalyst that was out there, and that was a catalyst that started to see some free up, call it modest but some free up of spend in that regard because despite it being a catalyst kind of been held back before, it really was the lowest friction choice for customers. And so that's how the quarter played out."
},
{
"speaker": "Christine Leahy",
"content": "Yes. And I would just add that the durable categories we've seen over the last several quarters are security and cloud."
},
{
"speaker": "Erik Woodring",
"content": "Okay, very helpful. And then just maybe a clarification, quick follow-up is, you mentioned expectations at least for 2024, U.S. IT market growth to be relatively similar. You did guide to low single-digit gross profit growth versus low to mid-single-digit growth last quarter. So that would presume weak gross margins would be a bit weaker than when you guided 90 days ago, but Al, you reiterated kind of the expectation for similar gross margins to 2023. So can you just help me maybe on package what is the main factor that is causing the gross profit dollar? The slight change in gross profit dollar growth guidance for 2024? And that's it for me."
},
{
"speaker": "Albert Miralles",
"content": "Yes, Erik, a couple of things. So look, from just working from the -- from a customer spend perspective, we're calling for low single digits plus our typical premium. So that's come off a bit. And if it were coming off in a category, that would probably be substantially from a solutions perspective. That is the slow start that we experienced in Q1. We're not suggesting we're going to make that up. So that comes off the top. And then that's basically just kind of works its way down to GP. We're getting an earlier start to client device, at least for the first quarter than maybe we would have anticipated."
},
{
"speaker": "",
"content": "So while that doesn't help from a gross margin perspective, it certainly does help from a gross profit perspective, right, because you're getting the volume. And I think if you look down our P&L for the quarter, you'd see the delta on net sales was closer because we saw more from a client device perspective. So there are some puts and takes within that. But I'd say, we're in the range of -- with solutions being a little lighter, client being a little stronger and frankly, continued durability of netted-down revenues, there's not much of a change there on the gross margin front."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Vogt from UBS."
},
{
"speaker": "David Vogt",
"content": "I just want to come back to maybe a longer-term kind of discussion on AI and some of your hardware categories. As you guys look out maybe beyond this year into '25 as traction starts to really accelerate in AI, how are you thinking about sort of the uplift in maybe configurations, ASPs? And how does that flow through your business? So for example, obviously, AI PC, there's a lot of discussion of having considerably higher price points. The same obviously holds true, I think, with AI-enabled optimized servers. So just trying to think about how you're thinking about that as it impacts your business, maybe not this year but in '25?"
},
{
"speaker": "Albert Miralles",
"content": "Yes, David, I'll take this. Look, I think TBD, to some extent, right, we're going to see how pricing plays out. What I would tell you is in current context, we're not seeing much in the way of ASP changes. I'd say prices broadly, including on the client device front, held pretty firm. So our growth during the quarter was largely units. Certainly, there is plenty of buzz out there that as we start to see AI PCs and other AI categories emerge that you could see price increases. But I'm not sure that we're fully prepared to kind of call on what that would look like. Just remember for us, look, we're going to work closely with our customers as we are now, and we'll continue to in terms of how do you navigate that landscape, how do we help them get in front of it to the extent that they can. But also remember that for us in terms of kind of impacts, any lift there on the ASPs may lift the top line but we're largely still very much a cost-plus provider, so you may not see significant movement from a gross margin perspective."
},
{
"speaker": "David Vogt",
"content": "Got it. So just to clarify, obviously, wouldn't be subject to ASC fixed accounting, these would be grossed up revenue and then the commensurate gross profit dollars associated with the revenue, correct? Is the right way to think about it?"
},
{
"speaker": "Albert Miralles",
"content": "As we understand it now, and what the new product generations would look like, I think that's true."
},
{
"speaker": "Operator",
"content": "We currently have no further questions. I will hand it back over to Chris Leahy, Chair and CEO, for final remarks."
},
{
"speaker": "Christine Leahy",
"content": "Thank you. And let me close by reemphasizing my confidence in this team, our strategy and the durability of our resilient business model. Thank you to our CDW coworkers across the globe for your unwavering commitment to our customers. Thank you to our customers for the privilege and opportunity to help you achieve your goals. And thank you to those listening for your time and continued interest in CDW. Al and I look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's call. Thank you for joining. You may now disconnect your lines."
}
] |
ce | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Celanese Corporation Q4 2024 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce Bill Cunningham, Vice President of Investor Relations. Thank you. You may begin."
},
{
"speaker": "Bill Cunningham",
"content": "Thanks, Daryl. Welcome to the Celanese Corporation Fourth Quarter 2024 Earnings Conference Call. My name is Bill Cunningham, Vice President of Investor Relations. With me today on the call are Scott Richardson, President and Chief Executive Officer, and Chuck Kyrish, Chief Financial Officer. Celanese distributed its fourth quarter earnings release via Business Wire and posted prepared comments and a summary presentation of key 2025 actions on our investor relations website yesterday afternoon. As a reminder, we will discuss non-GAAP financial measures today. You can find definitions of these measures as well as reconciliations to the comparable GAAP measures on our website. Today's presentation will also include forward-looking statements. Please review the cautionary language regarding forward-looking statements, which can be found at the end of both the press release and the prepared comments. Form 8-K reports containing all of these materials have also been submitted to the SEC. Before we open it up for questions, I'd like to turn the call over to Scott Richardson for some opening remarks."
},
{
"speaker": "Scott Richardson",
"content": "Thanks, Bill, and good morning, everyone. I strongly believe Celanese is a company that has cash generation, productivity, and cost reduction in its DNA. These core competencies have driven shareholder value over our twenty years as a public company. We are keenly focused on invigorating and capitalizing on these foundational capabilities in how we lead and drive business every day to improve performance and drive value creation. My first two months as CEO have been about prioritizing and driving action. Decisive steps we have taken to date include the following: We've executed on over $75 million worth of cost actions that we outlined in our Q3 earnings call. We've reduced our 2025 capital plan to $300 to $350 million, which is about a $100 million reduction versus our spend last year. We've added a new leader to the Engineered Materials business in Todd Elliott to bring a fresh perspective and new energy to reducing complexity and driving improved results. We have added Chris Kean and Scott Sutton to our board of directors to bring additional finance and operational expertise to our boardrooms. Given the prioritization of cash generation, margin expansion, productivity, and deleveraging, we have added a finance and business review committee to the board of directors, which Scott Sutton and I will jointly chair. This committee will help evaluate all options to improve the company's operating model performance, drive cash generation, and review our portfolio. We are taking the right steps to accelerate shareholder value creation and restore our performance at top decile levels in the industry. We are moving forward with intensity and aggressiveness and are not hesitating to make all changes to generate cash and deleverage the balance sheet. We know the journey in front of us is not an easy one, but we are energized by the opportunity ahead. We will share wins no matter the size as we progress in the coming months. I look forward to reporting on our progress as we advance our plans to improve performance and drive value creation. Thank you. And now, Daryl, let's open the line for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now be conducting a question and answer session. You may press star two to remove yourself from the queue. One moment, please, for the first question. Our first questions come from the line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Begleiter",
"content": "Thank you and good morning. Scott, you mentioned some divestitures in the prepared comments. Could you get some sense of potentially the size of these divestitures and when they might occur?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. Thanks, David. Look, we've been working aggressively on divestitures for some time now. And, you know, we did a transaction a few years ago with the food ingredients business, and I would look at most of what we're looking at as kind of around that size. Some smaller, some maybe slightly a little bit bigger than that. But that's kind of the right range to look at the opportunities that we have."
},
{
"speaker": "David Begleiter",
"content": "Yeah. One more thing. I know equity raise is not your first choice, but given where the balance sheet is today, what are your thoughts on potentially raising equity at some point to help delever the balance sheet?"
},
{
"speaker": "Scott Richardson",
"content": "Our capital structure is to fund our acquisitions with debt. In addition, we're unlocking cash from actions we've taken on the dividend reduction of CapEx, reducing working capital, and we're aggressively working divestitures as I just talked about. Look, equity is extremely dilutive, and we don't believe that's a step that's necessary given the strength of the debt market."
},
{
"speaker": "Chuck Kyrish",
"content": "Yeah, David. Hey. I can add to that. Look. As Scott mentioned, we're taking numerous actions to reduce leverage. But what you're also gonna see is continue to do in the meantime is be proactive in reducing the risk in our debt maturities. We have a plan and we've prepared to access the debt markets quickly and opportunistically, and the credit markets are very strong right now. Yeah. The principles around that are gonna be to extend a portion of our more near-term maturities aligning what remains with our cash generation. And we'll make sure and do that at a prudent and reasonable cost."
},
{
"speaker": "David Begleiter",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question has come from the line of Frank Mitsch with Berenberg Research. Please proceed with your questions."
},
{
"speaker": "Frank Mitsch",
"content": "Hey. Good morning. I wanna dive into your outlook for the first half of the year. As you talked about the second quarter, you indicated that it wouldn't have the $100 million of non-repeating items that are impacting the first quarter. And yet if I look at the dollar increase expected versus the first quarter, that only implies, like, $20 million or so of improvement from volumes and SG&A, etcetera, which frankly, you know, looking at Q2 versus Q1, that really doesn't seem like that much. Can you help explain some of the thinking there?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. Thanks, Frank. Look, we're getting some of that here at the end of the first quarter. In that number, not a lot, a little bit. And so that incremental in the second quarter is about that right range you talked about. There's, you know, most of it will be on the run rate in the second quarter certainly to get to the full kind of $80 million that we called out, and we're continuing to work additional actions. So look, it's really important that we look at what we see right in front of us and be transparent with that. We're working a number of other actions to lift not just the back half of the year, but also work to get more in Q1. We're gonna do it and we're gonna do everything we can to make that Q2 number bigger than what you called out."
},
{
"speaker": "Frank Mitsch",
"content": "Gotcha. Thank you. And then the other thing in the prepared remarks was a comment that free cash flow for 2025 is poor. And I'm curious if you can kind of go through, you know, kind of order of magnitude that the street should be thinking about and how do you get there?"
},
{
"speaker": "Scott Richardson",
"content": "Well, Frank, you know, we haven't given the guide, you know, for earnings at this point in time for the year. But what I wanted to lay out is free cash flow below the EBITDA line that we do expect to improve significantly year over year. Right? So working capital was a use of cash last year, expect to be a source of cash. Cash tax will be significantly lower. You know, we've lowered CapEx, you know, roughly $100 million. Right? So, you know, before giving a guide for earnings as we're kind of working through several things, I just wanted to lay out areas in free cash that will improve year over year."
},
{
"speaker": "Frank Mitsch",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Jeff Zekauskas with JPMorgan."
},
{
"speaker": "Jeff Zekauskas",
"content": "Thanks very much. Scott Sutton has been brought into the board of Celanese. I was wondering, Scott, if you played a role in bringing him in or what role you played in Scott coming to the board?"
},
{
"speaker": "Scott Richardson",
"content": "Look, Scott and I have known each other for a long time, and I'm thrilled that Scott agreed to join the board. I think we have been on a path as a board that's been very deliberate in how we refresh the board with capabilities that are gonna help us navigate the landscape that we're in, and Scott's the latest addition. And, you know, he brings unique capabilities and has a track record of accelerating cash generation, deleveraging, value creation, and I'm really excited that he's gonna help us in this journey."
},
{
"speaker": "Jeff Zekauskas",
"content": "Second question is in your prepared remarks, what you said was that over time, you reduced costs associated with the M&M acquisition by about $250 million. And then later in the script, what you say is that there's been competitive dynamics in your largest product lines like nylon, which offset year-over-year improvements made to the cost position, you know, as well as lower raw materials and manufacturing footprint cost reduction. So when you look at the M&M business from the time that you acquired it, like, where do we stand now? Is the EBITDA really no different? Because price degradation has offset all of the cost improvement, or, you know, can you give us, like, where did we start and where are we now with the M&M acquisition?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. We have increased the EBITDA from M&M when you look at the synergies versus where it was when we closed the transaction, Jeff. And, you know, we have seen margin degradation in some product lines within the M&M portfolio. We've also seen some margin degradation in some of the product lines in the historical Celanese portfolio. We've also seen several product lines that have expanded margin. You know, this is a critical area of focus for us this year. You know, reversing this margin compression that we've seen, you know, broadly across the standard part of the EM portfolio is a critical action for us that we need to deliver on to kind of lift the second half of the year."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question has come from the line of Michael Sison with Wells Fargo. Proceed with your questions."
},
{
"speaker": "Michael Sison",
"content": "Hey, guys. Good morning. I maybe a follow-up on M&M. Could you maybe just give us your thoughts on, yeah, is this a good business for Celanese longer term? I mean, what do you think the potential is here and how do you sort of get it there? And, you know, I suspect there's some macro help that you'll need there, but just, you know, what is the potential for M&M now going forward?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. Thanks, Mike. I mean, we've seen some challenges, but we've also seen some strength in several of the businesses. I mean, our high temp nylon portfolio that we acquired with the business has been a nice source of growth for us in electric vehicle applications, you know, with things like superior thermal shock characteristics in certain application areas. You know, we have also seen kind of the elastomeric products that we acquired have been have given us kind of a new growth platform in athletic apparel and footwear that we didn't have before. So there are, you know, really nice pockets of opportunity for us, and we've gotta go really aggressive on the nylon portfolio as well. And so we've gotta keep kind of keeping this machine moving from a pipeline standpoint, and we've also gotta make sure that we, you know, aggressively work the cost side of the equation just given where, you know, the fundamental macro is at."
},
{
"speaker": "Michael Sison",
"content": "Got it. And then, you know, most folks haven't given an outlook for the full year 2025. I understand that. But, you know, should EBITDA be better in the second half versus the first half and maybe if you don't have specifics, you know, what should be better or could be better in the second half? In terms of the walk for a better EBITDA. And then can you just give us your general thoughts on what the economic backdrop we should think about in 2025 for Celanese?"
},
{
"speaker": "Scott Richardson",
"content": "Our focus is on moving with urgency, Mike, to take decisive actions to be able to drive wins. The actions that we're taking, we believe, you know, will be unique for us to drive value in the out quarters here. You know, we talked about the complexity reduction, $50 to $100 million of opportunity in EM. We need to make sure that we're fully leveraging the optionality model, which was challenging in the second half of last year. Historically, we've been able to drive good value by flexing up and down the value chain there. And the third is getting back to this point I just talked about on reversing margin compression in both the standard parts of the engineered materials portfolio but also in the acetyls business."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Ghansham Panjabi with Baird."
},
{
"speaker": "Ghansham Panjabi",
"content": "Thank you. Good morning, guys. Scott, first off, congrats on your new role and best wishes with everything. I guess, you know, going back to the EM segment and the new leadership there, you know, just curious as to how we should expect strategy to sort of evolve versus what you have been doing. And then relatedly, can you just comment on your view in terms of channel inventory levels downstream to that segment, you know, the customer level, etcetera?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. Look, Todd Elliott already is bringing intensity and focus around everything that we do. Looking at cost and opportunities, whether it be footprint, warehousing, distribution cost, SG&A, etcetera. Also on the customer side, as you talked about. And it really is about looking at the pockets of opportunity that are out there and accelerating in some of those higher growth segments like medical, like electric vehicles in China, future connectivity. And so you're really getting to that customer segment level. Defending the base is gonna be important, but then also accelerating growth and driving, you know, project wins no matter the size."
},
{
"speaker": "Ghansham Panjabi",
"content": "Got it. And then, you know, obviously, Scott, we've been in a two-year global manufacturing slump. You know, been pulling levers on the cost side and working capital the best you can. But what are some of the other contingencies you have at your disposal in this scenario that, you know, the current paradigm continues for another year or longer in context of your debt load? Thanks."
},
{
"speaker": "Scott Richardson",
"content": "But I believe there's always more that can be done, Ghansham. And, you know, I think we've shown that with cost given where, you know, the demand landscape is at. We are looking at, you know, really all elements of the business. And I just kind of highlighted on the engineering material side of things with these actions that we're taking to reduce complexity. We have some of the similar things on the acetyl side of the house as well. And so it's really about kind of taking a no stone unturned approach to everything that we're doing and also then looking at really almost every single customer interaction on how we can drive incremental opportunity and then also make sure we're really extracting full value on the margin side."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Josh Spector with UBS. Please proceed with your question."
},
{
"speaker": "James Cannon",
"content": "Hey, guys. This is James Cannon on for Josh. Thanks for taking my question. I just wanted to ask on earnings power of the acetyl business. I think previously you said 2024 was a typical run rate for the near term. I think if I think about the contract resets, that would be an incremental call in $40, $50 million headwind this year. Is that the right ballpark, or is there something to offset that gets us back to the $1.1 billion?"
},
{
"speaker": "Scott Richardson",
"content": "Well, go after what I just said, James. There's always opportunity for us to drive margin. And we had some contract resets. The team is working really hard to offset those. That's been hard in Asia with where the supply-demand landscape is at. But we're looking for ways at which to leverage our optionality model there and flex up and down the value chain to be able to offset that and get back to those levels that we were at in the first half of last year."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Vincent Andrews with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Vincent Andrews",
"content": "Thank you. Has anything changed, Scott, about the scope of assets that you might consider divesting? And I just ask that because you mentioned in the prior answer that the size would probably be similar to the divestiture that was done with the food ingredients. And my recollection was that in the past, more recently, we've been talking about maybe multiple smaller active divestitures rather than the opportunity to sell a few things or one thing at a larger cost? So are you looking wider or deeper or anything changed in terms of what you're willing to divest?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. We're looking at everything that is not critical to kind of our core operating model, Vincent. And that's really, you know, this engineered thermoplastic, thermoplastic elastomers portfolio in the engineered materials business and our optionality model that starts with methanol and acetic acid and goes all the way through redistributable powders. And if not in those operating models, we're taking a look at it. But it needs to facilitate deleveraging, and so, you know, that size I talked about was kind of in that range, but I also said plus-minus. So there is a series of smaller ones that, you know, we get you that when added up are in that range, and then there's some opportunities that are a little larger."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. And then in the prepared remarks, you talked about the dissolution of the JV with Tayshaun on the Mylar. Is there anything else about your asset footprint that you're looking at? Maybe areas where you're not as advantaged or places where it might make sense to take capacity out of the market?"
},
{
"speaker": "Scott Richardson",
"content": "We believe in having an efficient footprint, Vincent, and ensuring that we fully leverage the strong technical capabilities that we have in-house here at Celanese. I think, you know, we have a long-term history of reducing our footprint but yet adding capacity at our advantage sites. And that principle, that core principle of manufacturing is what we're leveraging to these M&M assets as well. By doing that, you get much greater leverage on fixed cost. And so we're consistently looking at opportunities to do that. We've taken action. We reduced our footprint by eight sites since we did the acquisition, and we're continuing to look for opportunities to be as efficient as possible."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from the line of Arun Viswanathan with RBC Capital Markets. Please proceed with your question."
},
{
"speaker": "Arun Viswanathan",
"content": "Thanks for taking my question. Hope you guys are well. And congrats on the new roles there. So I guess two questions. So first off, I know that you've taken actions on eight sites there and evaluating some more options as well and divesting of other assets. But is it also the case that there has been some structural weakness in the auto market and you guys are potentially overexposed to underperforming regions, such as Europe? Do you think because we've seen this inventory overhang now for two or three quarters and then I think you guys have taken decisive action in Q3 and Q4 as well, but it doesn't seem like that's been enough to really clear out the inventory. So do you think the actions in Q1 will result in that inventory reduction, or would they linger beyond into Q2 and Q3?"
},
{
"speaker": "Scott Richardson",
"content": "The value chain has too much inventory. We talked about that on our last earnings call, and we are working to match, you know, our inventory levels with where, you know, the fundamental demand is at. You know, demand has held pretty stable here in the first quarter. But the value chain is rebalancing the inventory book. That's our channel partners, it's the tiers, the molders, and the end customers. And so, you know, the line of sight that we had today based upon, you know, outlook is that we would see that come to a closure in the first quarter."
},
{
"speaker": "Arun Viswanathan",
"content": "Okay. Great. And then if I can follow-up, just on the guidance, it looks like the Q1 guidance, again, is in the $400 million or so EBITDA range, maybe slightly below that. Do you expect that to kind of lift up through the year maybe into the $1.5 billion to $2 billion range on an annualized basis? And, again, that'd be, you know, more of second half weighted. Is it mostly those cost and productivity actions that we get you there, or does it require some recovery and volume growth as well? Thanks."
},
{
"speaker": "Scott Richardson",
"content": "Look, our focus is on the decisive actions that we're taking right now. We can't control what happens in the macro, but we can focus on, you know, where we spend money, how we drive a level of efficiency, how we interact and access our customers to drive opportunities. And one of the things we called out is, you know, a focus on smaller projects in engineered material. One of the great things about smaller projects is they tend to be able to be commercialized in six to twelve months. And so it is very important that we continue to work that with a level of aggressiveness, you know, to be able to improve kind of that outlook in the second half."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Patrick Cunningham with Citi. Please proceed with your question."
},
{
"speaker": "Patrick Cunningham",
"content": "Hi. Good morning. Thanks for taking my questions. You know, some estimates we see on, you know, acetic capacity, you know, upward of three million tons in 2025. You know, maybe a little less on the BAM side but still meaningful capacity in the next few years. Now, what gives you confidence that there will not be, you know, significant incremental impact from near-term capacity? And what does, you know, what does this capacity mean for utilization rates of your own network?"
},
{
"speaker": "Scott Richardson",
"content": "We don't see a big change coming in the supply-demand landscape, Patrick. And, you know, where things are today is the SBL industry is operating below the cost curve. And that's not sustainable. It's not been historically sustainable. And we haven't seen things degrade further even though we see new capacity. And so we continue to look at where are those pockets of opportunity up and down the value chain and asset yields where we can pivot. And the team was successful last year, you know, growing, for example, our redisperseable powders business, you know, largely outside of China and other parts of Asia like India and Southeast Asia, you know, where there was a strong pull and growth for, you know, some unique applications such as composite insulation systems, large style of thesis. And so it seems like that that are gonna be critical where we'll partnering with our customers to get the full pull through of that value chain where we have unique technology."
},
{
"speaker": "Patrick Cunningham",
"content": "Got it. Understood. And how should we think about, you know, incremental benefits from Clear Lake into 2025? I mean, are volumes any sort of offset to contract resets here? Is there any reason why run rate utilization should get, you know, worse than where you exited the year, whether it's raw material availability or depressed demand levels? Just trying to understand the US operating footprint here."
},
{
"speaker": "Scott Richardson",
"content": "Look, we're seeing the full run rate of the expansion offset from some of those contract resets, which is why we're working other opportunities to offset that. You know, we've got some natural gas headwind in the US to start the year. That is, we've seen higher cost, but we do expect that that will wane and come off as the weather improves and we move into the second quarter."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Aleksey Yefremov with KeyBanc Capital Markets. Please proceed with your question."
},
{
"speaker": "Aleksey Yefremov",
"content": "Thanks. Good morning, everyone. So it sounds like you're deliberately reducing inventory in EM in Q1. Is it possible to size it in terms of EBITDA so that we can understand how much could potentially come back in the second quarter from this deliberate action?"
},
{
"speaker": "Scott Richardson",
"content": "It's really not that substantial, Aleksey. I wouldn't say it's kind of material like we thought in the fourth quarter."
},
{
"speaker": "Aleksey Yefremov",
"content": "Okay. And a follow-up on EM as well. It looks like pricing came down maybe low single digit for the segment in Q4. What do you expect from price in Q1 and potentially Q2? Another step down or stabilization?"
},
{
"speaker": "Scott Richardson",
"content": "What we are seeing right now is stabilization for the most part. You know, we're having to be competitive in certain standard grade applications, but the team is also working tenaciously on offsets. I mean, this has been a headwind, but again, in these standard grade applications, you know, where margins are at for the industry are really at unsustainable levels. And so we are working on opportunities to be able to turn that tide. The best way to do that is improving mix, and that's what the critical of working the pipeline and continuing to be successful in some of these more unique higher growth, higher margin segments."
},
{
"speaker": "Aleksey Yefremov",
"content": "Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question has come from the line of Kevin McCarthy with Vertical Research Partners. Please proceed with your question."
},
{
"speaker": "Kevin McCarthy",
"content": "Yes. Thank you and good morning. Scott, are you essentially running Celanese today to maximize cash flow as opposed to maximizing earnings, or is that not the case? And you're really trying to strike a balance between the two."
},
{
"speaker": "Scott Richardson",
"content": "With cash as a priority, Kevin, you know, given where our debt is at, we are looking to do everything that we can to unlock cash. And I think some of the actions that we have taken, whether it be the dividend, the reduction of capital, the reduction in working capital, and the tenacious focus there, as well as aggressively working on the divestiture side, it is a focus on cash first."
},
{
"speaker": "Kevin McCarthy",
"content": "Okay. And then if I may, want to follow-up on acetyls. I think you idled some capacity temporarily in Singapore and Frankfurt as you discussed in the prepared remarks last night. Do you do that because they go temporarily cash negative or perhaps for a different reason? And, wondering if you could talk about your specific operating rate at Clear Lake in the fourth quarter and how you expect that to trend in the first quarter?"
},
{
"speaker": "Scott Richardson",
"content": "The acetyl team wakes up every day, Kevin, and looks at the landscape that it's in, and it pivots. And it pivots up and down the chain. It pivots geographically where it sells, and then we match operating rates to the needs to maximize, you know, margin and EBITDA across the landscape. And to meet our customers' needs. And that is a model that that team will continue to operate on, and we'll continue to focus on, you know, striking that right balance between volume and margin."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question has come from the line of Hassan Ahmed with Alembic Global. Please proceed with your question."
},
{
"speaker": "Hassan Ahmed",
"content": "Morning, Scott. First of all, congratulations on the new role and also congratulations on bringing Scott Sutton on board. Big fan. First question on the guidance. You know, you guys talked about $0.25 to $0.50 in Q1 EPS and $1.25 to $1.50 as demand recovers in Q2. Now, I mean, if there is no change in the macro, how do you get from $0.25 to $0.50 to $1.25 to $1.50 as the run rate?"
},
{
"speaker": "Scott Richardson",
"content": "We're doing everything that we can to drive our run rate much higher than that, Hassan, and it's the actions that we talked about. And, you know, our focus on not giving a guide in the second half is because we have multiple actions that are underway. May I talk about the complexity reduction in engineering materials? You know, riding our acetyl optionality model to a level that was that performed better than we saw at the end of last year and then this margin compression component. In addition to everything else we're doing broadly across the cost side in SG&A and the manufacturing footprint. So we believe that there are decisive opportunities and actions that we can take here at Celanese to lift the run rate performance even if we don't see a change in the macro."
},
{
"speaker": "Hassan Ahmed",
"content": "Understood. And in the presentation, you know, one of the things that you guys talked about was, well, I guess you gave six reasons to own Celanese shares today. And one of them was the strong earnings leverage, you know, as obviously demand recovers. My question to you is, you know, as you take a look at the geographic footprint you guys have, as well as the end markets you guys are exposed to. Is the leverage the same today as it was in prior years, particularly, you know, as you look at the sort of changing sort of dynamics globally with tariffs out there, with your exposure to EVs, and you guys yourself flagged, you know, the higher exposure to EVs that China today has and how that today is lower margin business than it was historically."
},
{
"speaker": "Scott Richardson",
"content": "We have a core principle that we believe in having a very efficient manufacturing footprint. You know, we acquired the M&M business, their footprint was not as efficient as what we had historically here at Celanese. As a combined organization, we are looking at what is the right efficiency profile that we need, and we're overlaying what we believe and where things are at from a demand perspective geographically. And it's that matching that's really critically important. And, you know, as a corporation, we are pretty evenly split between Americas, Europe, and Asia in terms of where our revenue comes from. But Asia is growing and Europe is declining, and so it's gonna be very critical that we continue to drive that intersection point to a level that allows us to enjoy kind of that operating leverage that we historically have."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of John McNulty with BMO Capital Markets. Please proceed with your question."
},
{
"speaker": "John McNulty",
"content": "Yeah. Good morning. Thanks for taking my question. So Scott, when you think about the acetyl capacity that's coming on in Asia, have you seen any offsets where you're seeing closures, you know, assets coming down permanently? It looks like there's a significant amount of more capacity still to come. So just wondering, how that gets placed and works. It's just gonna have to be where we wait for demand to absorb it all."
},
{
"speaker": "Scott Richardson",
"content": "We haven't seen, I'd say, permanent capacity reductions. We definitely have seen the industry operating at lower rates, and, you know, I think what's a little bit different about this cycle on capacity adds, first what we saw fifteen years ago. Fifteen years ago, it was all almost all new players to the marketplace. This is about fifty-fifty existing players having capacity and some new players. And so, obviously, for those with existing capacity, they're kind of flexing their networks up and down based upon what they need. So we have definitely seen probably a little bit more kind of down to match where demand is at."
},
{
"speaker": "John McNulty",
"content": "Okay. Fair enough. And then I guess do you see there being any risk that that capacity makes its way more meaningfully into other markets, or does it really kind of stay in the market that it's been over the last, you know, whatever the last few years?"
},
{
"speaker": "Scott Richardson",
"content": "That arbitrage window is not open, and, you know, it's kind of stayed right at or below kind of what it costs to move product. And, look, shipping is expensive and complex, and storage is complex as well right now in other markets. And so, you know, just given transit times, etcetera, we have not seen a lot of that move out of the region."
},
{
"speaker": "John McNulty",
"content": "Got it. Thanks very much for the call."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question has come from the line of Laurence Alexander with Jefferies. Please proceed with your question."
},
{
"speaker": "Laurence Alexander",
"content": "Good morning. So first on the divestitures, are these assets that you've decided you just don't fit in the portfolio and you will exit even if things get better, or as things get better, would you, you know, keep them and, you know, focus on deleveraging through other means? And secondly, with acetyls, can you elaborate a little bit on kind of the execution issues in the back half of last year? And to the extent that they've been changed or fixed, you know, should we see the improvements this summer regardless of the environment, or do you need a better level of aggregate demand in order to also fix the execution issues that you've identified?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. Let me hit your second sort of execution issues. I think it was just a length and supply-demand really driven by kind of where demand declined at the end of the year. And look, the team's doing everything we can to really flex that model up and down the value chain and look for pockets of opportunity. On your first question around divestitures, look, I think we have identified pieces that are not, you know, critical to kind of those core operating models, and we're looking at and having a lot of conversations. I mean, it has been, you know, a tough M&A market the last several years. And, you know, we are very principled, and I've heard from a lot of investors that are concerned about, you know, us buyer selling assets. We're not in the business of fire selling assets. Our focus is on divestitures to drive deleveraging, and it's gonna be important that we continue to stick with that principle and be aggressive about doing deals as they present themselves to us."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is come from the line of John Roberts with Mizuho. Please proceed with your question."
},
{
"speaker": "John Roberts",
"content": "John, could you check if you're muted, please?"
},
{
"speaker": "Operator",
"content": "Okay. Well, Daryl, it seems like John might be muted. Let's go ahead and make the next..."
},
{
"speaker": "John Roberts",
"content": "We can hear you now. Yep. Oh, sorry. Yeah. Sorry. Yep. Congrats, Scott, and welcome back to Scott Sutton. Could you talk about the new JV rules in China? We have other companies with China JVs, and I don't recall hearing anything about those. Is it all JVs in China or something specific to the Celanese kind of JVs?"
},
{
"speaker": "Scott Richardson",
"content": "Yeah. I look, I think some JVs have gone through some of this and some haven't. It's really related to the rules that govern certain JVs, and really what changed here is that there's a rule that requires an audit to be completed before dividends can be paid. And so that audit gets completed here in the first part of the year, and so we should see dividends starting too. So that's a rule change that at least our JV is now subject to."
},
{
"speaker": "John Roberts",
"content": "Okay. Well, Daryl, thanks. Let's make the next question the last one."
},
{
"speaker": "Operator",
"content": "Thank you. You got it. Our last questions will come from the line of Salvator Tiano with Bank of America. Please proceed with your question."
},
{
"speaker": "Salvator Tiano",
"content": "Yes. Thank you. So firstly, I want to ask a little bit about, you know, as you're thinking here about if you talk a little bit about the packets of cost savings, I know you mentioned also the $50 million, the sorry. The $50 to $100 million from complexity and $80 million SG&A, but I think last quarter, we're talking about some of the M&M co-synergies not being realized in 2024 and that's being pushed in 2025 and Clear Lake, obviously, the $100 million also not fully realized last year in part due to the personal share. So are these part of this package you already gave, or is there upside from this, especially on the Clear Lake side?"
},
{
"speaker": "Scott Richardson",
"content": "Look, we achieved $250 million of synergies as we exited last year, Sal. And we still have more that are in our plan to be realized here this year. You know, clearly, like, we're on the run rate as we talked about. There's been some offsets from margin compression, and that's why I really talked about that as a critical element of focus for us on really reversing that trend as we go forward so we get the full value of these actions that have already been executed on. We are looking at driving productivity every single day. Looking at every dollar that goes outside of the company, and where we can save and where we can prioritize. And this is a focus on cash. And so, you know, that tenacity will continue. Everything is on the table."
},
{
"speaker": "Salvator Tiano",
"content": "Perfect. And I won't go back to your old exposure to China to equal the number of questions. I'm just wondering, how are things different in China versus Europe and the US when it comes to the OEM? And a big tailwind for Celanese has been obviously light weighting and replacing metal, wood, and other components with plastic. Is there a bigger or a smaller opportunity right now in Chinese models versus what you had in the Western Hemisphere over the past couple of decades?"
},
{
"speaker": "Scott Richardson",
"content": "Look, there's still a huge opportunity for us in China, and it's why we're continuing to put a heavy focus there. I think, you know, one of the things that's really important is that the technical requirements of electric vehicles, particularly from a powertrain standpoint, are becoming a lot more demanding. And there's also a lot of other applications where China's moving up this technical requirement curve. This requires materials with higher performance requirements, and we have, you know, really we believe the best portfolio to match. Yeah. And, you know, where our, you know, KPDs sit in China, we're about half of where we are in the Western Hemisphere, and that's moved up substantially the last several years. But it is critical that we maintain that focus. Just really since the beginning of the year, we've had, you know, two sizable technical exchanges with two of the top five, you know, Chinese OEMs as a way to accelerate and drive business. Great thing about China Auto is that commercialization time tends to be much shorter, kind of more like six to twelve months as opposed to twenty-four months in the Western Hemisphere."
},
{
"speaker": "Salvator Tiano",
"content": "Perfect. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you, everyone. We'd like to thank everyone for listening today. As always, we're available after the call for any follow-up questions. Daryl, please go ahead and close up the call."
},
{
"speaker": "Operator",
"content": "Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day."
}
] |
ce | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Celanese Corporation Third Quarter 2024 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the opening remarks [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce Bill Cunningham, Vice President of Investor Relations. Thank you. You may begin."
},
{
"speaker": "Bill Cunningham",
"content": "Thank you. Welcome to the Celanese Corporation third quarter 2024 earnings conference call. My name is Bill Cunningham, Vice President of Investor Relations. With me on the call today are Lori Ryerkerk, Chairman of the Board and Chief Executive Officer; Scott Richardson, Chief Operating Officer; and Chuck Kyrish, Chief Financial Officer. Celanese distributed its third quarter earnings release via Business Wire and posted prepared comments on our Investor Relations Web site yesterday afternoon. As a reminder, we'll discuss non-GAAP financial measures today. You can find definitions of these measures as well as reconciliations to the comparable GAAP measures on our Web site. Today's presentation will also include forward-looking statements. Please review the cautionary language regarding forward-looking statements, which can be found at the end of both the press release and the prepared comments. Form 8-K reports containing all these materials have also been submitted to the SEC. Before we open it for questions, I'd like to turn the call over to Lori Ryerkerk for some opening remarks."
},
{
"speaker": "Lori Ryerkerk",
"content": "Thank you, Bill. And good morning, everyone. As Bill said, before we get started with questions today, I wanted to take a moment to emphasize a few key points. First, it is clear from our prepared comments that our results for Q3 were disappointing and the outlook for Q4 and into 2025 is below both our expectations and our goals. Despite the many actions that we've taken to continue to deliver value, the benefit from these measures has been increasingly offset by the broad and persistent macroeconomic headwinds. Given this dynamic, we intend to temporarily reduce our quarterly dividend beginning in the first quarter of 2025. While we recognize the importance of the dividend to our shareholders, we've carefully considered a variety of options and we have determined that this is the most prudent and cost effective measure to support our deleveraging efforts at this time. We will look forward to accelerating the return of capital to shareholders once we have progressed our deleveraging efforts. To further help us navigate this challenging environment, we have identified and will take additional bold actions to strengthen earnings and cash generation. We have a strong track record of delivery and operational excellence and are confident that we are taking the right actions. For example, we are significantly slowing production to match demand in Q4 and implementing further cost reductions, particularly in SG&A. We hold ourselves to a high standard and the steps that we are taking are driving durable improvements for the company as we build an increasingly disciplined cross structure and better position the business to drive long term growth. In closing, I want to thank our teams for their dedication and resilience in the face of persistent demand challenges in our end markets. I am confident that our actions have and will continue to position Celanese to create substantial value for our shareholders. We believe in Celanese's long term potential and we are leaving no stone unturned to capture opportunities that will benefit us both now and once demand begins to recover. With that, we'll open the line for questions."
},
{
"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 Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"content": "Wondering if you could just give us a little bit of a bridge in terms of the cash flow divestitures and how you're going to sort of delever over the next year or so? I'm assuming you're anticipating some improvement in the operating environment at some point, as well as divestitures and cost savings. But if you can just sort of bridge us from today maybe through '25 and into '26 in terms of what your expectations are?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So Vincent, obviously our first objective is to focus on EBIT. We don't know what the environment is going to be next year. So in that way, our focus is really on the cost reduction initiatives I talked about as well as doing things to really fill the project pipeline and make sure that we're generating additional business. I think as we called out in the prepared comments, we would see, even at today's environment, being near a more typical level because we did have a lot of one offs in cash flow this year. A more typical level that would yield about $800 million to $900 million. Obviously, with the steps we're taking, we would hope for some additional cash flow generated from that. We continue to focus on divestitures. And timing is uncertain, which is why we never really figure them into our free cash flow statement. But we do remain very focused on opportunistic divestitures where we can find someone who values our assets more than we do. So maybe I can turn it over to Chuck and he can add any additional color."
},
{
"speaker": "Chuck Kyrish",
"content": "Yes, and I think that's right, Lori. And Vincent, we have this prepayable term loan that we can deleverage throughout the course of next year as we generate cash and any other cash sources. So we've got the facilities in place to use that cash to continue to deleverage. And we remain committed -- we remain strong committed to deleveraging the balance sheet to 3 times net debt to EBITDA as fast as we can get there. We've talked a lot about significant actions underway to underscore that, right? Additional cost actions that we've announced, continued CapEx reduction and focusing on maintenance, reliability, safety, we're working divestitures as Lori said, divestitures that make sense. And obviously, the significant announcement of our intention to reduce our dividend starting in Q1. So that's what we're focused on is deleveraging the balance sheet down to 3 times net debt to EBITDA and we put things in place to be able to do that."
},
{
"speaker": "Vincent Andrews",
"content": "And if I could just follow-up on the Clear Lake. There's supposed to be $100 million of benefit that's going to come from starting up that asset. If I read the prepared comments correctly, I believe there was $20 million in the third quarter. So first, is that correct? And then second, what is sort of the bridge to getting between the $20 million, if I'm correct, and the $100 million?"
},
{
"speaker": "Lori Ryerkerk",
"content": "On Clear Lake, you may recall we called out about $10 million in the first quarter and then $20 million now in the third quarter, we would expect some additional amount in the fourth quarter as well. We still think the benefit of Clear Lake is on a 100 range on a full year basis. And so we would expect to see the majority of that then occur next year as well."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Mike Leithead with Barclays."
},
{
"speaker": "Mike Leithead",
"content": "I wanted to start, Lori, at a high level, I think the magnitude and abruptness of the decline in the second half of the year was a bit surprising. So can you help contextualize or just help us better understand sort of how the past three months progressed relative to your expectation and sort of when order books really started to deviate versus your expectations, and you realize you need to pivot here on your production and your cash management?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Let me give you just a little bit of color. So when we made the guidance last quarter, we were coming off a stronger June, things we're looking a little bit stronger into the second half and in discussions with our customers, particularly auto, industrial, we were expecting some lift in those segments and across, and of course, we were seeing the impact of synergies and other things. I would say as we went through the quarter, we continue to see further pressure specifically on auto and on industrial. I think as an example and if we look at European registration of autos, they fell from June to August. So I would say really starting to see the big impact of that in August. I think we've seen the OEM announcements from Mercedes and Volkswagen, and everyone, which suggests maybe that situation isn't getting quicker anytime soon. Even if you look at full second quarter to third quarter, European auto builds were down 14%. So that's really where we started to see the big impact is as we worked our way through the quarter and frankly, conditions just continue to worsen, as we went through the quarter, including then in the US where we started to see announcements from Stellantis and GM."
},
{
"speaker": "Mike Leithead",
"content": "And on the dividend, I appreciate we're at day one here, but you emphasized in the prepared remarks the temporary nature of this reduction. Is there a specific leverage target or earnings level that you're initially aiming at or how long you want to keep the dividend at this level or will we need to see how cash flow evolves over the next year or so here?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Mike, our focus is really laser focused right now on getting to that 3 times leverage. And given the current market conditions that we're seeing and the fact that it looks like these are continuing into the early parts of 2025, at least, we felt the need to take further actions. And after a lot of consideration along with the board determined that reducing the dividend at this point was the most prudent and most cost effective options. So that's really where our focus will remain. It's driving activities to really rapidly deleverage to 3 time as quickly as we can."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Michael Sison with Wells Fargo."
},
{
"speaker": "Michael Sison",
"content": "So when I take a look at the fourth quarter and the EBITDA outlook for EM, are you getting close to a write down for the M&M business, if not, why? And you have a lot of one-offs there. Do those sort of come back or do we sort of add that back as we head into the first quarter?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Let me address the second half of your question first. I mean -- so there are a number of one-offs in the fourth quarter and we would expect the destocking that we expect to see, the mix effects, the effects from affiliates inventory, we expect the vast majority of that to come back in the first quarter. And let me turn it over to Chuck to talk about our -- how we go through valuation and looking at write down."
},
{
"speaker": "Chuck Kyrish",
"content": "So third quarter each year is when we do test our goodwill and indefinite live intangibles. I'll remind you, goodwill is tested at the reporting unit level, that's an engineering materials level. So we tested that quantitatively with the help of big four valuation specialists and we did not record an impairment. We did also test all the trade names of Engineered Materials individually with the same process and we did record a $34 million impairment on trade names, most of that was Zytel. So that kind of concluded our third quarter cycle of those testings."
},
{
"speaker": "Michael Sison",
"content": "And as a quick follow-up, if you think about 2025. Clearly, the end markets have impacted you all and everybody else in chemical is pretty negatively. If the environment doesn't improve in 2025, how do you think EBITDA or earnings should shape up next year, given you do have some stuff within your control to get some upside?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Mike, I would start with -- if you look at the performance over the first three quarters of this year, we have seen quarter-on-quarter improvement in performance being driven by synergies being driven by our product pipeline, et cetera. Those things will be true next year as well. We'll have additional synergies next year. We are putting a lot of effort into really trying to accelerate the project pipeline. It has grown significantly versus a year ago. But clearly, in this current macroeconomic that's not sufficient to support the business growth that we expect. That, combined with our cost reduction programs, I would just say for 2025, there is so much uncertainty while we are going to take a lot of steps to help ourselves to really control what we can control whether that market environment gets better or deteriorate, what we see in terms of interest, there is a lot of open questions out there around 2025. And I think it's just simply too early to speak with any authority about 2025 expectations."
},
{
"speaker": "Scott Richardson",
"content": "So as we close 2024 and go into 2025, we have four priorities that we are focused on as an organization. Number one, reducing cost, making sure that we're scrutinizing every dollar that we spend and that we're being very deliberate and targeted with where we invest. Two, is deliver the synergies and make sure that, that number one is in addition to the synergies that we've already committed to. Number three, on the Engineered Materials side of things, is supercharge the pipeline. While we have had some good metrics, it's not been enough to offset the downside we've seen from some of the demand challenges. But we've got to continue to aggressively work with customers, continue to penetrate in nonautomotive sectors to where we increase our share of wallet there. And then the fourth area on the Acetyl Chain side of things, is really fully leverage this integrated model that we have to be able to ensure that we're driving profit every single day. And we know that's going to be different from one week to the next but we have to keep the focus on those four priorities. And if we see a change upward in the demand landscape, that's just going to lead to more upside. So our focus really is on those things that are within our own control right now."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jeff Zekauskas with JP Morgan."
},
{
"speaker": "Jeff Zekauskas",
"content": "What would have been the consequences of you not cutting your dividend? And is the dividend cut based in a diminished expectation for longer term operating cash flows in '25 and '26, and what caused that?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Let me try to answer the second part first, Jeff. Look, our long term expectation for this business is no different than it's been. I mean, we still believe in the long term performance of our Acetyl and our EM businesses, including the acquisition. The challenge we've had is the current macroeconomic conditions and recent demand deterioration have really challenged both businesses. And because of that, we are taking all of these actions but we are not getting the cash flow we expected to be on the deleveraging plan that we had planned for. So looking at the dividend, we really did determine this was the most cost effective and prudent way to get back on that cadence of deleveraging that we wanted to do for our business and that's really what drove the decision around dividends."
},
{
"speaker": "Jeff Zekauskas",
"content": "And secondly, I think you spent roughly $125 million in cash costs for restructuring this year, you expect to spend that. What's your number for 2025? And then secondly, in your expectations about the auto markets, I mean wasn't IHS already expecting down auto production in Europe for the third quarter in July? I mean was the downturn in Europe really that unexpected?"
},
{
"speaker": "Scott Richardson",
"content": "Let me answer the second question first, Jeff, and then I'll turn it over to Chuck. I mean, look, there are a variety of publications that we look at. And when we made our forecast for the quarter, there was still an expectation of a slight uptick that did come down relatively quickly to the end of July and early part of August, and there was that flip. And as Lori talked about then, we started to really see the acute change in car registrations and other data in the month of August. So that is really where we saw the bigger flip in expectations. And I think there was what has kind of materialized, I think, if there was an expectation in the second half of the year that there would be a list, and we saw a buildup in Q2 of inventories. And so what we've seen now in the end of the part of the third quarter and into the fourth quarter is customers destocking that inventory in preparation for lower builds and lower sales here in the second half of the year."
},
{
"speaker": "Chuck Kyrish",
"content": "Jeff, on the cash cost synergies, next year with [Indiscernible] to M&M, those are going to drop off probably about $50 million. Now we will have some cash costs from the new cost reduction actions that we announced. And so that's -- if we talked about greater than $75 million, the cash cost of that will be less than a one year payback. So I think when you roll it all up, total cash spend on cash cost synergies plus there's no cost actions somewhere pretty close to this year."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ghansham Panjabi with Baird."
},
{
"speaker": "Ghansham Panjabi",
"content": "Lori, going back to your prepared comments and also the comments from this morning, weakness in China and autos, et cetera. And none of that is truly all that surprising relative to what your peers have been saying as well, but the dividend cut is. So going back to that component, is the dividend cut more a function of you not seeing or anticipating a recovery in 2025 relative to your initial plan or are you anticipating a much more worsening of the trend line, if you will, near term just given the uncertainty that's out there? How should we sort of think about those two dynamics?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I would think about it in two parts. One is the performance we've experienced in '24 and the reduction in free cash flow we've had in '24, although, we have sufficient cash for the debt that is due next year. We just aren't deleveraging as quickly as we like, right? Our EBITDA is lower. We haven't been able to pay down additional cash towards the debt. And then if you look at '25 and beyond there is so much uncertainty. We feel it's prudent to be prepared for that and to stay on track with our deleveraging plan. And again, the most cost effective and prudent way to do that is by reducing the dividend at this time."
},
{
"speaker": "Ghansham Panjabi",
"content": "And then going back to the delayed draw term loan. Was the dividend cut part of that sort of process in terms of securing that loan? Just trying to get some context behind that. And then separately, on the $75 million program targeting SG&A. Is that to adjust to the new baseline of volumes or are you still assuming some sort of recovery as it relates to the operating dynamics, '25, '26 onwards?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So let me answer the second part and then Chuck can answer the first part. So the $75 million is additional identified cost cutting to better adjust our SG&A organization towards the current level of demand. It's also -- we also believe as we get more efficient as our systems get more mature, now that we've gotten through our new system implementations. We also believe though it will be an area that will -- or a level we will be able to sustain even if we start to see some demand recovery."
},
{
"speaker": "Chuck Kyrish",
"content": "Ghansham, on your other question. Those two are not tied together. The delayed draw term loan is something was put in place to help us bridge those maturities. And the dividend cash is because we made a commitment to deleverage this balance sheet to 3 times, and we're not doing that as fast as we want to."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Josh Spector with UBS."
},
{
"speaker": "Josh Spector",
"content": "I was wondering if you could just talk about your view on the earnings power of Engineered Materials at this point. I guess if I look at 3Q, you were up year-on-year, your EBIT level volumes were up but that's supposed to be a bigger chunk of the synergy savings and maybe a bit before you're seeing some of the negatives of the actions you're taking in fourth quarter. So if you can maybe look at second half and talk about some of the puts and takes that we should be thinking about and some thoughts on the back of our heads are more around if there's something impaired around the nylon side of things, either pricing or share loss that means earnings are structurally lower than what we should have thought a year or two ago?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So that's a lot of thoughts in one question. So let me just talk about how I see, my view of the EM business. So the EM business, our long term view of the EM business has not changed. I mean we still feel we have the most unparalleled portfolio of engineered materials. We have a structure that really drives in a very disciplined way, new projects, growth into new customers, growth into new applications. And while we continue to improve all those as well as improve our cost structure, this is fundamentally a very good business, still in demand by our customers who demand innovation and who want to buy products from us. So what we're seeing is a short term turn down. I also wouldn't just focus on nylon. I mean PA66 is certainly challenged at this point with an oversupply of non-differentiated polymer. But I would say our focus on PA66 is really on the differentiated polymer, the compounding and that's why you've seen us take all of the steps that we've done. I would say for M&M, in particular, even if PA66 is less than we originally thought, many of the other parts of the acquisition, such as Mylar, or Vamac, or Hytrel or high temperature nylon are outperforming where we thought they'd be at this time. So in aggregate, we still see the value of the MM acquisition and the value of the total EM portfolio as being as strong as it ever will be once we get back to a more normalized demand condition."
},
{
"speaker": "Josh Spector",
"content": "Maybe one quick follow-up, just I guess, thinking about the synergy side then within 3Q. So I guess some context here is that volumes were up. Obviously, things deteriorated later in the quarter, but we didn't see the flow through in 2Q -- or in 3Q. So what offset that? If you think about the synergy, what were the minuses that led us to only up 10 in the quarter?"
},
{
"speaker": "A - Scott Richardson",
"content": "Yes, I think there is some timing around inventory, Josh, that has rolled through both in the quarter as well on a year-over-year basis. So that played a role there. Also pricing. As we called out, we've seen degradation in standard grade pricing, which has been the other bigger offset. So I think those are the two biggest chunks. I think when you look at things on a year-over-year basis for the year end total, volume up, price/cost mix up positive, spending down. So another positive there. Offset currency, we've had some headwinds on currency year-over-year, both in the quarter and for the full year and then turnarounds in inventory. So I think that's where it's been offset. And so we do believe in the earnings power, as Laurie Lori talked about, but that doesn't mean we're just going to live with where we are today. And that's why we talked heavily about the actions we're going to take both in the business as well as the corporate level on cost and then continuing to aggressively work pipeline and drive close wins. So one of the big synergy areas we talked about for '25 and beyond is revenue synergies. And so we need to deliver on that going into next year to continue to uplift the possible earnings power of the business."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Arun Viswanathan with RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"content": "Maybe I could ask the Q4 guidance question again. So if we think about going from around 2.50 for Q3 or 2.44 down to $1.25 for Q4. Maybe could you break that out maybe into some buckets of seasonality and how much is associated with the inventory draw downs and maybe some incremental weakness in auto and industrial or any other end markets that would be helpful?"
},
{
"speaker": "Scott Richardson",
"content": "So I think on the acetyl side of things, it's seasonality. So call it roughly in that $20 million range. So I'd put that to seasonality, Arun. On the corporate cost side of things, that's really timing of cost flow through there more than anything. And then it's really engineered materials and kind of looking at where we are there, and those are the big buckets we called out in the prepared comments. So destock of about $45 million, which is probably a little seasonality in that number. We have mix which is really all seasonality of about $15 million. Affiliates are down $15 million. Again, that one is more seasonality driven. And then you've got the inventory and absorption costs, which is really the balance there. So when you kind of put that in there in the Engineered Materials buckets, it's $30 million, maybe a little bit more than that, but seasonality from the affiliates in that mix bucket we talked about in addition to the acetyls number."
},
{
"speaker": "Arun Viswanathan",
"content": "So just taking that a step further into Q1 then. Do you anticipate these actions that you are taking on the inventory side to allow you to -- is that the complete inventory actions that you have to take? And so when you look into Q1, you won't necessarily have those drags and you also may have less seasonality so that could get you back closer to maybe $2 or so in Q1? Or how are you thinking about how that evolves and maybe some of the bad guys that won't repeat in Q1?"
},
{
"speaker": "Scott Richardson",
"content": "Let me start kind of high level and I'll turn it to Chuck to provide details on inventory flow through. Look, we are constantly looking at really matching our production levels with where demand is at. And given where things are and a need here with what we've seen from a destock perspective to take plant rates down, bring inventory down. This is a level of inventory that we've been pretty clear we wanted to reduce for the year. We expected it to be split a little bit more balanced between Q3 and Q4, a little bit more Q4 heavy, given where we're at. And then we'll look at what plant rates need to look like in the fourth quarter depending on what the order book looks like and when we get to that point."
},
{
"speaker": "Chuck Kyrish",
"content": "Yes, I think it's going to be really important for us to manage to generate free cash flow that will make these decisions. And if we're [preferencing] cash flow, you could see some see some P&L from some of those cost flow throughs, but it's important for us to generate free cash flow here and deleverage this balance sheet."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Frank Mitsch with Fermium Research."
},
{
"speaker": "Unidentified Analyst",
"content": "It's [Aziza] on for Frank. Just want to start off with Chinese VAM margins sitting at a decade low here with the lackluster demand and new capacity. How long are you guys thinking it might take to absorb?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Look, I think the reabsorption for acetyls is really going to depend on when we start to see demand recovery. I mean we've called out now for many quarters the reduction we've seen in the construction, paint and coatings market. We've also seen demand destruction for derivatives, particularly in China for things like EVA into the solar markets and some other. So it's pretty impossible now to predict like how quickly that can be reabsorbed. It really will -- it's more dependent at this point on the shape of demand going forward."
},
{
"speaker": "Scott Richardson",
"content": "Because of that unpredictability, it is absolutely imperative that the team continues to maximize daily where we're selling product and look at where those opportunities are. And so the team is being very surgical on looking at how we want to monetize the molecules of acetic acid, downstream into VAM and then into the derivatives and looking for, is it better to sell an emulsion, a powder, VAM. And given the challenges we've seen in VAM, we've moved further downstream and we'll continue to pivot up or down depending on where those opportunities are at."
},
{
"speaker": "Unidentified Analyst",
"content": "And I was just curious, what are your expectations for the fourth quarter and early read on to 2025?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Just to clarify, fourth quarter in general or fourth quarter for acetyls?"
},
{
"speaker": "Unidentified Analyst",
"content": "In general, just raw material expectations for the company for the fourth quarter and 2025."
},
{
"speaker": "Scott Richardson",
"content": "Raw material right now for the fourth quarter is largely stable as we look at things today, but obviously, that can change. And I think a lot will depend upon where fundamental energy dynamics are at as we go into 2025. So we'll continue to remain flexible. One of the elements that we're focused on here at year end is reducing raw material inventory as well as finished goods inventory, which will give us the ability to be flexible depending on what happens with raws next year."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Begleiter",
"content": "Laurie and Scott, going back to the comment on supercharging the portfolio or the project pipeline EM. This used to be a strength of this business from my perception, it's now being called out as an area of weakness. So obviously, the business has changed with DuPont. But what's really underlying the change and that it's gone from a position of strength to perhaps a position that needs to be improved?"
},
{
"speaker": "Scott Richardson",
"content": "The pipeline model is still a position of strength, dated, and there's no question about that for us. And the stats that we have proved that. The size of projects being up over 30% year-over-year is a really good example. Our project win rates are also up since the acquisition. And so the issue we're seeing now, though, is the amount of volume that's coming with each of those projects is smaller. In addition, the amount of challenges we've seen in the base has come both from a volume perspective and a pricing standpoint. So the pipeline needs to be enhanced and needs to be bigger in order to offset some of those headwinds that we're seeing. So when we talk about supercharging, it's not a confirmation on where things that it's just the opposite. It is a strength of this business. We feel like it can do more and we're going to continue to invest resources and partner with customers in a way that allows us to be successful, because we need the pipeline to be generating more in this environment."
},
{
"speaker": "David Begleiter",
"content": "And just on Singapore, given new supply in China, can Singapore be brought back online unless -- or do you need trying to recover strongly for Singapore to be brought back into production?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So we do expect that Singapore will come back online. I mean, Singapore is still economic to run, especially into the non-China Asia market. And remains an important part of our portfolio and very much in line with how we'd like to have the optionality about what we produce and where we produce and into what market. And so our expectation is that, and because it is so profitable, we do expect that portfolio, we'll continue to come online and run as needed. Fortunately, we have the flexibility there now because of the structure of our contracts that we can make that choice more than we did in the past. But much like we're using Frankfurt as kind of our swing VAM capacity, more and more we'll see Singapore becoming more of our swing acetic acid capacity."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Aleksey Yefremov with KeyBanc Capital Markets."
},
{
"speaker": "Aleksey Yefremov",
"content": "In EM, is the bigger issue that you're selling less volumes or is it that you're selling at lower prices? And are prices stable at this point or they're continuing to fall in Q4?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So Aleksey, it's both. I would say for differentiated products to keep -- the main impact has been around volume, because the pricing tends to be sticky. But for standard grade products, it's more of an issue around -- we're able to sell the volumes but the issue is around price and margin."
},
{
"speaker": "Aleksey Yefremov",
"content": "And also in EM, are you pulling inventory below normalized level in Q4 such that you may need to rebuild it in 2025 or you need to get back to your normal inventory seasonality at the year end?"
},
{
"speaker": "Scott Richardson",
"content": "I would not expect we'll be below normalized levels, Aleksey, unless we see a change in demand levels."
},
{
"speaker": "Operator",
"content": "Our next questions come from the line of Patrick Cunningham with Citibank."
},
{
"speaker": "Patrick Cunningham",
"content": "I wanted to follow up on the project pipeline. It's encouraging to see the value per project has increased 30% since 2022. Are there any secular growth markets or applications where you're getting the most traction? And any strategic shift or change in thinking as how you approach auto OEM customer base given the recent weakness?"
},
{
"speaker": "Scott Richardson",
"content": "Well, look, I think where we're seeing change in the mix of where -- who's winning from an OEM perspective. And as we think about this with China still growing and Chinese OEMs being more successful, a continued focus there in winning in China is very important. And so we have seen some wins just recently. We're very focused on the EV market. We've had really good traction in things like thermal management models, cooling houses, light weighting on the auto side of things. But then on the non-auto side of things, if you recall, this was one of our most important areas of synergies, really getting the M&M products into nonautomotive applications in a much bigger way. We did that historically in the Celanese Engineered Materials portfolio and we're heavy focused on it. We've had some wins in things like oil well pipes with flexible covers around those. Just recently, we've been heavily focused around high performance athletic shoes with some big wins there with products that are creating, particularly in running shoe applications, increased performance. And so really good uptick and those are global opportunities. And so the team is working on not just having these singular wins and focused heavily around once we get a win, sharing that translation opportunity across the globe so that we can be penetrating with each of these as much as possible in a much shorter time frame. The nice thing about nonautomotive is the projects tend to move through the pipeline quicker. And so that's why that heavy focus around non-auto is really important as we go into '25 and '26."
},
{
"speaker": "Lori Ryerkerk",
"content": "I would add, one of the sectors that Scott didn't talk about that we're very excited about is electrical and electronics. And if you think about the demand for electricity current outlook is that that's going to double over the next five years, and that requires a lot of build-out of electrical infrastructure. And we are seeing the pull through of polymer demand as part of that build out."
},
{
"speaker": "Patrick Cunningham",
"content": "How committed is Celanese [indiscernible] grade rating? Would you consider issuing additional equity to preserve this rating or do you believe the current steps you've taken are enough?"
},
{
"speaker": "Scott Richardson",
"content": "We're committed to deleveraging this balance sheet to 3 times net debt to EBITDA as fast as we can to get it there. As Lori mentioned, we've assessed a variety of options to support that and determine what the support of the Board that -- but given the challenging environment and our goals that the announcement of our intention to reduce the dividend was the prudent action to take."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Kevin McCarthy with Vertical Research Partners."
},
{
"speaker": "Kevin McCarthy",
"content": "Just to follow up on the prior question. If I look at your term structure, you've got the billion senior unsecured notes in March that presumably the delay draw term loan will take care of. But beyond that 1.5 billion in '26 and 3.4 billion in '27 in. So to get to that three turns of leverage goal based on the current glide path of EBITDA, it seems like you've got some heavy lifting ahead. And so would you consider a mandatory convert and/or acceleration of the divestiture options to try to take some of the pressure off your ongoing efforts to deleverage?"
},
{
"speaker": "Scott Richardson",
"content": "Well, we're working divestitures as aggressive as we can, the ones that make sense, Kevin, and the timing of this could be uncertain. I think the other thing you mentioned kind of falls in the category of other things that we have considered, right? So -- and again, kind of -- for the Board took the path of -- intention to reduce the dividend. I mean, I think looking forward to those maturities, we've got access to various outlets in the capital markets and we're going to deleverage with the cash that we generate and the cash that we achieved through any things like divestitures, and we'll look and see what the prudent approach is on our capital structure with these access to various capital markets, outlets and balance cost and risk on that and our capital structure at all times."
},
{
"speaker": "Kevin McCarthy",
"content": "As a second question, if I may, a lot of chemical companies are reviewing their asset footprints, particularly so in Europe, as you know. I think in years past, Celanese took a hard look at Asia. Lori, and listening to your comments, it sounds to me like you're thinking of Singapore as a keeper, so to speak. I would like to ask you more broadly though, do you have plans to reexamine the asset footprint anywhere in the world or are we going to play the cards we're dealt, so to speak, for the near term?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I'd say Celanese has always been known for being very aggressive about footprint optimization and we look at it continuously. I mean if you go back over even just the five years I've been here, we have we have made decisions around shutting down, reoptimizing our footprint, something almost every year. Now that we have added the assets from the M&M acquisition, we have been going through that process again. And you've already seen us make announcement around intro and facility in Argentina and some other facilities around the world. And we are really looking now on a combined basis what does that footprint optimization look like. Again, you've seen some of the announcements we've already made. Mechelen, which will be shut down now in 2025, that activity will continue because it's what we normally do. We constantly reassess and reevaluate what is the right footprint for us given where our customers are and what our demand profiles look like?"
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Hassan Ahmed with Alembic Global."
},
{
"speaker": "Hassan Ahmed",
"content": "A question around -- I mean, you guys have always done a very good job at matching production with demand. And obviously, it seems Q3 and Q4 of this year -- from the commentary, it seems auto production kind of surprised you guys and the like. So just a broader question around just forecasting how you guys are looking at the order books, forecasting based off of that, particularly in light of what appears to be significant changes in customer buying patterns, how customers are thinking, it seems buying patterns are more just in time. It seems customers through lessons learned through COVID or keeping leaner and leaner inventory levels. So are you -- do you think those customer habits are sustainable on a go forward basis or just a function of this erratic sort of macro we're in? And how are you guys adapting in terms of forecasting and matching sort of your production with that demand in this environment?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Let me ask Scott to address the broader question. But I would just say, really, if you look at the inventory situation we have in the third quarter, we had really been building inventory across the first half for two reasons. One, an expectation, particularly in auto of an upturn in the second half, which is being called out by the majority of our customers and the indices, as well as we had built some inventory because we were doing footprint optimization. So we were building inventory so that we could shut facilities down and switch customers to new facilities. When we got into third quarter, we acquired raw materials, anticipating a normal level of builds, if you will. And then when we saw demand really dropped down midway through the quarter, we slowed production now but we still sit there. So a lot of the inventory we built in the third quarter was actually around raw. So there's some very specific dynamics around third quarter. But I mean, your question is a fair one, which is how are we looking at customer demand and forecasting because it is changing slightly. So let me hand that to Scott."
},
{
"speaker": "Scott Richardson",
"content": "Hassan, we have to remain very flexible. And now that we're all on one system with the M&M business coming into the Celanese system in the first quarter, we are going through a process of really looking at where we make and how we make and run our network from an optimized basis right now. And we're overlaying that with the changes that you kind of alluded to that are happening more or less in the Western Hemisphere. The one thing you didn't mention that we also have to be very cognizant of is the rapid pace of change on who's winning, particularly in automotive in China. We've seen over the last year a rapid change of the Chinese OEMs taking a bigger share there. That has also driven an inventory rebalancing at the end user, customer base, that then we're feeling now. And so we've got to make sure that we have adapted and our manufacturing footprint and how we operate our assets to where we need that product. And as we go forward, at least in the short term, it's probably going to be a little heavier towards Asia. And so optimizing those assets and making sure that we can respond to customer needs very quickly is something that the team is very much focused on."
},
{
"speaker": "Hassan Ahmed",
"content": "And as a follow-up, obviously, a lot of questions around EM. So I want to change gears a little bit and move to acetyls chain. The prepared remarks in reading those, it seemed you guys -- obviously, you guys reported continued sort of strong margins in that segment despite the headwinds the macro brings. And you guys talked about the sustainability of those margins within the Acetyl Chain segment. What gives you guys the sort of comfort level in sort of believing that those margins are actually sustainable on a go-forward basis?"
},
{
"speaker": "Scott Richardson",
"content": "Hassan, I think a lot of it is global trade flows and what we've seen and how things have transpired and where the global cost curves sit, particularly on the upstream part of the value chain. And so I do believe we've been able to exhibit resilience in that part of the value chain. And then as you get further downstream, the amount of flexibility that we have in that part of the chain is a lot more than it ever has been before. And so the team has a lot more choices on where they can pivot, which does enhance our ability to drive earnings power, and some of that may just be offsetting headwinds. But because of that flexibility, we do believe that the sustainability margins in these ranges is kind of where we think they'll be."
},
{
"speaker": "Lori Ryerkerk",
"content": "And I would call out two additional factors. One is we do have an advantaged technology for acetic acids, which gives us some cost advantage as well. And then we have a very advantaged cost footprint in the US Gulf Coast with our largest acetic plant there, which we believe is the lowest cost and lowest carbon -- acetic acid plant in the world today."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Matthew Blair with Tudor, Pickering, Holt & Company."
},
{
"speaker": "Matthew Blair",
"content": "Can we circle back to the potential asset sales and could you say, would they be more targeted to the EM segment or the Acetyl Chain segment? And then also on a regional basis, are you looking to sell assets in Europe or would this be kind of all over include US and Asia as well?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Well, on divestitures, we have had a very robust look and a list of possible divestitures that we've been looking at, multiple opportunities for various sizes as we talked about on the call last quarter. I would say we tend to look at these more in line with not as much even just specific assets as necessarily as you've seen us do in the past, maybe joint ventures or a very specific product line that we no longer fit with our portfolio or where someone values it more. So it's a combination of all of those things. So because of that, I wouldn't say it's really focused on any one region, although like our footprint optimization has been very focused on Europe, but even there, you've seen us do things throughout various regions. So this is just really looking at what's the best fit for us going forward and where do we have assets that may be of more value to others."
},
{
"speaker": "Matthew Blair",
"content": "And then could you also talk about what you're seeing in the European auto market so far in the fourth quarter? It looks like Germany new car registrations picked up a little bit in October but some of the other markets might be a little sluggish. Does that match with what you're seeing as well?"
},
{
"speaker": "Scott Richardson",
"content": "We've taken the most recent data, Matthew, into our forecast that we're guiding to."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of John Roberts with Mizuho Securities."
},
{
"speaker": "John Roberts",
"content": "Back in 2018, Celanese and Blackstone drop plans to merge [Acetow]. Do you think the environment has changed enough or maybe a different structure like a manufacturing JV might allow that opportunity to come back?"
},
{
"speaker": "Lori Ryerkerk",
"content": "We've talked about this a lot, John. I would say we don't see any opportunities there for tow. I mean, since we've been able to integrate it into the full Acetyl Chain, we do think that's the best place for it, that allows us to operate it as part of the chain and maximize the value of the chain. And I think the things that prevented that from happening back in '18 in terms of regulatory concerns still exist today. So I don't see that that's changed."
},
{
"speaker": "Operator",
"content": "Our last question will come from the line of Salvator Tiano with Bank of America."
},
{
"speaker": "Salvator Tiano",
"content": "So firstly, I want to trickle a bit. What are the lessons learned or what are the actions you intend to take going forward when it comes to things such as financial planning, forecasting guidance? Because coming back to one of the questions ask being earlier about auto builds and recognizing that at the day of the guidance of your Q2 results, S&P IHS was showing different numbers, of course. There were several other, I guess data points, including old suppliers that have very much outright said that auto builds are moving lower. So it was something that essentially, I guess, should have been expected. And the same goes to the whole Acetyl Chain margin, where I think we've had a lot of discussions about new acetic acid and VAM supply this year and next, which haven't -- which didn't appear like it was taken in account as much at the beginning of the year. So given that and in hindsight, what are the -- what can be done to improve the forecasting here?"
},
{
"speaker": "Scott Richardson",
"content": "Look, Sal, we're going to continue to use the data that -- a variety of data sources to drive inputs into our forecast. We also use customer forecast as well. I think one of the things that we always adjust and we'll continue to adjust in this environment is how much we use historical statistics to be able to drive forecasting, just because in periods where demand is more volatile, that changes. And so we will continue to take that into account as we make our forecast."
},
{
"speaker": "Salvator Tiano",
"content": "And I just wanted to clarify a little bit for next year. It seems to us that there is both on acetyl and on VAM more capacity underlying in Asia. So is it fair to say that absent the Clear Lake contribution, the other whatever $50 million or so you get or other cost cutting measures, we should expect Acetyl earnings to be down in 2025 versus 2024?"
},
{
"speaker": "Scott Richardson",
"content": "Look, Sal, I wouldn't make any assumptions as of yet. As we've talked about, it's still early and looking ahead. Lori mentioned earlier what we would expect to get from Clear Lake. We're just going to have to see where demand is at and particularly in Asia, to see kind of where the margin levels will be as we get into next year. And we'll provide more color on that when we get to the call in Q1."
},
{
"speaker": "Bill Cunningham",
"content": "Well, thank you, everyone. We would like to thank everyone for listening today. As always, we're available after the call for any follow-up questions. Darrel, please go ahead and close out the call."
},
{
"speaker": "Operator",
"content": "Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day."
}
] |
ce | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings and welcome to Celanese's Second Quarter 2024 Earnings Call and Webcast. [Operator Instructions]. It is now my pleasure to introduce your host, Bill Cunningham, Vice President of Investor Relations. Thank you. You may begin."
},
{
"speaker": "Bill Cunningham",
"content": "Thanks, Diego. Welcome to the Celanese Corporation's second quarter 2024 earnings conference call. My name is Bill Cunningham, Vice President of Investor Relations. With me on the call are Lori Ryerkerk, Chairman of the Board and Chief Executive Officer; Scott Richardson, Chief Operating Officer; and Chuck Kyrish, Chief Financial Officer. Celanese distributed its second quarter earnings released via Business Wire and posted prepared comments on our Investor Relations website yesterday afternoon. As a reminder, we'll discuss non-GAAP financial measures today. You can find definitions of these measures as well as reconciliations to the comparable GAAP measures on our website. Today's presentation will also include forward-looking statements. Please review the cautionary language regarding forward-looking statements, which can be found at the end of both the press release and prepared comments. Form 8-K report containing all of these materials has also been submitted to the SEC. With that, Diego, let's please go ahead and open it up for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We'll now conduct our question-and-answer session. [Operator Instructions]. Our first question comes from Josh Spector with UBS. Please state your questions."
},
{
"speaker": "Josh Spector",
"content": "Yes. Hi, good morning. So I wanted to ask on some of the moving pieces within Engineered Materials. I mean, obviously nice to see a good step up here in the second quarter, but I think there's been a constant debate around where the market is, and what's stable and in your control versus what needs to have a market improvement. So I guess when you look at your expectations about the improvement into 2Q, or sorry into 3Q, and maybe a stable second half, what are you assuming behind the market to get there versus cost savings in your control? And given all the cuts we've made in expectation, is this kind of the point where you feel like you're now conservative enough, or are there other things that you would have us watch out for? Thanks."
},
{
"speaker": "Lori Ryerkerk",
"content": "Good morning, Josh. Thanks for the question. If we look at our Q3 guidance, I would say, we're generally expecting things to be unchanged in terms of overall market conditions. We do expect a little bit of growth in auto builds in the second half, particularly in China, which I think is consistent with what others in the industry are seeing, but generally everything else is pretty stable. We're not expecting a lot of downturns. That said, we do continue to expect some moderate growth in our volumes based on the strength of our product pipeline. We also expect some continued growth in margin based on synergy pull-through and also pull-through of lower cost raw materials in inventory. So I would say, we don't need market improvement. I guess maybe other than that, a little bit in auto, in order to achieve our second half outlook from an Engineered Materials standpoint."
},
{
"speaker": "Josh Spector",
"content": "And I guess just within the auto side specifically, considering that's been an area of kind of weakening demand. Is it specific new platforms on certain cars that has driven it. Is it regional with Asia? I guess, what gives you the confidence there specifically?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I think a lot of it is the work around the integration. We now have access to customers with Celanese materials that we previously didn't have, because of the contacts that our heritage DuPont had. It's particularly in non-China, parts of Asia. And similarly we have some outlets for some of the heritage M&M materials that we didn't have before. And I think it's really, again, the project pipeline. I mean, we've been working now for, well, for a long time, but with the entire portfolio for 18 months to really identify those new customers, those new orders, those new areas within existing customers and make sure that we're strong across all the platforms and auto, ICE, Engineered Materials and hybrids. And we called out last quarter earnings, in fact, some of the applications we're getting on EVs with nylon, which is an area where DuPont didn't necessarily play."
},
{
"speaker": "Josh Spector",
"content": "Understood. Thanks, Lori."
},
{
"speaker": "Operator",
"content": "Our next question comes from Mike Sison with Wells Fargo. Please state your questions."
},
{
"speaker": "Mike Sison",
"content": "Hi, good morning. In terms of the fourth quarter versus the third, it does look like you'll need some improvements sequentially, is, at the midpoint, is a lot of that within your control. Some of the factors that you've talked about in the past?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. If you do the math, you would expect that we need some additional lift in the fourth quarter. I would put it down to a few things. We, it should be our largest quarter of synergy capture, for the Engineered Materials. We should start seeing more of a full year run rate on Clear Lake, as we'll have gotten through all the effects of the supplier outages and a little bit from Hurricane Beryl in the third quarter. So that will be an uplift there. I would also say, our mix has changed. So with the acquisition of M&M, we now have a higher presence in China. And so we wouldn't expect as much seasonality, now in the fourth quarter, as we've typically seen with the heritage Celanese portfolio. So all of those things come together. Again, we're not, other than this a little bit of uptick that's being predicted in auto. We are not really expecting material conditions to change. So, it really will be the results of kind of the self-help, the activities that we've undertaken over the last 18 months."
},
{
"speaker": "Scott Richardson",
"content": "Yes. The one thing I'd add to that, Mike is, is the work we're doing in the commercial organization, in the Engineered Materials business. We integrated the commercial teams in the early part of Q2 last year, and the average length of time that projects sit in our pipeline is about 18 months to 24 months. So we're really coming up on that kind of first 18 months plateau here at the end of this year in the fourth quarter and going into next year. And given kind of the trajectory we've seen on the success of the volume lift from Q1 to Q2, we're really starting to see the benefit of that model play out with bringing M&M into that EM business. And so you do have a little bit of an element of that as well from how we see the pipeline developing at the end of the year."
},
{
"speaker": "Mike Sison",
"content": "Right. And the quick follow up. The macro hasn't been very helpful for you and can be in general. So, if things get worse sequentially into the second half, what changes can you make to sort of hit this range? And then how do you sort of help us think about '25, and the ramp up potential of earnings - the earnings process for Celanese longer term."
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, things can always get worse, right? And we've seen that, but I would also say, things, things have been certainly very challenging this year, and the results that we're delivering this year are really based on the remarkable efforts of our teams and their ability to innovate, the resilience that they've shown, and really looking under every rock for sources of value. So, if it gets worse, that will continue. I would say, Europe for all practical measures has been in a near recessionary kind of condition. So, we think it's going to be stable based on what we can see in our order books right now, certainly for Q3. As we go into 2025, we will continue to have self-help, which will help lift us in '25. I think if you look at '25, we can think about the run rate that we'll see in the second half of the year continuing through '25. Then we'll have another tranche of M&M synergies on top of that, as well as full productivity from Clear Lake next year and probably some additional interest rate benefits as well. So I think, the things that we've seen this year will continue to compound into next year and raise the 2025 results. But frankly, it's just too early to tell what the fundamental economic conditions are going to be in 2025, yet."
},
{
"speaker": "Mike Sison",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Mike Leithead with Barclays. Please state your questions."
},
{
"speaker": "Mike Leithead",
"content": "Great. Thanks. Good morning, team. A few questions on the acetyls force majeure. I guess, first, are we still in force majeure? And when do you expect to fully resolve these disruptions? Two, should we think about any insurance proceeds or any sort of restitution for you guys from these disruptions. And then finally, apologies if I missed this, but what is the all-in expected cost impact from this outage?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Thanks for the question, Mike. We are still in force majeure. The units obviously are restarted, running well, but it is a longish supply chain in the western hemisphere. So we're in force majeure till we can reestablish those supply chains into Europe, which is the work going on currently. But we fully expect that we'll lift the force majeure sometime in this quarter. In terms of restitution. We're really just focused right now and have been focused in the second quarter on working with our suppliers to understand what the issues were, how we could get through them more quickly, how to address reliability issues going forward, how to make sure that we maintain really good relationships? That's really been our focus now. And we'll have discussions about any, any form of restitution later."
},
{
"speaker": "Mike Leithead",
"content": "Okay. I'm sorry. And then just in terms of all-in cost impact?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Oh, I'm sorry. I just missed it. Yes. So, this quarter, second quarter, I would say, it was about $35 million. And then next quarter we'll see another $5 million to $10 million."
},
{
"speaker": "Mike Leithead",
"content": "Okay, great. And then I just want to follow up on some of the competitive dynamics in your product. I think in the remarks, as commodity, commodity nylon is below the cost curve. There's been some opportunistic pricing, if you will, in some other areas. I guess, what is your best kind of judgment about where we stand today? Or are we still atrophying in price in some of these areas? Are we stabilizing, or have we started to recover here?"
},
{
"speaker": "Lori Ryerkerk",
"content": "As you called out, Mike, I mean, we definitely saw price pressure on raw nylon, polymer, this last quarter. It has definitely gone down, and it's, it's affected some of the margin uplift we expected from pull-through. That said, I think this really points out the benefit of the strategy, we took though to shutdown standard grade polymerization at Uentrop. And really be able to give ourselves flexibility in terms of where we choose to source raw nylon, polymer and compounded for our customers. So that's really paid off. We would have seen more of a hit this past quarter, if we, if we hadn't done that. I would say, on the other products, not as much pricing pressure as margin pressure as we've seen some increase in raw materials, especially think about palm, where we've seen some, some increase in ethylene. So those being the two biggest, I would say, again nylon, its priced, but mitigated by the steps that we've taken; palm, we've seen pressure on ethylene pricing."
},
{
"speaker": "Mike Leithead",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jeff Zekauskas with JPMorgan. Please state your question."
},
{
"speaker": "Jeff Zekauskas",
"content": "Thanks very much. Were the outages at Clear Lake caused by anything else other than carbon monoxide difficulties? Was there some other source of inefficiency in the quarter?"
},
{
"speaker": "Scott Richardson",
"content": "Yes. Thanks for the question, Jeff. Yes, with the suppliers that we have, and we've talked about multiple suppliers, was really around several different raw materials that we source."
},
{
"speaker": "Jeff Zekauskas",
"content": "Several. So, so it's a wider issue than CO."
},
{
"speaker": "Scott Richardson",
"content": "Yes. We're not talking about the specific materials, Jeff. I mean, at the end of the day, we talked about acetic acid, and we buy several different raw materials for that."
},
{
"speaker": "Jeff Zekauskas",
"content": "And then secondly, can you talk about your preference as to whether you would sell acetic acid, or you would sell them in the current environment. How is that, can you compare the profitability of those two chemical outputs?"
},
{
"speaker": "Scott Richardson",
"content": "Yes. Honestly, Jeff, it really does fluctuate week-to-week region-to-region. And we are looking at kind of where the different markets are at, and kind of where they're trending based upon kind of where the fundamental supply/demand dynamics are. And that is, is going to be kind of one way in one geography for the first part of the quarter and maybe a little different. I would say, in general, we tend to be pivoting more as we talked about last quarter, in Asia more further downstream. We've seen more opportunities in our emulsions as well as our redispersible powders business to be able to grow in some of those areas. We talked in the prepared comments about some of the, out of a kind substitution that we've been successful driving there with the expanded capacities that we have. In addition, with those expanded capacities, we've been able to really work with our customers in India, specifically to kind of help develop that market and really start to drive there. So that has been a nice growth area for us more on the Asia side. And I would say, it's a little more balanced than where we're selling in the Western hemisphere."
},
{
"speaker": "Jeff Zekauskas",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ghansham Panjabi with Baird. Please state your question."
},
{
"speaker": "Ghansham Panjabi",
"content": "Hi, guys. Good morning. Lori, I just want to go back to my usual question on the sort of the macro pulse. Obviously, your volumes have been weak for several quarters. But just based on your sense as we spent around the world, do you feel like the macro is relatively stable on a consolidated basis? Or is it just your own initiatives that are masking what is otherwise a sequential deceleration? And I'm just asking because, obviously, the data in China is very poor. Commodity prices have pulled back, including oil, et cetera, more recently. So on a real-time basis, what are you seeing?"
},
{
"speaker": "Lori Ryerkerk",
"content": "On a real-time basis, Ghansham, I would say, stable is the right word. Again, I go back to auto. Auto actually has been a little stronger in the U.S. and Asia. Europe has weakened year-on-year. But globally, auto has been pretty stable. And we do see, especially in China, some further strengthening in the second half. Consumer and electronics, again, pretty stable globally. But in our own, own portfolio because of what we've been able to do through the project pipeline, and the good work by our teams on the ground, we are starting to see some growth in consumer and electronics. We've had strong Q-on-Q growth in medical implants, which is a little bit unique to us and as expected. And we really are not destocking the cadence and consistency of orders. It continues to improve. We've got a few percent growth from that. And really, I would say, overall, I call the market stable, but we're starting to see a little bit of volume growth in Engineered Materials, anyway just because of the project pipeline and the revenue synergies, et cetera. I think in acetyls, again, stable is the right word. It is just, it is stable for construction, paints and coatings, specifically that sector at a, at a very low rate. And we thought we'd start to see some seasonal uptick there. We have not seen that in the second quarter, and we're not anticipating it now for the third quarter as well. And I think that, that's true for, for all regions. But to put it in perspective, for the company as a whole, I'd say, remind you that 25% of what we make is auto. And auto has been stable to slightly up this year. Everything else is less than that. So, we're really seeing the value, I think in our portfolio, the diversity of our portfolio and the ability that has to help us stabilize earnings and buying pockets of improvement."
},
{
"speaker": "Ghansham Panjabi",
"content": "Okay. Fantastic. And then for my second question, in terms of free cash flow, I mean, you guys have been very efficient in pulling levers to kind of protect free cash flow throughout this, the challenging volume environment. Is there anything for 2025 that we need to keep in mind, as it relates to the bridge, '24 versus '25 that, that you're benefiting from this year that may not repeat next year."
},
{
"speaker": "Lori Ryerkerk",
"content": "Chuck, so you would take that."
},
{
"speaker": "Chuck Kyrish",
"content": "Yes, Ghansham. I would say, actually there are a couple of things in our components of our free cash flow in '25, which will get better. It's a very heavy year for cash taxes. I've tried to talk about a lot and explain. Cash tax will be significantly lower next year. Our cash interest will continue to drive lower next year as we, as we pay off our debt. I don't see our CapEx changing materially while we're hearing our deleveraging phase, right? So we've done a lot of work on, on our inventories as well. So, there's actually a few things, next year, that we built in cash positives versus 2024."
},
{
"speaker": "Ghansham Panjabi",
"content": "Okay. Thanks so much."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Arun Viswanathan with RBC Capital Markets. Please state your question."
},
{
"speaker": "Arun Viswanathan",
"content": "Great. Thanks for taking my question. So just going back to the force majeure comment. So, it sounds like 30, maybe [$40 million to $45 million] for the full year, which is maybe around $0.35 or so on the EPS line. So, if you think about the reduction, the remaining reduction maybe $0.65 at the midpoint. How do you think about that between price and volume? And any, any other factors, I guess driving that reduction?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. I would think about it, really in, in four buckets. So the first bucket is, what you called out the $45 million or so associated with our supplier issues this year. There's probably another $40 million on top of that of Clear Lake productivity because of the timing of when all this happened relative to our startup, et cetera, that, that $100 million of productivity. We won't get there's about $40 million more of that. So that's about half of that, of that step-up that we would expect, have expected to get to foundational earnings, for, in that dollar. And then the other part of that, sorry, I'm thinking about '25, let me back up. So for your question, which is really about the dollar we went down. Again, it's the same, but so we have about, nearly half of it is coming from that. Then we have, I'd say, the issues we're having around construction, paints and coatings. And it's really more there a question of, of margins in the acetyl business. And then on the EM side, which is the third bucket, it is really the question of what are we able to pull through on raw materials, because as we've talked about with palm, margins being compressed and nylon margins being compressed, but one, because of raw materials; one, because of pricing. We had said we may get as much as 150 pull-through in, of lower raw materials. We're probably only going to get about half of that this year. So I would think about it that way."
},
{
"speaker": "Arun Viswanathan",
"content": "Okay. That's very helpful. And I guess you're answering my other question, there a little bit as well. So, just as you think about '25, then which of those factors kind of come back to you? It sounds like maybe half of that. And then on top of that, how much do you expect from synergies and deleveraging as you look into '25? Thanks."
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. So when you think about '25, as I said, the run rate we see in the second half, I think is a good indicator as a base for '25. And then you think about, we also, of course, in the second half, we will get the majority of that Clear Lake supplier issues will have been cleared off. We'll start getting some more productivity. So, if you look forward, I would think about synergies. We will definitely have a good tranche of synergies next year, similar to what we've had this year and last year. And then we should have a little bit of additional help from turnarounds as well. And then, of course, we have some additional help from interest rates."
},
{
"speaker": "Arun Viswanathan",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from Vincent Andrews with Morgan Stanley. Please state your question."
},
{
"speaker": "Vincent Andrews",
"content": "Thank you. Lori, can I ask you on the Acetyl Chain. You noted that the Clear Lake outage, I think you said was the biggest one you've had in 15 years. And obviously, it didn't lead to, to the market improving. So as you bring Clear Lake back up, are you making any adjustments to production anywhere else? Or do you think that the, the market is going to be able to absorb the resumption of production even as we kind of come out of what, what usually is a seasonally stronger period of the year?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Vincent, it's, it's hard to say. I mean, we make adjustments all the time to our production. And so we'll continue to look at that. I mean, it's a call that happens daily just about in the acetyl team is what we should be making where based on, on where the markets are going. So, I don't see this necessarily changing it. You're right. We didn't see much price response with the shutdown are with the loss of production during that time. But I think that just reflects how really weak the demand environment is for constructions and coatings. Scott, do you have something?"
},
{
"speaker": "Scott Richardson",
"content": "Yes. I mean, how I would add to that, Vincent, is it's kind of going back to what we talked about earlier is, we're constantly looking at, at matching rates with where that demand is, and where we can maximize that really on a weekly and monthly basis. And assuming that we are able to, to get back the key raw materials where we had multiple suppliers that had issues on that, then it's going to give us the ability to have that optionality to kind of operate the chain as we normally do. And so we're rebuilding our inventories now and getting that flexibility back and to be able to get that flex, which is just going to kind of depend kind of where things are from month to month."
},
{
"speaker": "Vincent Andrews",
"content": "And then if I could just follow up. Also in the prepared remarks, you made some comments, Lori, about the new assets in China that, that have started up and that obviously, that's incremental supply that, that hasn't been absorbed. But what I was trying to square was you said that, that supply seems to have stayed largely in Asia and that European exports or exports in Europe are down are down 40% over the last 12 months. So, I just wanted to understand, is that saying that, that excess product that's come out of those Chinese facilities is just sort of weighing on only on the Asian market, but they've also actually taken product out of Europe? Or I just didn't understand why the European exports had come down?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. I think if you just look at the low margins that are associated right now, I mean, China has been basically at the cost curve. So all these new units have started up and they may be slightly advantaged that, that given the low demand in China, especially in some of the areas like construction, but also EBA, where we've seen quite a downturn here recently. That material, quite frankly it's more affordable for them to ship it, and put it in other parts of Asia, than necessarily to get it to China. So, I think it's the economics of taking that demand into Asia, which has left the channel to Europe more to the U.S."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. That makes sense. Thanks very much for the clarity."
},
{
"speaker": "Operator",
"content": "Our next question comes from Kevin McCarthy, Vertical Research Partners. Please state your question."
},
{
"speaker": "Matthew Hettwer",
"content": "Hi. This is Matt Hettwer on for Kevin McCarthy. In the prepared remarks, you mentioned the potential for targeted divestiture opportunities on the same scale, as food ingredients. Would you consider looking at your other JVs there, maybe something along the lines of the Fairway Methanol JV?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, Matt, I would just say, we really never comment on what specific assets or processes that we're in. We are actively working multiple opportunities now, on various assets. We've always been very clear that if our assets are worth more to someone else, than they are to us, we are open to look at divestment. And of course, the timing of that is unpredictable. So I can't comment on any specifics."
},
{
"speaker": "Scott Richardson",
"content": "Yes. The only thing I'd add is, we have stated that we do like having an integration in methanol somewhere between about 40% and 50% of our total needs. And we think that gives us, kind of a nice balance from being in the market, much like we, articulated we're now doing with nylon. We like being able to buy and make a little bit and be in the market, for a portion of that. For methanol, we consistently - relook at what that right balance is. And we've, we've landed right in that kind of 40% to 50%."
},
{
"speaker": "Matthew Hettwer",
"content": "Okay. Thank you. And then just a quick one, you paid down 500, excuse me, $500 million in debt in the second quarter. Now looking at another $500 million in the third, how do you expect that to trend in the fourth quarter?"
},
{
"speaker": "Chuck Kyrish",
"content": "Are you talking interest expense?"
},
{
"speaker": "Matthew Hettwer",
"content": "Yes."
},
{
"speaker": "Chuck Kyrish",
"content": "Yes. I would, there's some moving parts in there. There's some short-term revolver draw and there is - the debt paydown. When you look at it, some of those bonds that we're paying down have really low coupons. One of the maturities was swapped down to 1%. At the same time, you've got cash that you're using to pay that down. That's actually making really good rates. So, I do expect a decline in interest, a slight decline in the second half of the year. I'd say in both Q3 and Q4, the interest expense on a net basis should be a few million lower, than you see in Q2."
},
{
"speaker": "Matthew Hettwer",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Aleksey Yefremov with KeyBanc Capital Markets. Please state your question."
},
{
"speaker": "Aleksey Yefremov",
"content": "Thanks. Good morning. In your prepared remarks, you talked about expansion between pricing raw materials and EM in the third quarter. Do you need to raise prices to achieve that, or raises due to cheaper layers of raw materials inventory?"
},
{
"speaker": "Chuck Kyrish",
"content": "Aleksey our focus is really on, kind of controlling the things that we can control as Lori mentioned earlier, and launching new projects from our pipeline model. As Lori mentioned, we are assuming very similar landscape in Q3 overall to what we saw in Q2. So, we're not necessarily baking that in to our base. It really is about the raw materials flowing through. And also as we launch new projects and new opportunities, getting a mix uplift from that. So I see that being the larger portion of margin expansion."
},
{
"speaker": "Aleksey Yefremov",
"content": "Very helpful. Thank you. And on Clear Lake expansion, can you just clarify how much do you expect it to contribute this year to your EBIT, given all the challenges in total versus your $100 million target? And then how much can we expect next year, assuming the margin picture does not change?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, Aleksey, I would expect about half roughly this year and then, the other half next year in addition."
},
{
"speaker": "Aleksey Yefremov",
"content": "Thanks a lot, Lori."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Frank Mitsch with Fermium Research. Please state your question."
},
{
"speaker": "Unidentified Analyst",
"content": "Hi, good morning. This is [Yuzan] for Frank. First question around the lowered CapEx, that $400 million to $450 million range, how much of that is maintenance CapEx? And I just want to confirm I heard correctly that the early look on 2025 is calling for a similar range?"
},
{
"speaker": "Chuck Kyrish",
"content": "Yes. What we said in the past is our maintenance right now, most years is going to run between $300 million and $350 million. And then the balance of capital we would spend each year is going to be for productivity and growth. So really kind of the earnings growth piece of it. I would just kind of remind you that as we've said historically. We have been able to generate a high-teens low 20% return our entire bucket of capital. So that tends to be we do focus on returns overall on all of our capital, but maintenance is in that $300 million and $350 million range."
},
{
"speaker": "Unidentified Analyst",
"content": "Got it and I know that the synergies for the first half came in around $40 million. Just curious what gives you guys the confidence that it will more than double in the second half of the year to reach that $150 million level?"
},
{
"speaker": "Chuck Kyrish",
"content": "Yes it's really the run rate that we're on and the actions that we've taken. I mean most of the synergies this year are on the cost side of the equation. There are some revenue synergies as I alluded to earlier, but it's mainly cost and the actions that we've taken. We made several announcements around our manufacturing footprint. Those are rolling in. The Uentrop facility has been shutdown, and we're kind of ramping up servicing customers from other locations now. We'll have the next site, which will come out of the network here in the fourth quarter. And so, with some of those announcements as well as some of the actions we've taken on the functional side of things, such as implementation of our IT systems on an integrated basis. The benefits of that really were always more second half weighted than first half weighted."
},
{
"speaker": "Unidentified Analyst",
"content": "Got it. Thank you guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Begleiter with Deutsche Bank. Please state your question."
},
{
"speaker": "David Huang",
"content": "It's David Huang here for Dave. I guess you noted lower level participation in spot activity in both acetyls and tow. What percentage did you sell to the spot market before the outage, and I guess how should we think about the ramp of those activities in second half?"
},
{
"speaker": "Scott Richardson",
"content": "Overall, each product line has a different kind of percentage that's weighted towards spot versus contract, and each region is a little bit different. I would say on the acetate tow side of things, things are a little lower percentage that is spot versus contract. Most of that business is contract. In our other product lines in acetic acid VAM emulsions for example it's different by region. And so, I think just with the constraints that we had, due to some of the supplier outages. We just - we didn't have the same flexibility that we typically do, to be able to flex our value chain in the Western Hemisphere, which limited some of those opportunities."
},
{
"speaker": "David Huang",
"content": "Okay. Got it. And then medical can you explain the other timing impacting the quarter. And I think some of your peers are still talking about continued destocking medical. I guess how has applications outside of implants performed in the quarter?"
},
{
"speaker": "Scott Richardson",
"content": "It's been very stable. Our medical business it has been a key growth area for us. It has been an area focused really around growing in the areas where we can be successful, and picking some of the winning spaces. We've talked a lot about implants. We've also talked a lot about drug delivery, continuous glucose monitoring. A lot of different mega trends there that have been useful for our polymers. And we've been working these opportunities for a long period of time. Our medical implant business in general certainly is getting better each year, but you are going to have some fluctuations from quarter-to-quarter. So I said that's really not demand related it's just kind of more normal order patterns, and our business outside of implants has been extremely stable and growing."
},
{
"speaker": "David Huang",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Hassan Ahmed with Alembic Global. Please state your question."
},
{
"speaker": "Hassan Ahmed",
"content": "Morning Lori. Lori, a couple of quarters ago in your prepared remarks you guys talked about sort of maximizing the make versus buy flexibility at Celanese. Particularly now in light of the force majeure on the acetate/VAM side of things, is there a sort of heightened level of urgency around that? I mean how are, you how are you thinking about that and what form will that take on a go-forward basis?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I don't think what we've experienced Hassan would change our view. I mean we always want to have the flexibility. If you look at this past quarter, we were unable to make, because of our supplier issues in some instances. And so, we actually went into the market to buy, to the extent we could, but at a higher cost. I mean, that's not ideal, but, our first priority is to keep our customers whole and to meet our contractual commitments with our customers. So in reliability situations or turnarounds, or whatever, having that ability is good. And then, the other side of that is like we've seen in nylon, when the margins for raw polymer got so low, it is really helpful that we had taken the steps to shutdown Uentrop, and put ourselves where we could be buying raw polymer on the market, in what was a very, low-priced situation, certainly lower than we would have been able to make it ourselves. So, again, I don't think our view is changing at all in terms of wanting to always have that ability, to make or buy depending on the economic situation. And also to help us through periods of operational shortages."
},
{
"speaker": "Hassan Ahmed",
"content": "Understood. Understood. Extremely helpful. And just as a follow-up, I know you've made a couple of comments about the undifferentiated sort of nylon side of the market. Can you sort of dig a little deeper for us on, what the goings-on are with regards to supply-demand fundamentals over there? I mean, you obviously flagged the whole notion of, Chinese capacity being below the cost curve right now. So, how do you see, this year and over the next couple of years supply-demand dynamics planning out?"
},
{
"speaker": "Scott Richardson",
"content": "I mean, look, nylon is no different than the rest of our portfolio in engineering materials. You kind of have three categories of business there. You have a standard-grade category. You have a kind of a spec-in category where you have more competition. Then you have the really specialty new applications area. And it's really important that we play in all three buckets there just because, customers oftentimes are buying all three. And we want to make sure we're also filling out our assets. And so, it is while the competitiveness in the standard grades is definitely there, there's still really good opportunities kind of in that spec-in and specialty area. I mean, just a simple data point, in the first half of the year, we actually closed over 400 projects in our nylon business using the pipeline model. That's a significant step up from the second half of last year. And so, it's a good proof point that what we're doing there and really the commercial team's focus on working with customers and building really nice differentiated business for the long-term is going to pay off. We're going to have to participate in the basic blocking and tackling part of the marketplace. But having that flexibility Lori just talked about, is so critical in us kind of building this more contemporary nylon model that can be overall successful, and can continue to grow."
},
{
"speaker": "Hassan Ahmed",
"content": "Very helpful. Thank you so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Salvator Tiano with Bank of America. Please state your question."
},
{
"speaker": "Salvator Tiano",
"content": "Yes, thank you very much. So, firstly, I want to understand, I think you - so on the $25 million package that, you mentioned the timing as well as some inventory changes that will weigh on Q3 in engineering materials. Does this mean that you were essentially producing above sales in the first half, and therefore what this $25 million is - while this is a headwind to Q3, it was actually a pull forward effectively in H1 for the full year? Is that how we should think about it?"
},
{
"speaker": "Chuck Kyrish",
"content": "Yes. So a large chunk of that is some of the footprint actions that we've taken. We've been building inventory now for a number of quarters. So I wouldn't look at it as kind of being a big benefit in Q2 in particular. It's kind of been a gradual uptick. We also just have some kind of normal - we have certain products that have campaign runs. And so, you'll have a little bit of an uptick from time-to-time, and then a down tick. So, I wouldn't look at it as being materially different for that piece than what we've typically seen."
},
{
"speaker": "Salvator Tiano",
"content": "Okay. Perfect. And the other thing I want to understand is that if I heard correctly, I think there was a comment that next year's synergies will be similar to this year's levels, which I believe we're still targeting $150 million. Firstly, is that correct? And secondly, if I go back to the initial co-synergies targets from your M&M slides, I believe there was more like a $50 million, $60 million, $70 million figure left. So how do you get to a number that's more than double that next year?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. So let me clarify itself, because probably, my comments weren't clear before. If you look at '23, we had $100 million of synergies than if you look at '24, $150 million. And so my comment was, look, I don't have an exact number yet for '25, because we've been very focused on '24. But I think our synergy should be based on the actions that we're taking here this year in the same range as the last two years. So somewhere in that range. And then the remainder of the step-up in '25 is really the improved performance of acetyls tills with no force majeure, a full year of CLK productivity. And then we should have some further interest rate reductions. So, those are the things that I know about for 2025. But as I said, it's still too early to give any number with confidence on 2025."
},
{
"speaker": "Salvator Tiano",
"content": "Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Laurence Alexander with Jefferies. Please state your question."
},
{
"speaker": "Laurence Alexander",
"content": "Good morning. I just want to confirm that the midpoint of your outlook, for the back half of the year is predicated, it looks like it's predicated on your automotive volumes being up like mid-single-digits, call it 2%, 3% above a flat to slightly positive auto build rate. Is that right?"
},
{
"speaker": "Lori Ryerkerk",
"content": "We are expecting some uptick. Some moderate volume increase, I would say, in volumes into automotive."
},
{
"speaker": "Laurence Alexander",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Patrick Cunningham with Citi. Please state your question."
},
{
"speaker": "Patrick Cunningham",
"content": "Hi, good morning. Thanks for taking my question. You talked a little bit about the weaker non-contracted sales for tow. How meaningful is this in terms of typical to sales? How is the contract side of the business performing? And what are your medium-term supply and demand expectations for the tow business?"
},
{
"speaker": "Scott Richardson",
"content": "I mean, tow business has been very stable, Patrick. And the contracted piece of the business has performed as expected. Again, as I mentioned earlier, the noncontract part is a small percentage. It's just we did see a little bit of inventory reduction from our customers in that part of the sector during the second quarter. So, it we don't expect it necessarily to continue going forward."
},
{
"speaker": "Patrick Cunningham",
"content": "Got it. That's helpful. And then maybe just within nylon, you touched on this a little bit, but can you just talk about the contemporary business model here, how you feel it performs, how you're maybe thinking about the footprint, if we see further pressure from here? And on the flip side, would you put incremental costs back into this business if demand improves, or the make versus buy economics change?"
},
{
"speaker": "Scott Richardson",
"content": "Look, we're really proud of the team. I mean the team has come together and embraced a different way of operating here. And we're taking the ideas really across each function in the organization to really go and build out a model that we can be proud of that can deliver greater than 25% EBITDA in any economic environment and that's our target. We're early innings. I mean we've had some good success. We're seeing margin expansion, as we talked about. We're seeing nice wins coming from our project pipeline, but we have to continue to work the cost side of the equation. We have to continue to focus on really bringing our organization together to embrace the pipeline model and continue to elevate the returns that we're getting overall from the business. So depending on what the market gives us, we're going to have to pit it, much like we do in other parts of our business, both in acetyls and EM. And it's building those muscles to be able to adapt as things change from quarter-to-quarter."
},
{
"speaker": "Patrick Cunningham",
"content": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from John Roberts with Mizuho Securities. Please state your question."
},
{
"speaker": "John Roberts",
"content": "Thank you. Just going back to nylon and China here. They have a lot of producers who serve both the plastics and fiber markets. And given the weak carpet and textile markets, are you seeing some of that China nylon shift from fiber to plastics. I know some applications can't switch, but I thought there was enough that could switch that maybe that would be pressuring the market."
},
{
"speaker": "Scott Richardson",
"content": "John, that's really not where we're seeing the pressure from. I mean there's a lot of consistent players in the plastics market. So I wouldn't say that's been a material issue."
},
{
"speaker": "John Roberts",
"content": "Got it. Thank you."
},
{
"speaker": "Bill Cunningham",
"content": "Diego, we'll make the next question, our last one, please."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question for today comes from John McNulty with BMO Capital Markets. Please state your question."
},
{
"speaker": "John McNulty",
"content": "Yes. Good morning. Thanks for taking my question. So Lori, I think you said of the original $150 million that you expected to get from lower raw materials kind of working through, you're going to get about half that. Does the other half get pushed out into 2025? Or is it really just an opportunity that just given the circumstances you're just not going to be able to capture, I guess, how should we be thinking about that?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I would think about it as we weren't able to capture it here. There's no guarantee it will be there next year. If you think about the cost of inventory we're building right now will be what we see in the first half of next year, at least in the Engineered Materials. So I can't count on that for next year. I mean, we just have to see how cost of inventory goes for the rest of this year."
},
{
"speaker": "John McNulty",
"content": "Okay. Fair enough. And then, I guess with regard to the acetic acid capacity that came on in China, the two new world-scale plants, I think like one of the issues was that you didn't see a whole lot of the downstream assets come on yet, and I think that was putting pressure on acetic acid prices. Can you give us an update as to whether or not those downstream assets have come on yet? And if they if they haven't, does that mute the ability for growth, or improvement in the market even as China construction starts to come back on and some of the downstream demand starts to come back on? I guess how should we be thinking about that?"
},
{
"speaker": "Lori Ryerkerk",
"content": "So John, some of the uses that those plants were expected to serve were things like caprolactam, which is new, PVOH, EVA, I'm not sure about the capital action plan, if I'm honest. But PVOH, I think, is up and okay. EVA is up from what we know, but honestly, EVA demand right now or not EVA demand, but utilization of the EVA plants has gone to 7% or below from what we know. So again, just because of the softness right now in solar panels. And so, I think while it may be up, we're not seeing those plants consuming the volume of VAM that we would normally expect."
},
{
"speaker": "Scott Richardson",
"content": "Yes. John, really, the real cause of that is the end-user demand, particularly paints, coatings, construction and some of the solar space, as Lori mentioned, are just are weak. And so yes, while we've seen capacity come on in acetic acid and pricing kind of up and down, our margins have been largely stable now for quite a while. We've seen compression in VAM margins because that construction sector as well as solar has been so weak. So I think that's more of kind of where that compression has been seen."
},
{
"speaker": "John McNulty",
"content": "Got it. Thanks very much for the color"
},
{
"speaker": "Operator",
"content": "Thank you. And I'll now hand the floor back to Bill Cunningham for closing remarks."
},
{
"speaker": "Bill Cunningham",
"content": "Thank you. We'd like to thank everyone for listening in today. As always, we're available after the call for any follow-up questions. Diego, please go ahead and close out the call."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. All parties may now disconnect. Have a good day."
}
] |
ce | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Celanese First Quarter 2024 Earnings Call and Webcast. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Bill Cunningham, Vice President of Investor Relations. Thank you. You may begin."
},
{
"speaker": "Bill Cunningham",
"content": "Thanks, Diego. Welcome to the Celanese Corporation First Quarter 2024 Earnings Conference Call. My name is Bill Cunningham, Vice President of Investor Relations. With me today on the call are Lori Ryerkerk, Chairman of the Board and Chief Executive Officer; Scott Richardson, Chief Operating Officer; and Chuck Kyrish, Chief Financial Officer."
},
{
"speaker": "",
"content": "Celanese distributed its first quarter earnings release via Business Wire and posted prepared comments on our Investor Relations website yesterday afternoon. As a reminder, we'll discuss non-GAAP financial measures today. You can find definitions of these measures as well as reconciliations to the comparable GAAP measures on our website. Today's presentation will also include forward-looking statements. Please review the cautionary language regarding forward-looking statements, which can be found at the end of both the press release and prepared comments. Form 8-K reports containing all of these materials have also been submitted to the SEC."
},
{
"speaker": "",
"content": "With that, Diego, let's please go ahead and open it up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from Ghansham Panjabi with Baird."
},
{
"speaker": "Ghansham Panjabi",
"content": "I guess, Lori, just first off, just given all the various moving parts globally and so on and so forth. Maybe you can just share with us your updated view on just the macroeconomic construct globally. You [indiscernible] the U.S., Europe and China in context from the previous headwinds of destocking and just weaker growth, et cetera?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Ghansham, look, on the macro, what I would say is, look, it's generally unchanged from what we've been saying in the past few quarters. I would say we haven't seen any big positives or negative this quarter from what we had expected. We called out last quarter, we really thought we were at the end of destocking. I think the movements this year, what we're seeing in the order book, the stability of the order book has proven that to be true."
},
{
"speaker": "",
"content": "In China, specifically, I'd say, as we said last quarter, China for China is pretty steady. It's okay. It's the exports that are lagging to primarily Europe, but also other regions of the world, and we're not seeing some of the pull-through of material because of those -- that lag in exports. The U.S. remains pretty steady, I would say, across all the sectors. And Europe, although we did see a little improvement since the middle of last year, I would still say it remains lackluster and below normal levels in Europe."
},
{
"speaker": "",
"content": "I would also say, as we move forward, we're really not seeing some of the seasonal uplift we would have expected at the end of the first quarter and into second quarter. Overall, I'd say all the sectors are pretty steady. I think the notable sector in terms of poor demand continues to be construction, paints and coatings, et cetera. And although I do think there, we would expect as we move into the second half that we maybe start to see recovery there. I think PPG called out this quarter that they've had 11 quarters of flat to down."
},
{
"speaker": "",
"content": "And there in second quarter, expecting to see low single-digit growth and some further growth in second half. So we hope that's true. If so, we should see a little bit of recovery there as we moved into the second half. I mean I would characterize it much like we did even a year ago, which is we still think people are still spending. They're still spending on experiences, on travel, airlines are having a good time, but they're not spending on goods yet. It will normalize at some point, but we're not seeing that normalization yet."
},
{
"speaker": "Ghansham Panjabi",
"content": "That's comprehensive, Lori. And just in terms of the related question as to what would actually kickstart demand from your perspective? Would it just be as simple as interest rates being [ reduced ] on a global basis? And then related to that, you had called out new capacity over the last 6 months, specific to the comments on Chinese acetic acid, et cetera. Is that capacity more disruptive than you thought? Or is it just that demand was weaker than you thought initially?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, I think in terms of kickstarting it's really just when do people get confident in the environment again, when do we see a shift back to normalized spending on durable goods. Clearly, we could use some China -- sorry, some Europe recoveries would be really helpful. But it's nothing more than that. Like I said, consumers are spending. We just need them to start spending on durable goods again. And again, I do think that will happen in time."
},
{
"speaker": "",
"content": "I think your question on China, what I would say is, I would say the new capacity has it been more disruptive than we thought, I would say, yes, because the demand for that, which was being planned to go in, has not developed. So there were some downstream consumers that were being built at the same time. They've been delayed. Obviously, they've been delayed because the demand for those products are delayed. So it is ultimately a demand answer."
},
{
"speaker": "",
"content": "The good news there is though we are seeing some acetic acid flowing into new applications, like [ caprolactam ] and others. So again, I think it's a temporary phenomenon. If you look at what's been added, even what's to come, this is not such a large number that I think we're back where we were 20 years ago. I think we -- it's just a question of demand normalizing and catching up with the supply we have now."
},
{
"speaker": "Operator",
"content": "And our next question comes from Mike Leithead with Barclays."
},
{
"speaker": "Michael Leithead",
"content": "Great. I wanted to dovetail and ask about full year guidance. Lori, it seems like from your remarks just now the macro conditions are maybe still a bit uninspiring. So the bridge from sort of the $5 is funded out of the EPS in the first half to about 6 50 at the midpoint in the second half. Is that all controllable Celanese action? Or do you need the world to get a bit better from here to hit those numbers?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Thanks, Mike. I would characterize it as we will hit those numbers with just controllable actions. And if you think about it, M&M synergies are heavily loaded and compounding as we go through the year. So now that we have full visibility into the data, everything due to our S/4HANA upgrade for the M&M assets. And some -- and also the results of like the Uentrop shutdown and some of the other footprint actions we took last year, we really start to see those synergies grow and compound as we move through the year."
},
{
"speaker": "",
"content": "So that's a major impact. The Clear Lake expansion, while we did have a little bit of help in the first quarter from that, that will also continue to grow as we move through the year. Debt service is another one, which is more heavily loaded into the second half of the year. And I would also say our turnaround costs in the first half is about double what it's going to be in the second half. So we get some tailwind there as well. So I would say everything we know now says we're well in that range, just based on what we know. We've not really built in any recovery other than the end of destocking, as we've said before. So I think we -- I feel very -- still feel very confident that we will be within that range for full year."
},
{
"speaker": "Michael Leithead",
"content": "Great. So that's helpful. And just as a follow-up question on Engineered Materials. I think in the prepared remarks, you talked about continued pricing pressure. I was hoping you could unpack that somewhat. Just where exactly are you seeing the most pricing pressure today? And was that a nylon specific comment or more broad based across the portfolio?"
},
{
"speaker": "Scott Richardson",
"content": "I would talk -- think about that, Mike, in terms of -- it's really continued from what we saw in the fourth quarter of last year. Really no significant changes there. Raws have come down as well. And we've been really mismatched here in Engineered Materials for more than a year on where kind of pricing for standard grade materials was versus the cost structure. And as you saw with some of the margin expansion we alluded to in the prepared comments, we're definitely catching up there. But we're not seeing a lot of ability to move pricing here in those spaces. So the team is focused, however, really around continuing to move the pipeline and work on upgrade of mix as we work our way through this year and then into 2025 to address that."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jeff Zekauskas with JPMorgan."
},
{
"speaker": "Jeffrey Zekauskas",
"content": "When you look at your Engineered Materials volumes year-on-year, they're down 12%. Maybe global auto production is down 1%. And when you look at the demand for the coatings companies, maybe it's down low single digits. Why is Engineered Materials have a larger volume decrement."
},
{
"speaker": "Scott Richardson",
"content": "Yes, Jeff, I would really point to some of the real standard spaces we participated in last year, really to start moving some of the inventory levels that we had as we finished 2022. And that's really more of the driver than anything else. We also saw a little more seasonality in the medical sector here this year versus what we saw last year. So those are the main drivers."
},
{
"speaker": "Jeffrey Zekauskas",
"content": "Okay. And then sort of the reverse is the Acetyl Chain, where volumes are up year-on-year, 11%. And I take it that what you want to do is run your Clear Lake expansion more or less full out? Is that part of the reason why volumes are up? And do you expect as a base case for your volumes to be up 10% or more this year? And maybe could you comment on filter tow in that we saw really strong numbers out of Eastman, but your Acetyl Chain doesn't seem to be growing its adjusted EBIT very much."
},
{
"speaker": "Lori Ryerkerk",
"content": "Jeff, maybe -- let me just make a few comments, and then I'll let Scott add more detail. I mean, what I would say is we don't have a strategy to run at still necessarily at higher volume. The justification for the Clear Lake expansion was really in productivity, right, energy, catalyst, shipping by shipping more out of the U.S., less out of Asia. So that's not the strategy. Now having said that, we will run all of our assets where it makes sense from a demand standpoint and from an economic standpoint. So I wouldn't say that's the biggest factor there."
},
{
"speaker": "",
"content": "What I'd say on tow is we did see a significant uplift in tow this year. That uplift is continuing into this year. And if you look at our first quarter volumes, I think some people have called out more seasonality. We really saw first quarter within the typical seasonality for tow, which is minor, we're talking 1% or 2%. So I think we're seeing that -- I would suggest to you we're seeing -- enjoying the same markets for tow that our competitors are. But of course, it is now in our Acetyl Chain, and we have more decision points that we can make around it to really maximize the value of the chain."
},
{
"speaker": "Scott Richardson",
"content": "Yes. Let me just add. I think as Lori said, on tow, 2024, very similar to 2023, not a continued lift, very stable there. When you look at a year-over-year basis, Q1 to Q1, Jeff, the main driver volumetrically is really just where the industry is. If you recall where we were in the first quarter of last year, we were coming off very high energy prices in Europe in the fourth quarter of 2022. European demand was relatively soft. In addition, we were still seeing China dealing with COVID in the early part of the years, which impacted volumes. So that's really the main driver on a quarter-over-quarter basis here in the acetyl business."
},
{
"speaker": "Operator",
"content": "And our next question comes from Michael Sison with Wells Fargo."
},
{
"speaker": "Michael Sison",
"content": "Nice start to the year. For 2Q, will EM volumes [indiscernible] I guess it still looks like it's going to be down year-over-year. But the third and fourth quarter for EM, do you need volumes to improve year-over-year to sort of hit the outlook and -- how much, if at all?"
},
{
"speaker": "Scott Richardson",
"content": "I think as we work into Q2, my volumes will move up a little over where they were in Q1. On a year-over-year basis, relatively flattish. Any differences are more mix related, as I talked about earlier, with kind of where we were on moving nylon last year to really get our inventory levels down. And we will see an expectation that volumes move up, really driven by 2 things in the second half. One, just as destocking has ended and that kind of normal flow through, not a real significant restocking or anything, but just slightly higher levels of volume coming from that in the second half."
},
{
"speaker": "",
"content": "But more importantly, really a commercialization of our pipeline. And we went really to an integrated commercial model in Engineered Materials in April of last year. The average length of time projects in our pipeline takes is about 18 months. So we expect kind of the efforts the commercial team has been putting in now for the last year really to start to take hold and see the value coming towards the end of this year from that."
},
{
"speaker": "Michael Sison",
"content": "And then more of -- a little bit of a longer-term question. Sales in EM running about $6 billion, maybe a little bit better than that. But longer term, when demand does recover, China, goods, et cetera, does this a $7 billion business? And what would the operating leverage [ trying to get ] volume come back look like on that growth?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, I don't know the exact number where that could end up. I mean the way I would characterize it is we expect over the next year or so that EM basically starts contributing at the same level as acetyls from a margin standpoint. And then after that, while acetyls will continue to grow at kind of GDP, GDP plus a little bit, we would expect margin growth for EM to still be in that roughly 10% range that we've had in the past. So I would think about it that way. So ultimately, there's no like in number. The number continues to grow, but that's the growth rate we expect."
},
{
"speaker": "Operator",
"content": "Our next question comes from Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"content": "Starting to read a bit that some of the trade complexities in the Red Sea area are starting to resolve themselves. And so I guess, one, would you agree with that? And two, if the case and if the shipping channels become a little less challenged, how would that impact your businesses, good, bad or indifferent?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Vincent, thank you. Look, I would say we've been pretty indifferent so far. What we found is shipping channels and stuff where there can be a temporary disruption pretty quickly, renormalize in a new way. So I -- we haven't really seen an impact so far. And similarly, I wouldn't expect a big impact if we see some of the issues resolved. I think the market is pretty quick to correct itself."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. And then if I could just ask a follow-up on the nylon business. In the prepared remarks, there was a comment about higher variable costs for higher velocity products. That's quite a mouthful. Could you just unpack that for me?"
},
{
"speaker": "Scott Richardson",
"content": "Yes, Vincent, it's really related more to the Palm business, and it's really the flow-through of methanol since we weren't producing as much of our own methanol in the first quarter. It's the flow-through of that higher cost product into Palm that gets sold here in the second quarter. That's really the main impact."
},
{
"speaker": "Operator",
"content": "And our next question comes from Josh Spector with UBS."
},
{
"speaker": "James Cannon",
"content": "This is James Cannon, on for Josh. You in your prepared remarks talked about the price-to-cost benefit in the first half. Are you expecting much flow through into the second half? Or does lower pricing kind of erode that?"
},
{
"speaker": "Scott Richardson",
"content": "I wouldn't expect lower pricing to erode that, James. A lot will depend upon what happens with the raw material complex. We kind of know for the first half, what the flow-through of that is going to be. So a lot just depends upon how raws develop in the second half to see how much of that continues or not."
},
{
"speaker": "James Cannon",
"content": "Okay. So just as a follow-up to that. I think if I look back -- if I look back a quarter or two, you gave in your prepared remarks, comments on price/cost being potentially the highest part of the year-over-year bridge. Is that still possible? Or just given where we stand, is that maybe a little bit more in question?"
},
{
"speaker": "Scott Richardson",
"content": "It's definitely still possible based on what we're seeing for the first half. And then again, we'll just have to see how raws develop in the middle part of the year to see what then gets expensed towards the back half of the year."
},
{
"speaker": "Operator",
"content": "Our next question comes from Kevin McCarthy with Vertical Research Partners."
},
{
"speaker": "Kevin McCarthy",
"content": "In your prepared remarks, you talked about 2 key synergy drivers for Engineered Materials, namely the shutdown of nylon 66 in Germany and the SAP ramp. Can you address those and maybe translate it to how much earnings uplift you might be anticipating in the second quarter through the fourth quarter. It didn't sound like there was much in the first quarter from those items."
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, I would characterize it as for the footprint actions we've taken, and there's been a number of smaller actions that we've taken as well, not including Mechelen, which we've just announced because that will really show up in next year's number. We expect about a $50 million synergy lift on a full year basis from those. And you're right. I mean we're just now starting to see the benefit of Uentrop, which is the biggest piece of that. So there's that."
},
{
"speaker": "",
"content": "And then I would say on the SAP, the direct impact. I mean, obviously, we get rid of the TSA, but we've had to add our own people. So that's a smaller number than you might think, although significant. The real benefit is that we now have one view of the data, and we have everything in one system, and it is really helping us with our planning and scheduling and forecasting of demand in Engineered Materials. And so again, we're -- all of that kind of gets rolled into our synergy number, and that number for the full year is 150 lift from last year."
},
{
"speaker": "Kevin McCarthy",
"content": "And then secondly, for Chuck, perhaps, can you talk about how your free cash flow outlook has evolved? And specifically, I'm interested in any guidance you might be able to provide on cash taxes or the expectation therefore, in 2024. It sounded like maybe there's some timing issues around taxes we should be thinking about."
},
{
"speaker": "Chuck Kyrish",
"content": "Yes. Good question, Kevin. Yes, let me walk through how we're thinking about '24 cash flow. I would say we do expect the same cadence as we saw last year where our cash flow will be second half weighted. Teams are working hard to generate a total result for the year that's roughly consistent with last year. It will be subject to a few timing elements, of course. Outside of EBITDA growth, I would point to these drivers. We are working really hard to produce a working capital benefit to free cash flow this year. And that would be driven by further inventory reductions."
},
{
"speaker": "",
"content": "Right now, we've assumed $100 million working capital benefit for the year. And it will depend on a few factors. I would say working capital, though it will be back-end loaded. It should be a use in the first half, particularly as we're preparing for some of these footprint actions and then a source in the second half. Either way, I would point out, that's a significant headwind to free cash flow versus 2023 as we had a tremendous year in working capital benefit to free cash flow last year, that was really driven by about $400 million positive cash from reducing our inventory. So I just wanted to point that out."
},
{
"speaker": "",
"content": "You're right, cash tax, it is an unusual year for us for cash taxes. In total, this year, there'll be about $300 million. That's higher year-over-year by $75 million. One unusual item that we have that will hit us in the second quarter, we're going to pay almost all of a roughly $90 million transfer tax that's related to the previously announced debt redomiciliation projects that are currently in execution phase and are key to our cash repatriation plans. We'll pay this onetime tax in the second quarter, but we would expect to be able to recoup that tax in future years and through the associated foreign tax credits. It is a big payment here in the first half, so I did want to call that out. I mean if you think about cash tax of the $300 million, 3/4 of that will be in the first half."
},
{
"speaker": "",
"content": "I would say cash cost of synergies should be $100 million to $150 million this year. That's higher year-over-year by $25 million to $75 million, which will just kind of depend on what that final number ends up being and the timing of some of those actions. Positive offsets to free cash flow this year, year-over-year, lower cash interest by about $50 million and a benefit of $100 million to $150 million in lower CapEx versus last year. So I hope that helps in terms of some of the drivers and how we're thinking and especially the timing associated with those."
},
{
"speaker": "Operator",
"content": "And our next question comes from Aleksey Yefremov with KeyBanc Capital Markets."
},
{
"speaker": "Aleksey Yefremov",
"content": "Now that Clear Lake is up and running, is rationalization of your acetyls assets firmly off the table? Or is that an option to be considered because of this tough supply-demand environment?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Aleksey, thank you. I would say we're pretty satisfied with where we are with our footprint for acetyls. I mean, everything we have is specifically designed to serve a certain region and set of customers, and we like having the optionality and flexibility that we have. We've also continued to build out our downstream. You saw the announcement about new VAE in China, some of the RDP debottlenecks we're doing. And that really is all about how do we continue to build the foundational level of earnings in acetyls and really kind of stabilize our earnings from acetyls."
},
{
"speaker": "",
"content": "But if you look at just specifically at acetic acid, for example, Clear Lake, clearly, we believe the lowest cost, lowest carbon footprint, really important to meet our needs in the U.S. and now into Europe. China really serves China, again, because of our technology there, we believe, one of the lowest cost producers in China. And then Singapore meets the need for the rest of Asia, particularly India and some other areas, and is still very competitive with other sources of supply into that region. So again, I would say we're always looking at our footprint. What we need to add, if there's opportunities to debottleneck, but also opportunities to rationalize. But right now, I would say our footprint is pretty good for purpose."
},
{
"speaker": "Aleksey Yefremov",
"content": "And as a follow-up, you used to be fairly transparent to investors to see outgrowth in Engineered Materials versus end markets. It's been harder to judge through the last few quarters. Are there any metrics such as wins, I don't know, your size of your pipeline that you can point us to, to kind of demonstrate that you keep outperforming your end markets or that outperformance will resume perhaps in future periods?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Look, I would say the pipeline is our winning factor, if you will, for Engineered Materials and what has allowed us to outperform in our sector. I think that continues to be true, especially now that we're 1 year since we went into a common system for both our heritage assets as well as our acquisition of M&M. And we do continue to look at it very closely. I will tell you the number of projects being generated is consistent. More importantly, the value of the projects that are being generated is very strong."
},
{
"speaker": "",
"content": "But maybe I'll ask Scott if he has any more details on that he wants to add."
},
{
"speaker": "Scott Richardson",
"content": "Yes. I mean we gave a stat last quarter about the fact that we created about 20% more revenue opportunity per sales employee in the second half of last year compared to what we did in the second half of '22. And so that is, I think, a really good proof point to how things are moving. The only other thing I'd add is we've been doing a lot of really cleaning up of this new kind of integrated business over the course of the last 18 months. And that will start to stabilize as we get the footprint actions in place and really get our inventories now kind of back in line with where they need to be. So I think it will be a little more visible, Aleksey, as we get into the end of this year and into the next year as to being able to see that outperformance versus the various end markets."
},
{
"speaker": "Operator",
"content": "Our next question comes from Arun Viswanathan with RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"content": "I guess first off, just curious about your comments around volume. It sounded like the activity in Q1 was seemingly getting slightly better in the -- in the earlier part of the quarter and then maybe it sold out in March. And then are you seeing a similar pattern here of things may be getting better in April? I mean how would you kind of characterize Q2 thus far versus your comments and then what you saw in Q1?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, I would say from a volume standpoint, both for acetic acid and EM, it was very much as expected in Q1 throughout the quarter."
},
{
"speaker": "Scott Richardson",
"content": "And then as we look to Q2, the order book is in line with the guide we put together right now, Arun. I mean we're through the month of April, and we have good visibility here to May. So I think we feel comfortable with the comments we put in our prepared comments."
},
{
"speaker": "Arun Viswanathan",
"content": "Okay. And then just a question about the second half and as you look into '25. So it looks like you'll be ending the year on a, say, $6.60 rate for EPS for the second half. If you were to annualize that maybe you're $13.25 or so. If you add some volume and maybe some deleveraging on top of that, it seems like you could get close to $14. So is that kind of how you're thinking about '25? I know it's a ways off, but just maybe got some -- wanted to get your initial thoughts."
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, we've had so much variability in the last few years. I hesitate to go much further out than a quarter these days. But look, I think if you look at the run rate in the second half because it's built on controllable actions, not built on market that not an unreasonable place to start as you start thinking about '25."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Begleiter with Deutsche Bank."
},
{
"speaker": "David Begleiter",
"content": "Lori, there was a competitor outage in acetyl starting, I think, late, late February. I believe it's still on allocation of VAM and acid. Did you benefit? And are you still benefiting from that competitor situation?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I would say while there was some temporary run-up in pricing, it was pretty small and fairly short lived. So I would not say we're seeing any benefit from it continuing, and the benefit was pretty small during the quarter. And I think that just is reflective of really the lower demand that we've been seeing globally that an outage of that magnitude really didn't move the market very much. And again, I think it's not as much question on supply, but just demand is really still not back at normalized levels, particularly even in the Western Hemisphere."
},
{
"speaker": "David Begleiter",
"content": "Understood. And just on M&M synergies, what were they in Q1? What will they be in Q2? And what should be the cadence in the back half of the year?"
},
{
"speaker": "Lori Ryerkerk",
"content": "I don't have an exact number here in front of me. I mean I would tell you, Q1 is definitely the lightest and they continue to build and compound as we move through the year."
},
{
"speaker": "Operator",
"content": "Our next question comes from John McNulty with BMO Capital Markets."
},
{
"speaker": "John McNulty",
"content": "So I guess the first one is on raw materials. So I believe for EM, you were expecting as much as $150 million benefit as kind of lower costs rolled through the system. It looks like you got -- you're going to have 20 in the second quarter, and it's comparable to what you saw maybe in the first. So is that still or reasonable outlook just based on where raws are right now that you could see $100 million, $110 million of benefit in the back half of the year? Or have things gotten better or worse? I guess, can you help us to think about that?"
},
{
"speaker": "Scott Richardson",
"content": "Yes, John, as I said earlier, definitely in line to be in that range based upon what we're seeing for the first half. And again, a lot just depends upon what -- how things move in the middle part of the year to see how our cost structure will develop as we get into the second half."
},
{
"speaker": "John McNulty",
"content": "Okay. And then I guess the second question would just be in the Acetyl Chain business. Obviously, there's some new capacity in the markets beyond just yours that are impacting the business. It looks like there's more capacity coming on next year potentially as well. So I guess, if we don't see much of an improvement in the overall demand environment, are there other levers that you can pull in your Acetyl Chain business to drive incremental profitability? Or are we at a point now where it's really going to be about the market improving and developing from a demand perspective?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. So let me make a few comments on that, John. If we look at this year, there were two large, I'd say, world-scale capacities added in acetic acid in China. And again, the impact of those has been a bit more than we thought because some of the companion downstream consumers that were supposed to come on at the same time have been delayed due to the overall demand in the market. Next year, there's really only one small unit coming on that we're aware of in acetic acid, some other capacity a little bit in [ VAM ]. It's not enough that it should have a major impact."
},
{
"speaker": "",
"content": "But we're still not at the [ whim ] of the market. I mean we still find opportunities to use both our global and our chain flexibility to really maximize our earnings in this market and try to maintain that level of foundational earnings. I'd say the other good opportunity, which is developing for us is our ability now to provide sustainable products into the market based upon the CCU project that we've put in at Clear Lake. Now that we have our ISCC certification for methanol as low carbon material, we're able to offer that to all of our customers in kind of whatever acetic acid products they desire, and we are seeing a lot of interest in that."
},
{
"speaker": "",
"content": "We also have a sustainability advantage for VAE, which customers are interested in for kind of its low odor, low VOC emissions. So I think there are some opportunities we have that are unique to us that others do not currently have at this period in time. And we see that demand starting to grow and hope that will become a more significant part of our portfolio."
},
{
"speaker": "Operator",
"content": "Our next question comes from John Roberts with Mizuho."
},
{
"speaker": "John Ezekiel Roberts",
"content": "It sounded like the sequential change in EM earnings was nylon up sequentially and other plastic earnings down sequentially. Was the decline in the -- sequential decline in the other plastics due to the downturn or price pressure or what drove that?"
},
{
"speaker": "Scott Richardson",
"content": "I would focus on the turnaround costs, John. I mean that was really the largest driver is really offsetting the nylon."
},
{
"speaker": "John Ezekiel Roberts",
"content": "And then I wasn't thinking that medical was that seasonal? What's driving the seasonality in medical?"
},
{
"speaker": "Scott Richardson",
"content": "It's -- honestly, John, it's kind of what we always see. In some years, it's more acute than others, and we saw it come down a little more than what we saw last year from Q4 into Q1. And it's really just the timing of how our customers build inventory for the new year. And it -- Q4 ends up usually being one of our strongest quarters and Q1 tends to be weaker, which kind of goes counter to how everything else moves, but that's kind of been the historical seasonality really in most of our medical business."
},
{
"speaker": "Operator",
"content": "Our next question comes from Laurence Alexander with Jefferies."
},
{
"speaker": "Daniel Rizzo",
"content": "This is Dan Rizzo, on for Laurence. We talked a lot about the Clear Lake expansion. I was wondering if an expansion in Singapore or some place like that would be necessary given the growth that's potentially there in India over the next, I don't know, few years to a decade."
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. We don't see that on horizon. It probably wouldn't -- if there were more of an increase in demand, it probably wouldn't necessarily make sense to expand the Singapore plant. But for what we have right now and for that developing market in India, Singapore is [ sufficient ]. And we have options to bring material into Singapore from other parts of the world, should we see that demand increase."
},
{
"speaker": "Scott Richardson",
"content": "Dan, the only thing I'd add is on a downstream basis, the VAE expansion that we've just done is as much for growth in Southeast Asia and India as it is for China, honestly. We have a -- we already have VAE plant in Singapore. That plant was actually supplying some demand in China. We're now able to kind of shift that network really to service growing customers in our VAE demand, such as paints and coatings, mortars and adhesives."
},
{
"speaker": "Daniel Rizzo",
"content": "That's really helpful. And then with costs, we talked again a lot about price cost with raw materials. But I was just wondering what's happening with labor and potentially transportation costs if they're kind of elevated and going higher and that, that could have a kind of a negative impact towards the second half of the year?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Look, I think we've seen over the last several years, pressures on labor cost, as has everybody, but I would say through productivity steps and others, that's managed, that's baked in. And I'm not seeing any significant pressure there for the second half of the year."
},
{
"speaker": "Scott Richardson",
"content": "Yes. And on transportation, I mean, this is a common theme we've seen now for a while. And I think that has impacted product movements around the globe for the industry broadly. So really nothing is different now or in the second half than what we've been seeing here for a while."
},
{
"speaker": "Operator",
"content": "And our next question comes from Patrick Cunningham with Citi."
},
{
"speaker": "Eric Zhang",
"content": "This is Eric Zhang, on for Patrick. On the incremental excess supply in China acetic acid, do you have an outlook on when the delayed downstream startups will be resolved? And once that is resolved, do you expect it to have a meaningful uplift in acetic acid pricing in China?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Look, the projects that we were aware of, I think are a quarter or two delayed. I mean, the real question, of course, is that demand for those products has to be driven by more demand for exports quite frankly. And so how long that takes to resolve is really tied to consumer spending, general view of the economy, people's confidence in buying goods again. So I would say, while we do expect that capacity to be -- to start up, whether over in full or whether it will just replace other capacity remains to be seen."
},
{
"speaker": "",
"content": "The other thing that I said earlier, which I emphasize again, is there are some new uses in China of acetic acid that should start taking some of this capacity, like [ caprolactam ]. So I can't give you a number now, but I would say, I think we're still several quarters away from starting to see any significant movement in that."
},
{
"speaker": "Operator",
"content": "Our next question comes from Salvator Tiano with Bank of America."
},
{
"speaker": "Salvator Tiano",
"content": "Yes. So firstly, I want to ask a little bit on Engineered Materials and specifically your auto exposure. As we're seeing more and more automakers delay their EV plants and sticking with ICE engines, even just a few months ago, how does this change against your plan and your potential margin uplift? And also, are you seeing any impact for consumers trading down to lower-priced models as well?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Let me try to answer the first part, and then I'll let Scott take the second part. I would say, look, as long as consumers are buying vehicles, we're happy. EVs do have about a 10% higher content available to us than ICEs, but we still have a very large position in ICE vehicles. As to the extent people are converting to hybrids, hybrids are about 20% more content available to us than ICE. So while there are some shifts and shifts in which products, as long as people are buying vehicles, like I said, we're happy."
},
{
"speaker": "Scott Richardson",
"content": "Yes. And we have to continue to work our pipeline really to touch on all 3 areas, whether it's battery electric, hybrid or ICE, just because each market is developing a little differently. I mean, in China now, over 20% of the market is EV. And so we still have to continue to focus EV there pretty heavily. So it is important that we kind of build that broadly speaking. We have not seen a significant change in terms of the types of vehicles and what our customers are buying and really an impact to our business at all."
},
{
"speaker": "",
"content": "And in fact, I mean, if you look at things on a year-over-year basis, which is probably the right way to look at it, auto builds were up, I think, around 2% or so. Globally, our business, our volumes were up about 4% on a year-over-year basis into auto. So I think from that perspective, specifically, we feel like the project pipeline model continues to deliver value for us."
},
{
"speaker": "Salvator Tiano",
"content": "Great. And I also want to ask to go back a little bit on the China acetyls capacity expansion. I assume some of these downstream projects that were supposed to absorb the acid demand are on the polyester chain, but at least on our estimates, there are a bunch of VAM and EVA projects as well. So certainly, as they come online, they will absorb more of the acetic acid, but you do participate in these markets, and you did have a comment in the prepared remarks that you have much higher variable margins, I believe, in the downstream projects. So as this capacity comes online? On a net basis, would that actually be good for you? Or could it be a source of margin pressure because you may lose some margin of the -- on your downstream business?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Look, I would simplify it and just say, any additional demand for acetic acid, no matter which end market is in to, is good for us. So again, because we do sell a lot of acids to others as well."
},
{
"speaker": "Scott Richardson",
"content": "Yes. And I would just add, I think when new capacity starts up, whether it's acetic acid, VAM, et cetera, it's going to come in and it's going to have a near-term impact. But those things then even out over the subsequent quarters. And our business is really about flexing our global network and that full value chain. And so one quarter, we're going to make money one way. The next quarter, we're going to make money a different way. And that really is the uniqueness of this kind of integrated value creation model that we have within the Acetyl Chain."
},
{
"speaker": "Bill Cunningham",
"content": "Diego, we will make the next question our last one, please."
},
{
"speaker": "Operator",
"content": "And that final question comes from Hassan Ahmed with Alembic Global."
},
{
"speaker": "Hassan Ahmed",
"content": "I again, wanted to revisit the Acetyl Chain, particularly in China. I mean, reading through your prepared remarks, it just seemed like the first quarter was like a tale of 2 cities. It seemed you guys started very strong. And then by February pricing started weakening. Just trying to understand the dynamic behind that. I mean it seems the 2 new facilities that you guys talked about, they've been around for, call it, 5 or 6 months. So what really caused that change between the first half of Q1 and the second half?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Well, Hassan, you may recall, I mean, typically in China, Q1 is seasonally lower demand quarter because of Chinese New Year. So if you look at total -- if you look at acetic acid prices, specifically in China, I mean, what we did see in Q1 was the lowest price since fourth quarter of '20. And again, not unexpected, very much in line with what we've expected. And again, it is based on the lower demand. I would also tell you, even though that new capacity maybe came on 2 quarters ago, it takes a while for them to ramp up and to really get into the market. So I would say it's shaping up very much as expected. I would also say this is normal as Scott said, that there is some minor disruption in the market when these come online, but things do settle down over time."
},
{
"speaker": "Scott Richardson",
"content": "Yes. And let me just add, Hassan, I think it's important to remember, we have the single largest -- our single unit -- the largest single unit turnaround in the history of the corporation in the first quarter, largely hitting the Acetyl Chain business. We had some of these dynamics in China, yet the business still generated a 28% EBITDA margin. So it's a very resilient business that finds a way to still deliver value even when we see market disruptions or when we see higher costs from things like turnarounds."
},
{
"speaker": "Hassan Ahmed",
"content": "Very helpful. And as a follow-up, if I could just sort of hit on the 2024 guidance again, maybe in EBITDA terms. I mean over the last couple of months, you talked about some of the drivers, and I just want to make sure, numerically, I'm thinking about them or they're trending as you guys had stated a couple of months ago. I mean you talked about the M&M synergies being, call it, $150 million EBITDA-wise worth of a tailwind, Clear Lake expansion being around $100 million. And then obviously, you had some offsets in terms of headwinds from some of the outages that you had last year. So I mean, as you sort of sit there and think about some of those headwinds and tailwinds, incrementally year-on-year, how much of a boost will we get from some of these controllables and new capacity additions?"
},
{
"speaker": "Lori Ryerkerk",
"content": "Yes. Again, I think if you look at versus 2023, those things that you called out, M&M synergies that $150 million, Clear Lake expansion, we've asked them to still deliver $100 million for the year. And we probably have another -- an offset of about $100 million, maybe a bit more for higher turnaround-related expenses as well as some of the nonrepeatable impacts from last year. I think the 2 factors you are not factoring in there is we will have lower debt services year as we've paid down over $1.5 million of our net debt. And that's probably another 50 or so, and then we'll have lower costs flowing through from our inventories with all of the inventory we took out last year and be able to flush out some of that higher cost inventory and as we said, that may be the single biggest factor this coming year as well."
},
{
"speaker": "Operator",
"content": "And there are no further questions at this time. I'll hand the floor over to Bill Cunningham for closing comments."
},
{
"speaker": "Bill Cunningham",
"content": "Thank you. We'd like to thank everyone for listening in today. As always, we're available after the call for any follow-up questions. Diego, please go ahead and close out the call."
},
{
"speaker": "Operator",
"content": "Thank you. With that, we conclude today's conference. All parties may disconnect. Have a good day."
}
] |
ceg | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Thank you for standing by and welcome to Constellation Energy Corporation's Third Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session; instructions will follow at that time. As a reminder, this call may be recorded. I would now like to hand the call over to Emily Duncan, Senior Vice President, Investor Relations and Strategic Growth. Please, you may begin."
},
{
"speaker": "Emily Duncan",
"content": "Thank you, Latif [ph]. Good morning, everyone and thank you for joining Constellation Energy Corporation's third quarter earnings conference Call. Leading the call today are Joe Dominguez, Constellation's President and Chief Executive Officer; and Dan Eggers, Constellation's Chief Financial Officer. They are joined by other members of Constellation's senior management team who will be available to answer your questions following our prepared remarks. We issued our earnings release this morning, along with the presentation, all of which can be found in the Investor Relations section of Constellation's website. The earnings release and other matters which we discuss during today's call contain forward-looking statements and estimates regarding Constellation and its subsidiaries that are subject to various risks and uncertainties. Actual results could differ from our forward-looking statements based on factors and assumptions discussed in today's material and comments made during this call. Please refer to today's 8-K and Constellation's other SEC filings for discussions of risk factors and other circumstances and considerations that may cause results to differ from management's projections, forecasts and expectations. Today's presentation also includes references to adjusted operating earnings and other non-GAAP measures. Please refer to the information contained in the appendix of our presentation and our earnings release for reconciliations between the non-GAAP measures and the nearest equivalent GAAP measures. I'll now turn the call over to Joe Dominguez."
},
{
"speaker": "Joseph Dominguez",
"content": "Thanks, Emily. Good morning, everyone. Thank you for joining us today and a big thank you to our amazingly talented team at Constellation. Today, Dan and I once again have the privilege to share their results, results that outperform our plan, your expectations and require us to raise guidance. But before I do that, I want to touch upon Friday's FERC ruling that I know is top of mind for many folks. In Constellation's view, the 2:1 ruling rejecting Talen's ISA by a fraction of the commission is not the final word from FERC on colocation. The ruling, as many of you know, is very narrow and we believe that all of the commissioners, including the 2 who refuse themselves from Friday's decision, understand the critical importance of providing additional guidance. Now, how that's going to come could occur in a number of different ways. We could see the commission take action, we could see PJM take action or parties like ourselves could take action. It's premature at this point to say which of those pathways we are going to pursue. But we know this; colocation in competitive markets remains one of the best ways for the U.S. to quickly build the large data centers that are necessary to lead on AI. As Chairman, Phillips explained, our nation's entire economy and national security is at stake if we do not lead in AI. That sentiment is shared by both presidential candidates. As National Security Advisor Jake Sullivan warned just 2 weeks ago but even if we have the best AI models but our competitors are faster to deploy, we could see them seize the advantage in using AI capabilities against our people, our forces and our partners and allies [indiscernible]. We all know that power has emerged as the key to America's ability to meet the challenge and Constellation uniquely is positioned to help. There are multiple regulatory and commercial pathways to resolve the colocation issues and we will work quickly with customers and other stakeholders to put these in place. In PJM, we have abundant baseload power almost all times of the year. We can power AI. I think sometimes we get sloppy and say, we have energy issues with AI growth. We don't. We have a capacity issue that manifests itself just a few hours of the year. This problem is fairly simple to address with demand response, peakers and batteries, all provided that we have the right market price signals. But to be fair, we have been a bit challenged on the issue of getting the capacity market moving. Now we agree with PJM's decision to delay the latest auction and we encourage PJM to do that because we support changing the reference unit and addressing the RMR units. Those narrow reforms should provide clarity, fair pricing and price stability for customers and generators alike. PJM should also proceed with streamlining the process for adding generation like our Crane restart. We're happy to see PJM progressing on this front and we're working hard to bring Crane on in 2027. We trust that FERC will prioritize these RPM matters and urge FERC to act on them quickly. The load is going up and the market needs the price signal to react. We note that the recent utility filings with PJM already indicate another 5 to 6 gigawatts of load in the next auction that we expect PJM to implement in its planning parameters. The PJM capacity market has a long track record of being able to deliver new capacity and to drive customer demand response but we need to let it work. Colocation will add, not detract from reliability in PJM. Here, Constellation's principles have been quite simple. First, in times of emergency, our power should support the grid. To be absolutely clear about what I'm saying, that means that nuclear energy supporting a co-located load will be switched to the grid when needed to prevent the reliability crisis and it should be fairly compensated when so called. Second, if the co-located load has backup power, it should be allowed to offer that power to the grid, subject, of course, to state and environmental permitting rules. Third, co-located load should pay its fair share of grid costs for what it uses. These issues should be brought together and advanced at FERC. Frankly, I think part of the issue with the ISA proceeding is that it did not bring these issues together and understandably, some of the commissioners want to see the complete package. We will pursue this regulatory clarity, while simultaneously pursuing commercial strategies for colocation that are permitted under existing rules. Now, turning to our results and guidance updates. In the third quarter, our 14,000-person team here at Constellation delivered GAAP earnings of $3.82 per share and adjusted operating earnings of $2.74 per share. Due to this strong performance, we are raising and narrowing our adjusted operating earnings guidance for the full year to $8 to $8.40 per share. This brings our midpoint to $8.20 per share, a whopping $0.60 per share above our original guidance midpoint and we remain bullish on the balance of the year. Our core value proposition is strong and our strategy remains on track. We will provide -- we will grow our base EPS by at least 13% through 2030, growth that is backstopped by nuclear production tax credit. We have the best operated and largest fleet of carbon-free, reliable nuclear plants that run 24/7 and we will be needed by the energy system for decades to come. These assets will benefit from both increasing demand for carbon-free electricity and reliable power. Through our industry-leading C&I business, we provide the innovative products and services our customers want. Our strong investment-grade balance sheet, along with strong free cash flows that can continue to be used for growth, meet our threshold and provide valuable opportunities for you, our owners. And finally, as you've seen this year, we have the ability to do better than our base level of earnings through multiple paths, including optimizing our portfolio and getting better-than-average margins. It's been an incredible 3 years for Constellation, a remarkable journey that perhaps is best epitomized by the restart of the Crane Clean Energy Center that we announced in September. Crane validates 3 points that we have discussed many times before. First, it's a powerful symbol of the rebirth of nuclear energy. And it happens at a location that once came to represent nuclear energies demise. Second, it confirms our thesis that the most valuable energy commodity in the world today is clean and reliable electricity. And third, it underscores the growing demand for 24/7 clean energy, driven by the data economy, onshoring and electrification. All of these macro points benefit our owners. We have talked about them before and I don't think we need to talk about it much more because by now, these points have become self-evident. In addition to Crane, we have at least 1,000 megawatts of additional nuclear generation that we could bring on to the grid through uprates. And I'm pleased to report to you that we are seeing a wave of interest from customers who are interested in these opportunities and in our relicensing and we are making significant progress on contracting. The intensity of our negotiations with hyperscalers and others keeps going up and up. Our entire team is focused on executing transactions and supporting data center development anywhere in PJM. Now, I want to emphasize the word anywhere. Recall that when Microsoft announced the Crane offtake agreement, they explained that their agreement with Constellation enables them to use the energy in 4 different states, not just Pennsylvania. That should tell you that Constellation easily construct the transactions to sell energy, capacity and sustainability products to data economy customers anywhere in PJM and in some cases, outside of PJM. And we can make those fixed price deals for as long as our counterparties desire. That's pretty unique to us. The governors in the states where we operate clean energy centers certainly understand the national security imperative and the value of economic development in their states. They want us to use the clean energy in their states and we want that too but we will follow the customers to all utilities and regions that are working with us to advance economic development and meet the vital national security needs of the nation. So as we look forward to the inevitable regulatory certainty and flexibility on co-location that Chairman Phillips emphasized in his descent, Constellation is continuing to hit on all cylinders on colocation opportunities, grid sales and in delivering new megawatts to the grid at attractive prices. We are proud that no one, no one is doing more to sustain and increase clean and reliable energy for America than Constellation. And we continue to lead research on new nuclear energy designs, such as SMRs and for natural gas with sequestration. Our partnership with Rolls-Royce Nuclear is advancing a very promising SMR design and we are working with other SMR developers as well. Our pioneering investment in NET Power is poised to undergo advanced engineering tests at our facility in La Porte, Texas. And we're partnering with GE on engineering tests and a pre-FEED study for CCUS at Colorado Bend. As I've said to you many times before, natural gas is a big part of our bridging strategy and we continue to be a player in natural gas provided we have a real pathway to sustainability. Because while powering the data economy is vital to our nation, defeating the climate crisis is vital to the world. In conclusion, our people are leading on all fronts. The 13% compounded growth that we've committed to you through the end of the decade is secure and we're very confident that we will outperform this target as we layer in new opportunities, just as you have seen us continuously outperform quarter-to-quarter and year-to-year. Turning to Slide 6. Nuclear performance was once again strong. We produced more than 41 million-megawatt hours of a reliable, available and carbon-free generation from our nuclear plants with a capacity factor of 95%. Our refueling outage performance was exceptional during the quarter. We completed 2 refueling outages during the quarter with each lasting less than 18 days on average. Great job to Bryan Hanson, David Rhoades and their team. For the year, our average is under 20 days; tracking 2 days are almost 10% below our historical averages and well below the industry average of 40 days. Our renewables and natural gas fleet similarly performed very well with 96% renewable energy capture and 98.2% power dispatch matching. Turning to Slide 7. We talk a lot about the advantage of creating value between our best-in-class generation fleet and our exceptional commercial business. Our results this year are further proof of the strategic advantages of the combination of these businesses. This is an area where the numbers, not the words, do most of the talking and you could see from the numbers just how spectacularly the commercial team has performed. We performed so well because our customer business is meeting demand in many ways, including through our CORe+ and CFE products, where we enable new renewable generation to be built and carbon-free electricity to be shared with our customers. Since 2020, our CORe+ business has grown by leaps and bounds as customers look for products to help them meet their energy and sustainability goals. As I mentioned before, through this product, 2,800 megawatts of wind and solar have been added to the system, helping to meet not only our customers' needs but the systems needs. We think CORe+ is a great way for customers to move forward on their sustainability efforts and it's a complementary pathway to our elite CFE product that provides 24/7 time and geographically matched clean energy. I'm now going to turn the call over to Dan for the financial update. Dan?"
},
{
"speaker": "Daniel Eggers",
"content": "Thank you, Joe and good morning, everyone. Beginning on Slide 8, we earned $3.82 per share in GAAP earnings and $2.74 per share in adjusted operating earnings which was $0.61 higher than last year. Starting with the generation, when we look at the quarter and the year, we've seen actual power prices materialize well below the outlook at the start of the year largely given weather-driven declines in natural gas prices as well as generally good renewables performance. Fortunately, with the Nuclear PTC now in place, the means-based tax credit worked like it was supposed to providing the revenue support as anticipated and helping us to meet our expectations. We also benefited from the earnings contribution from our interest in the South Texas project which we acquired late last year. Turning to the commercial business. As Joe mentioned, we continue to perform exceptionally well. The team has done an excellent job managing the variability in loads and market prices, reinforcing how it thrives in volatile markets. We're also continuing to see margins above the long-term averages we use in our forecast and above the enhanced margins we disclosed in February. Finally, as we discussed last quarter, our financial results and our stock have continued to perform very well year-to-date which results in higher employee compensation expense year-over-year. Altogether, we had a strong third quarter that is contributing to our improved outlook for the year. Before I turn to guidance, given the timing of our announced Crane restart and where negotiations were during the quarter following our second quarter earnings call, we were unable to be in the market and unfortunately did not repurchase any shares during the quarter. We still have approximately $1 billion of share buybacks currently authorized by the Board. As well as $1.8 billion of unallocated capital for the 2024-2025 period which I should remind is not updated for the increase in 2024 earnings guidance or outlook for 2025. Moving to Slide 9; we are raising the midpoint and narrowing full year adjusted operating earnings guidance. The updated midpoint goes from $8 per share to $8.20 with a range of $8.00 to $8.40. The new range is effectively above the top end of our guidance of our original guidance range of $7.23 million to $8.03 per share. The commercial business continues to outperform plan, allowing us to increase our earnings outlook for the year once again. As you can see in the appendix on Slide 21. We increased our enhanced gross margin by $275 million as a result of the commercial team's continued strong performance, created an additional value compared to plan through the optimization of our portfolio. As previously discussed, we are seeing higher O&M due to the strong earnings results and stock comp. On the fourth quarter call, we will roll forward our earnings guidance and other disclosures to include 2026. As you think through your modeling and as reflected in the disclosures in this deck, I want to remind you that we'll have more refueling outages in 2026 than in 2025 and these outages will be longer than our average outages because we'll be installing the first of our planned uprates at Byron and Braidwood. As a result, we will produce less electricity and have higher O&M. In addition, we expect the PTC 4 to be flat in 2025. We still forecast at least 13% compound base EPS growth through 2030 and we'll look for ways to further enhance our opportunity from here. Thank you. And I'll turn the call back to Joe."
},
{
"speaker": "Joseph Dominguez",
"content": "Thanks, Dan. Good job as always. Folks Constellation is like no other company. We have a unique set of existing assets that creates opportunities that no one else has. As Dan and I both hit, we expect to see 13% compounded growth through the end of the decade, uniquely; it's backstopped by the federal government. We're the best operator of nuclear plants in the world and our plant's performance is only getting better. We have 20% of market share in competitive -- with competitive C&I customers. And that's allowed us to have the products and services that now we are uniquely using with the data economy customers. Our strategy from the beginning is to provide America solutions to its energy problems and we're doing that. We're not done as a company, not far from done. Power demand is growing and at the same time reliabilities becoming a premium product. We don't need to look further than the recent capacity auctions and the load growth projections to see that. We see increased demand from the data economy but also from electrification and from onshoring. And it's going to mean that our resources are more important than ever. We have opportunities in the data economy for front of the meter deals. We've shown that through clean. We've shown that through our CFE product and we continue to see opportunities behind the meter in co-location. We've got 2,000 megawatts of new nuclear that we bring to the grid beginning in 2027. So think about that. That's 2,000 megawatts, roughly the equivalent of Vogtle and we think we could get that done all within the next handful of years. We're going to benefit from government procurements from clean energy and we're going to be able to capture energy and capacity prices above the PTC floor. Finally, I'd just like to say something about tomorrow's election and how it could impact us at Constellation. We're proud that nuclear energy has strong and bipartisan support from federal and state policymakers and from the American people. And in fact, the majority of Americans support nuclear. Congress has passed several pieces of pro-nuclear legislation in recent years, including the ADVANCE Act which passed Congress with strong bipartisan support. You'll recall and we've told you this before that the origins of the production tax credit came from Republicans in the House and the Senate. And both, Vice President, Harris and former President, Trump; have been strong supporters of existing and new nuclear during their time in the office. Politically and unfortunately, there are deep divisions in the country. But all Americans want clean and reliable energy and we're proud to provide what they want. We're proud to provide what our customers and our communities want, no matter who wins tomorrow, who are going to continue to do that. With that, Latif [ph], we'll end our prepared remarks and open it up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Jeremy Tonet of JPMorgan Securities."
},
{
"speaker": "Jeremy Tonet",
"content": "Just wanted to come back to post FERC here and thoughts. Just wondering if Constellation were to pursue more front-of-the-meter deals, how do you think that, I guess, impacts value creation and speed to market relative to, I guess, behind the meter solutions here. It seems like there's still an opportunity to get to the same place but just wondering any other thoughts that you can share."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, Jeremy, our foot is on the accelerator pressed all the way down on deals, whether they're front or behind the meter. And so we're pursuing both. I think -- we've, as I said, demonstrated through Crane, our ability to use our power stations to support data center development anywhere. And so I think that's going to create some real opportunities for partnering with utilities that want to ensure that customers in their region or their utility get first access to clean and reliable power so that they could meet their growth objectives and we look forward to partnering with them and customers who want to be in those areas. Speed to market is very clearly the most important thing for customers. And so that's going to depend on the transmission configuration in different places and certain places are going to be frankly, more attractive to others for the data economy customers and we're going to follow them where they need to go."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. That makes sense. And then I guess also looking at the state level, you see certain states out there really looking to promote the data economy development in their states. And I think there's some actions coming out of the governors to really promote, I guess, quicker speed to market interconnect queue timelines and just wondering any other thoughts that you could share there as far as what could be done on the state level?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, that's the irony of it. I have no -- look, I've talked to every governor in states from which we operate clean energy centers. And I could assure you that they all want to get this economy going, they understand that it's important for national security but it's also critically important for economic development in their states. And moreover, they understand this kind of fundamental point that they are part of an interstate grid. So that if they don't build the power from power plants that might be in their state is going to flow to different places, where those data centers are going to be built and those states are going to get the economic benefits, the jobs, the taxes, all the other things that come with it. So I see it as a circumstance where they're all leaning into this. And I think we will see more of that lean more aggressively into trying to advance rules at FERC and trying to do things that attract data center development to their jurisdictions. And that's Republicans and Democrats alike. So we're following that closely. We -- as I said, we'll continue to meet with utilities that we have common interest with and want to really advance data economy development work in those states and we could go anywhere. We've -- we have been selling hundreds of terawatt hours every year to customers across PJM and other RTOs. We know how to do that. We know how to manage the risk. We know what our costs are going to be 10, 20 years from now. We know how to get capacity to all places. And as more transmission is built, we'll be able to move even more capacity in a different place. So we'll follow the customers where they go, that's the entire focus of Jim's team and the work that Kathleen and others are doing right now. And that's what I have said before that the discussion with hyperscalers is only ramping up. It's about this sort of thing. How do they buy the energy capacity that they could deploy wherever they want."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Shar Pourreza of Guggenheim Partners."
},
{
"speaker": "Shar Pourreza",
"content": "I appreciate sort of the color you're giving around sort of the markets and stuff. But maybe just if you could speak a little more to the transmission capacity within the ComEd and PECO zones around your plants as you see it. I mean, one of your peers has pitched capacity in its primary zone is kind of advantageous in the shift towards more front of the meter deals. And obviously, some of the stock reactions we're seeing this morning is prompting that. So I just want to get a little bit more color there?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. Look, sure, I think both from a temporal standpoint, a long-term standpoint, we happen to operate in markets that have fairly robust transmission capabilities, right? When you think about the ComEd zone, as an example, it has probably the most robust export capabilities of any zone within PJM. I think numerically, that's accurate. And we're seeing new transmission are being built all over the place, that's really expanding that. So the ability to move energy and capacity in different places is growing really as the plans come into fruition and transmission is built. But there's a lot of lanes right now for us to move our power. So that's what we're exploring."
},
{
"speaker": "Shar Pourreza",
"content": "Got it. Okay, perfect. And then just the pathways to getting FRCC, some clarity on BTM tariffs. I guess what is the -- what do you see as kind of a realistic time line? I had a conference on Friday, could be a new chair next year with the election tomorrow. I guess what is the fastest this could get resolved at this point. Do you wait for [indiscernible]? Can you or PJM do something to expedite? I mean there's a lot of options that are being thrown around but nothing seems to be a quick fix besides shifting to sort of in front of the meter."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. Look, I probably would agree with you that there's not a quick fix. But by that, I mean, it's not going to happen tomorrow but there are a lot of parties interested in moving this forward. People are reacting to the tech conference. I think a bigger development wasn't the ISA which was a narrow thing. But how do we deal with the comments that came out of the tech conference and craft something globally that addresses those comments. I touched a little bit on that in terms of the principles that we think would be the framework for a bigger deal. How that happens, I don't think we're literally, what, 72 hours away from the tech conference and still putting that together. We're meeting with counterparties and we'll figure out how to move forward. I don't know if FERC at this point is going to take the lead, PJM will, or other parties will. I think it's just too early in the game for us to say that. But look, I think there's a strong appetite. I don't care who's in the White House. AI is going to be a growing importance. I fundamentally believe this sure -- this is the issue of our time. It transcends the energy business. This is the issue that will define America's success in this century, whether we lead or fall behind is going to be of critical importance. That may not be universally known to others, clearly, Chairman, Phillips, understood that with great clarity the other day in his comments. But not everybody does right now -- in November of 2024 -- handful [indiscernible] to next year. I think that whole picture will change and the energy around this issue is going to intensify and FERC and others will have to clear up these rules quickly."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Steve Fleishman of Wolfe Research."
},
{
"speaker": "Steve Fleishman",
"content": "I guess, I'd like to -- Joe, you talked about some kind of colocation broad thematics that including the first one being that nuclear would be switched to the grid for emergencies and be fairly compensated. Could you just talk more to that because that -- it seems like a little different than at least the things that we've seen so far structurally. So I'd like to give more color on how that would work. And then tied in with that, the DR aspect with the data center since that's been kind of a challenge since they run all the time. If you could talk to those 2 issues, be helpful."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, sure, Steve. Let me do it kind of backwards. I think we've seen historically; we have lots of megawatts show up of demand response when the price signals within PJM are consistent and sufficiently robust for commercial industrial customers like ours to pull back energy consumption during peak out. And the challenge, frankly, for that DR market isn't that the thesis doesn't work, it's that prices dropped so precipitously in capacity markets that it no longer made sense for businesses to participate to be willing to disrupt their business. But at the price levels we saw in the last auction to the extent that prices in that vicinity are sustained, I see a re-emergence of DR as an immediate resource that's going to address some of these hours of peak demand. That's what I was talking about. And I think we're in a good spot because we have those customers, those clients that could respond. And so I happen to know from our commercial team that we believe that those folks will respond if the price signal is right. So that's kind of the answer to that. But we've got to get this capacity market up and running. We can't be doing hand wringing about capacity and then at the same time, keep tweaking and delaying auctions that setting the price signals to the market so that market responds. We know historically the market always responds. So that's point one. Point two, what I'm talking about in terms of the nuclear units returning is -- and I think we're seeing some of this in ERCOT at some level, right, of advanced warning when the grid reaches some level and it's kind of multi-step hierarchy of a grid crisis, the nuclear unit will shut down the co-located load and cut back to the grid. And so we can get some legs under that exactly when it will happen. But that's something we're absolutely willing to do and our customers understand we will do. So this kind of notion that we're taking the energy off the grid and it never comes back or some kind of unrealistic fantasy that the grid is down, data center is up surrounding the nuclear plant is just -- it's a poor narrative. It's not -- doesn't accurately reflect what will happen. We will always go back to the grid as promising. In terms of being compensated, we have offered solutions that allow us to continue to participate in the capacity market and return to the grid in all configurations when needed. Now unfortunately, in the past, as an isolated issue that didn't make its way through the PJM committee process. But my point in my opening comments is we've got to bring all of this back together in response to what we heard at the tech conference and provide a credible and viable pathway for the nukes to come back when needed but also to serve the co-located load that is vital for this AI development."
},
{
"speaker": "Steve Fleishman",
"content": "One other, I guess, follow-up question. Just in the event that you wanted to shift to co-located structures that are more, I guess, front of the meter. Could you give us a sense of just the timeline that delay that, that would cause in your kind of key regions relative to being able to do it behind the meter."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. Look, I don't know, Steve. It will probably require some more study process but I think we've got -- it's going to depend on what the transmission is around the site, how long that study process will be. I think it is a bit of a longer solution but I think it could be staged cooperatively in a manner that really doesn't cost that much time. We have some ideas about how we will do that in accordance with the existing tariffs that allow us to get to the end state fairly quickly. We're probably going to be a little careful here on an earnings call spelling out exactly how that will work."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Paul Zimbardo of Jefferies."
},
{
"speaker": "Unidentified Analyst",
"content": "It's Julian [ph]. I appreciate it. Just wanted to follow-up a little bit on the sort of the cadence of the last 2 questions and asking, how do you think about [indiscernible] confidence is probably pretty key here right now. How do you think about being able to come to market with whatever it is, whether it's a behind meter type arrangement or some sort of portfolio in front of the meter type deal. How do you think about Friday representing any kind of setback in timeline on your front? Or do you think that you're still front foot here in terms of being able to bring something to market sooner than later?"
},
{
"speaker": "Joseph Dominguez",
"content": "Look, I think Friday is just what I said. I think it's a narrow ruling by 3 commissioners. I'm not even sure that's the ruling we would have seen if the 2 commissioners didn't recuse themselves. So -- it's going to be dependent on how fast. We always anticipated after the tech conference, there would be a process to deal with issues that came up. So that has been in our thinking from a strategic standpoint and in the thinking of our customers. And I just don't over-rotate on what happened on Friday and the ISA because I don't think that really brought the issues together in the most favorable way. So my point is, from our internal planning, it's kind of the same thing. In terms of front-end of the meter deals, we're doing that already. We've done it with dozens and dozens of customers already in PJM and you'll see those numbers in our disclosures. So -- and as well as the operates and other opportunities. Those things are moving along at pace and if anything, have intensive after the Microsoft deal with Crane, the appetite and desire to talk to us about the uprates has gone up pretty considerably. So we're moving at pace on all of those things. And I think they're all going to be additive to the 13%. We just got to get the deals done and incorporate them into our numbers and you'll see it."
},
{
"speaker": "Unidentified Analyst",
"content": "Yes. I appreciate all this takes some time, right. I mean obviously, TMI it took a lot of planning. How do you think about the upgrade structures here? I mean, obviously, there's incremental megawatts potential here. But as you think about contracting here, would you think of that as being kind of an opportunity to recontract entire plants? Or would you think about this being more discrete to the additionality provided by the specific megawatt upgrades? What you think about the structure of that timing?"
},
{
"speaker": "Joseph Dominguez",
"content": "All of the above. But guys, I think we're seeing such interest in the operates that we want to package it with other opportunities, okay? I think I have fewer operates than I have customers to sell them to. So there's a scarcity of that product. And so that tells us we should pair it with other things that we care about. Relicensing are another thing, that hyperscalers want to be a part of and support, right? So that makes a good pairing. So, I think about the uprates as a scarce opportunity that we have at Constellation and an opportunity we want to share with customers that are interested in a broader, more strategic relationship and perhaps just the uprates."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of David Arcaro of Morgan Stanley."
},
{
"speaker": "David Arcaro",
"content": "Wondering what's the perspective that you're hearing from the hyperscalers? What's the urgency level? Are they worried about regulatory issues in PJM? Are they sticking with PJM and still looking for behind-the-meter approach? Any changes in their thinking?"
},
{
"speaker": "Joseph Dominguez",
"content": "David, where are they going to go? Right. It's not like it's a lot better anywhere else than PJM. I think the reality everyone is facing is simply this. This power issue has become unlocking the whole deal. They're investing billions and as you can see from their disclosures, they're not slowing the pace of their investment. But what they're seeing is that there's no Nirvana out there. There's no place where you could easily hook up the amount of energy that they're looking to hook up. So no, I don't -- I don't see them as saying, \"Oh, no, PJM is not the place to go.\" I think competitive markets and PJM very much remain on their list of priority sites. But the truth of all of this and I think Phillips added exactly right, is this is going to require a degree of regulatory flexibility and creativeness that's going to stretch everybody. And that's not true, by the way, in vertically integrated markets than it is here. And you see that time and again. What won't -- I'll tell you what won't be the solution and I know this with absolute certainty. They're not going to wait around for 10 years until somebody builds a power plant transmission lines to power the data economy. If that's the U.S. plan, then we've got bigger problems than picking the right RTO."
},
{
"speaker": "David Arcaro",
"content": "Yes, got you. I appreciate that. That makes a lot of sense. And then maybe thinking about the PJM market broadly to appreciate your comments before and we're still waiting for this kind of supply response but there's some stakeholders that may not be as patient here. You mentioned demand response but what are you thinking there about potential major market changes or like subsidized new generation or reregulation just some of these broader approaches that have started to pick up in PGM discussions."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, I'd give you the same answer I gave you last quarter. I don't think that's realistic. I don't think it's lost on governors or stakeholders that we've had one auction and we've now delayed the second auction. We don't have final rules. We have a reference unit that was creating really this enormous variability in pricing against very few megawatts. That was the wrong decision. PJM is going to revisit that decision. They're going to do what they're going to do with the RMR units. And what I think the combination of those things is going to create is a more realistic pattern of pricing that's going to incentivize demand response and incentivize competitive supply options. So look, I know people talk about these things. They've been talking about these things for 20 years and they haven't made any significant progress on these fronts. But it's not the first time we've seen high prices result in utilities saying, \"Oh, we want to build.\" We welcome them into the water anytime they want to create emerging part of their business and invest in power plant generation. But we got to kind of let this market work and I think folks will let the market work."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Nick Campanella of Barclays."
},
{
"speaker": "Nick Campanella",
"content": "So a lot of questions have been answered. But I think a couple of quarters ago or I think it was even in the second quarter, you talked about grid charges. This is more in the face of the protest that was filed and you argue these were in kind of like the low single digits on a dollar per megawatt hour basis. But just -- if we are shifting towards front of the meter, I'm also kind of acknowledging that every T&D operator has increased their visibility to the gigawatts that they're seeing on the grid, their queues are becoming more valuable and just -- do you see that impacting the overall front-of-the-meter charge? And how do we kind of think about how that impacts the economics and the return hurdles you're targeting? If you could just update us on what you think those front of the meter charges actually are now."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. Nick, I haven't changed my view on what they should be. I think if they're charged for when they use the grid, I think the ranges I gave you before are the -- still the same ranges. So that's -- there's nothing really that has changed that. Look, I think what's kind of misunderstood here is the -- as long as the interconnection is done efficiently, the more people you have using the transmission system, the more that cost will be broadly shared and that will be a mitigate. And that means that you have to -- that means you have to get the connection right to begin with. You can't spend a boatload of dough, locating some of these projects in places that are completely unreasonable and then trying to socialize all of those costs. That may be good for the utility but it's not good for customers. But if you locate these things very near the data centers, who are very near to the power sources on a co-located basis, you shouldn't see huge interconnection costs. And as a result, you're not going to see much higher prices than what I shared with you previously. But I think I laid this out in what you're referencing that this is not a dollar's issue. This is a speed issue. And if you listen very carefully to the tech conference the other day, that's what the data economy customers are saying. We're not saying they're not willing to pay their fair share. What they don't want to get stuck in is being mired in years of study processes. And I think some utilities are going to be able to distinguish themselves and get these things done faster than others."
},
{
"speaker": "Nick Campanella",
"content": "I appreciate those thoughts. And then just one follow-up on the capital allocation. Do you see yourself leaning on the buyback more this year now that we've moved past this Crane announcement? And then just set the table on what you're expecting to bring in the fourth quarter. Are you going to wrap in the earnings guidance to that $1.8 billion figure? And should we have kind of a wider update in the fourth quarter?"
},
{
"speaker": "Daniel Eggers",
"content": "Yes, Nick. So just to give kind of our cadence now, right, as we provide a pretty comprehensive update on our financials on the fourth quarter earnings call. We'll roll forward, right, give formal '25 guidance, we'll give you the same significant inputs for '26 as we have for '25 today to give you some visibility into that multiyear view. We'll refresh the kind of the extended version of those numbers in the appendix, right? So we kind of go out to '28 now. So we'll probably add another year there. So you'll see even further horizon and keep supporting getting back to the growth rate we talk about out to 2030. On the 2-year cash available slide, yes, we'll update that for where we are closing out the year on cash and then our outlook for '25 and '26 will all go into that math. So you'll see a full new update on all those numbers and reflective of all of our CapEx plans and any growth opportunities that we haven't talked about with you guys at this point in time. On the buyback, we like you as long as we are not burdened by any material non-public information, we'll look to be in the market. We were bumped we weren't able to do it last quarter when the stock was lower and certainly, we see opportunities. So as we were allowed to, we'll be there."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Durgesh Chopra of Evercore ISI."
},
{
"speaker": "Durgesh Chopra",
"content": "I just had one question. Joe, I appreciate all the color. On the FERC decision, you shared -- you mentioned the decision being narrow. When we read through the order, there's clearly a willingness from one of the commissioners to get it right. They talk about not setting a precedent. Just do you expect FERC to start a process or some sort of a docket following the technical session on Friday or does something has to be initiated by you or your peer IPPs?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. Look, I think that's one of the things we still don't know, right? Because there's not clarity on where FERC goes but we could drive the agenda here if we're unsatisfied with progress and we know that. And so -- but we're not going to do that by ourselves. We'll do that with others better of a similar mind and we'll get that proceeding going. But want to see where PJM is going to be. We want to see where FERC is going to be -- it was -- it's one where without hearing really from these other 2 commissioners who recuse themselves on it. It's kind of hard to gauge based on the opinion because we obviously didn't see their words. So we got a little bit of work to do to understand it and we're going to be doing that this week and formulating the plan over the next couple of weeks."
},
{
"speaker": "Operator",
"content": "Thank you. I would now like to turn the conference back to Joe Dominguez for closing remarks. Sir?"
},
{
"speaker": "Joseph Dominguez",
"content": "Well, listen, I appreciate all of the good questions today and the discussion. We're charging forward on all fronts, as I said. We think we have a pretty unique value proposition here with a 13% compounded growth and many, many opportunities not yet realized; and we're quite excited for the future. So, thanks again for your interest. And with that, Latif [ph], conclude the call."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for participating. You may now disconnect. Have a great day."
}
] |
ceg | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to the Constellation Energy Corporation Second Quarter Earnings Call. 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. As a reminder, this call may be recorded. I would now like to introduce your host for today's call, Emily Duncan, Senior Vice President, Investor Relations and Strategic Growth. You may begin."
},
{
"speaker": "Emily Duncan",
"content": "Thank you, Michelle. Good morning, everyone, and thank you for joining Constellation Energy Corporation's second quarter earnings conference call. Leading the call today are Joe Dominguez, Constellation's President and Chief Executive Officer; and Dan Eggers, Constellation's Chief Financial Officer. They are joined by other members of Constellation's senior management team who will be available to answer your questions following our prepared remarks. We issued our earnings release this morning along with the presentation, all of which can be found in the Investor Relations section of Constellation's website. The earnings release and other matters, which we will discuss during today's call contain forward-looking statements and estimates regarding Constellation and its subsidiaries that are subject to various risks and uncertainties. Actual results could differ from our forward-looking statements based on factors and assumptions discussed in today's material and comments made during this call. Please refer to today's 8-K and Constellation's other SEC filings for discussions of risk factors and other circumstances and considerations that may cause results to differ from management's projections, forecasts and expectations. Today's presentation also includes references to adjusted operating earnings and other non-GAAP measures. Please refer to the information contained in the appendix of our presentation and our earnings release for reconciliations between the non-GAAP measures and the nearest equivalent GAAP measures. I'll now turn the call over to our CEO, Joe Dominguez."
},
{
"speaker": "Joseph Dominguez",
"content": "Thanks, Emily. Good morning, everyone. Thanks for joining us this morning and thanks for your interest in Constellation. During this incredibly hot summer, we've had, our best-in-class nuclear fleet has once again met the challenge and is delivering clean, reliable 24/7 power. Combined with our renewable and natural gas fleet, we're providing the power to keep families cool and businesses running, supporting our country's economic growth. Our commercial business continues to do an awesome job, providing needed products to our customers and managing our one-of-a-kind portfolio. I want to thank the women and men at Constellation for their tireless efforts and for helping our customers meet their energy and sustainability goals. At Constellation, we put our people first because they're the ones that are responsible for our success and because we think a good culture creates good results. In fact, I think it's the single most important driver of any company's success. Look, we're far from perfect but we work hard to make this place, some place where people want to come and spend a career doing important things for America and thriving. That is why we're so proud to report to you that Constellation was certified as a great place to work once again. We've been out as a separate company for about two full years, a little bit over that. And for two years, we've received this honor. And it's particularly impactful to us because you only get this certification through surveys and high marks by your people, independent surveys. So it's great to see that our folks are seeing the work we're doing. They believe in our mission, they're passionate and they're 100% committed. And it shows up again here in results for you, our owners. In this quarter, we're able to provide excellent results, but also raise guidance in just the second quarter. We delivered second quarter GAAP earnings of $2.58 per share and adjusted operating earnings of $1.68 per share. We are raising our adjusted operating earnings guidance from the initial range of $7.23 to $8.03 per share to a revised range of $7.60 to $8.40 per share. In effect, we're resetting the midpoint of our guidance to what used to be the top end of our guidance range. The fact that we do that here in Q2 as opposed to waiting until Q3 when these updates typically are provided should tell you how strongly we feel the business is performing. It's even more remarkable when one considers the compensation headwinds associated with stock comp, where the stock has obviously performed very well over the first half. Dan will cover all of the financial details in his slides. In terms of buybacks, we bought $500 million worth of our share during the quarter, bringing the total cash deployed on buybacks so far this year to over $1 billion -- or excuse me, to $1 billion. Although we've seen some slippage of late, we remain bullish on buybacks because our thesis is incredibly unique and compelling. We will grow base earnings by at least 10% through the decade, backstopped by the federal PTC, and that growth does not reflect the opportunities we have in front of us from adding new clean, reliable megawatts to the grid to meet reliability needs or from selling to data center customers. And as we have been throughout the year, we remain quite confident in our ability to do better each year than our base earnings, delivering even more value to our owners. And finally, we released our third sustainability report, highlighting our efforts to help customers achieve their goals. I encourage you to read it. It outlines the good work we're doing on so many fronts as we lead the nation in the production of clean and reliable energy and provide unique and powerful sustainability products. Now before I turn to the operational updates, I do want to spend a few minutes on two topics that are garnering a lot of attention. The PJM capacity market auction results and the data center opportunities and the FERC proceeding concerning those opportunities. First, let me talk about the PJM capacity option. We think and PJM said this in its press release, we think the same thing. It's telling us what we already know. The demand for electricity is growing and supply and demand fundamentals are tightening. We foreshadowed all of this in our lengthy 2023 Q4 call, when we walked through the market fundamentals in considerable detail. Fortunately, the reforms FERC recently approved for the PJM capacity market are designed to incentivize the supply that we need, namely incentivizing supply that can be counted on to operate when our customers need power. PJM proposed and FERC approved a design that provides greater compensation of the power plants like ours that historically deliver when the system needs power. We previously have shown you data on how nuclear energy performs extraordinarily well through grid emergencies, while other resources, frankly, do not, whether they are intermittent or dispatchable fossil assets. That means that nuclear is best positioned in this new market design and appropriately receives a fair level of compensation. In light of the forecasted load growth in PJM, we expect to see higher sustained pricing for capacity to address reliability needs and send more accurate price signals to retain, operate and relicense our plants as well as incentivizing the development of new resources and customer demand response. Over the years, the PJM market has a proven track record of attracting investment through price signals and has developed over 60 gigawatts of generation to meet all of the needs of the grid. And we're confident that the market will respond to higher prices and add more resources as needed. With that said, we know that higher prices impact families and businesses. And so our commercial team is working with these customers to provide solutions that manage the risk and smooth out bumps. But I think it's important to remember that adjusted inflammation, PJM energy and capacity prices are less today than they were 15 years ago. Markets work folks. What has changed for the customer is that the distribution and transmission elements of the bill have gone up. They've gone up to address reliability needs on those grid systems. But thankfully, that has been largely accomplished. And now we need to focus on investments on the reliability of the supply side. And that's what the capacity market is designed to do. Over the last two investor calls, we've emphasized that reliability is as critical as sustainability. They have to go hand-in-hand. Constellation's business is based on the thesis that the most valuable energy commodity in the world today is a reliable and zero emission megawatt of electricity. To us, the PJM results are just another data point that Constellation's thesis is right and that we're focused on doing the right things. First, by providing sustainability products to customers that expressly lead reliability to sustainability by time matching clean energy production to when our customers use energy. And second, by investments in relicensing and upgrading the clean energy centers that will reliably and sustainably power American families and businesses for decades to come. On this second point, in its recent comments concerning the auction, PJM alluded to potential efforts to speed up the interconnection of needed resources. We look forward to seeing PJM's ideas, and we certainly will support those efforts in any way that we can. The case for prompt and decisive action by PJM is manifestly clear. In sum, we need to invest to grow America's economy, and we need to invest and enable the technologies that support our economies and protect our nation. We think Constellation will play a big part in these efforts. That's our mission, and it is what inspires our people to make Constellation a great place to work. Now turning to Slide 6. We're continuing to do well in our discussions and negotiations with data center companies. The simple fact is that data centers are coming and they're essential to America's national security and economic competitiveness. We've heard this from a variety of policy bankers, a number of nations including China are buying for AI supremacy. And it's absolutely critical that the U.S. not fall behind it. Time is of the essence. We simply cannot wait years for the data centers that are going to bring transformations. They're going to bring transformations in medicines, bringing new cures to diseases and treatments that research alone cannot do. They'll better predict weather. They'll provide material enhancements and they'll do things for us on the energy supply system to more smartly manage the grid. Economically, data center investment means considerable construction as well as permanent jobs, tax revenue, community development and other benefits to our states. We appreciate what the utilities in our states are doing to attract this crucial economic engine. We're doing our part, too. All of our political leaders understand this and that's why states are competing with each other, Republicans and Democrats alike, to bring the development of data centers to their jurisdictions. All of the policymakers we talk to want data center development wherever it occurs on the grid or co-located. But as you're all closely following, there's an active conversation underway by policymakers and stakeholders, trying to understand the implications of the different ways of power and data centers. We welcome that conversation, and we're confident that any thorough examination of colocation with nuclear plants will show that it is both the fastest and most cost-effective way to develop critical digital infrastructure without burdening other customers with expensive upgrades. As we see it, utility connection will continue to make sense for some applications and in some parts of the grid. But where it's an option, we will continue to see customer interest in colocation, strong interest because there are just too many advantages of connecting large load directly to large forms of generation, especially clean generation. And I don't think that point is really debated. On Slide 6, you can see some of the many quotes from key stakeholders including the utilities that oppose Talen ISA talking about the significant benefits of colocation. I'll outline four of them. First, and behind-the-meter, configuration the data center customer, not other customers, pays for the infrastructure needed to connect to the power plant. Unlike in front of the meter projects, we're sometimes cost -- almost 90% or more of the costs are shared with other customers in these behind-the-meter configurations, the data center companies pay for the infrastructure. Second, co-locating a data center with the power plant is just more efficient and it is faster, which can, I think the complaining utilities have acknowledged telling the FERC, \"significant new load can be served without having to expend resources on expensive system upgrades.\" That's from their filing. At a time when RTOs are struggling to integrate new resources faster and time is of the essence, this benefit is a big deal. Third, these behind-the-meter configurations are long dated. So they'll allow us to have the economic certainty to relicense nuclear plants and to operate them with all the attendant benefits that creates for the grid in our nation. Fourth, in terms of new clean generation, the common thesis for these forms of generation, whether they're SMRs or carbon sequestration technologies is to co-locate them with industrial and data center look. We've seen that countless number of times. For all these reasons, colocation will be an essential tool for maintaining our national security, developing new generation and our overall economic competitiveness. Friday's actions at the FERC may have slowed things but ultimately will be constructive in our view. Notably, FERC did not grant requests by a small number of utilities to set the Talen Energy ISA for hearing or in the alternative to reject it outright. Instead the FERC ordered a technical conference that will provide all parties with the opportunities to talk about the benefits of colocation as well as other issues. Likewise, we thought the language of the deficiency letter was narrow. In fact, it mirrored standard deficiency letter language about a higher burden approved for ISA modifications that we've seen in a number of other applications. Just as an example of this, in the last 12 months, excellent subsidiary, ComEd received two deficiency letters using the exact same language about a higher burden improved that we saw in the Talen letter. In both instances, the project was approved. Of course, look, we don't know what FERC ultimately will do with the Talen ISA, but we think the benefits are compelling and we look forward to the conference and we're confident that any fair examination of costs will support colocation. So at this point, we and our customers are continuing to make progress, and we hope to execute contracts. At the same time, on a parallel path, we'll participate in the FERC proceedings or in any proceeding where these matters are discussed. But that doesn't mean we won't have conversations with utilities outside these proceedings. In my view, transparency is part of who we are as a company and the more we could share with policymakers, utilities and all stakeholders about how these facilities will operate, how they'll interact with the grid and their benefits, the better for everyone. I just want you to remember that in the grand scheme of things, colocation is not a new idea. It's actually quite an old idea. As PSEG and others have noted, cogen or combined heat and power projects were the first co-locators since I think they were the first micro grids. And when I came into this business, those projects were a common feature of our system. And not surprisingly, utilities were not always friendly to cogen, at least not at first. But policymakers insisted on non-monopoly alternatives to power and things get better. Now we're dealing with a whole new generation of policymakers and regulators, including many that weren't around when the cogen policies were created. So we need to do a bit of work here to educate and inform. But importantly, we simply don't see this as a zero-sum game. There's a great opportunity for Constellation and for the utilities to work together to bring grid connected and co-located data economy growth projects to our states. Here's what I think. In the fullness of time, those jurisdictions that have clean energy centers like ours and offer both colocation and grid connection will be the most successful in generating business development and economic growth and jobs for their states. Now look, I want to close this part out by talking about something that I think kind of got missed in the overwhelming amount of conversation about the FERC process. I understand why there is a lot of attention on that, but we don't want to leave this topic without saying that we are making great progress on power sales for on grid data centers through our 24/7 product. Utilities across PJM, and I think you've seen this in a bunch of the earnings calls, have been highlighting the growth of data centers in their service territory. In total, as you could see on Slide 6, they now identified 50 gigawatts or more that would come in over time. Now look, in fairness, I think there's a bunch of duplication in those numbers and it's going to occur over a longish time line. But the point is, I think it's powerful that everyone is seeing the same thing, growth in this area. And those growth opportunities are good for Constellation because each of these grid data center projects, whether they're located in Illinois, Ohio or anywhere else in PJM or in other regions, they present an opportunity for our commercial team to sell clean and reliable power through our 24/7 product and other offerings to these clients. So in conclusion, we continue to have multiple ways to serve our data center customers, both behind-the-meter as well as grid connected and create value for all of our owners. Nothing over the last quarter has changed our outlook, how Constellation can meaningfully participate. Turning to Slide 7, our fleet performance is laid out in this slide. And as you can see here, nuclear performance was again strong and ahead of plan for the quarter. We produced more than 41 million megawatt hours of reliable, available and carbon free generation from our nuclear plants with a capacity factor of 95.4%. That's including refueling outages, which we completed in an average of 21 days, again, industry leading as always. Our renewables and natural gas fleet also performed well and exceeded our plan, with 96.6% of renewable energy capture and a 98% power dispatch match. Congratulations to those teams. Excellent work. Turning to Slide 8. We talk a lot about the advantage of creating value because our best-in-class carbon free generation fleet is combined with an industry leading commercial business, and the results here again demonstrate the validity of that point. Our commercial business thrives in volatile and changing markets. The markets we're seeing with spot and prices going up and down a bit throughout the course of the year. This quarter our team priced in higher margins to customers to manage their exposure to volatile prices through firm products that offer price certainty. They optimized not only our individual generation and load positions, but they created the best positions using both. And they sold customized sustainability solutions. On that point, we're seeing more evidence of our customers, not just data center customers, but customers as a whole, evolving in their sustainability journeys from buying annual clean energy products to starting to match their hourly consumption with clean energy. And again, I think the reliability to mention here plays hugely in the outstanding of customers that we need to match clean energy production with the time of use for their particular application. And they also understand that, that's the best way to ultimately make a difference in the environment and to manage the energy volatility. A good example that came to us this quarter when John Hopkins University Applied Physics Lab joined the growing list of high-profile customers that have turned to Constellation to power their operations with 24/7 carbon free energy. As we did with the Comcast contract, the McCormick contract that we highlighted on our last call, we spotlight this agreement with John Hopkins because it shows that it's just the hyperscalers. But rather a wide range of customers that are looking at 24/7 carbon free energy matching as the best solution. With that, I'll turn it over to Dan to cover the financial update."
},
{
"speaker": "Daniel Eggers",
"content": "Thank you, Joe, and good morning, everyone. Beginning on Slide 9, we earned $2.58 per share in GAAP earnings and $1.68 in adjusted operating earnings, which is $0.04 per share higher than last year. Our commercial business continues to perform exceptionally well, creating value by optimizing our generation and load positions, demonstrating how it thrives in volatile markets. We're also seeing margins above the long-term averages we use in our forecast, and above the enhanced margins we disclosed in February. This performance flowed through our quarterly results and contributed to our improved outlook for the year, which I'll discuss in a few minutes. Compared to last year, we benefited from the nuclear PTC. More nuclear output combined with lower costs and refueling outages and contribution from our ownership share in the South Texas project that closed last fall. And as discussed last quarter, our stock has performed very well year-to-date, which creates higher employee stock compensation expense year-over-year. Following on the quarter, we recognized $33 million in the Illinois ZEC program in June for banked credits, which is down a bit from the $218 million recognized last year. As you may recall, the Illinois ZEC program is subject to an overall cost cap as one of its consumer protection features. In earlier years of the program, we generated more credits than we could use under this mechanism. We were able to bank those credits for future years. For the 2023, 2024 planning year, the last second quarter, power prices had risen to a level where the ZEC price was nearly zero and we are instead able to use our bank ZECs to get back to the cost cap. For accounting reasons, we had to book these revenues at the start of the planning year and hence, the $218 million we recognized in the second quarter of 2023. This year, the forward prices have moderated and the ZEC credits for the 2024, '25 planning year will largely get us to the cap, using only $33 million of bank ZECs, which we then recognized this quarter. So taking all these impacts together, when you think about our second quarter results, our year-over-year quarterly earnings were $0.04 higher, would have been $0.44 per share higher, if not for the timing of when we recognize the Illinois ZEC credits. Instead, we'll see these credits flow as a positive driver for the remainder of the '24-'25 planning year and have always been part of our full year expectations. Moving to Slide 10. We are raising our full year adjusted operating earnings guidance outlook with the midpoint of guidance going from $7.63 to $8 per share with a new range of $7.60 to $8.40. Joe and I spoke about our strong commercial performance to date, and that performance enables us to increase our earnings outlook for the year. As you can see in the appendix on Slide 25, we increased our enhanced gross margin line by $450 million due to better optimization of our portfolio and higher commercial margins than planned. Our expectations for enhanced commercial margins improved by $0.15 to $1.90 per megawatt hour, which is on top of our base commercial margin of $3.50 to $3.60 a megawatt hour. In addition to an increase in stock compensation due to our share price, we have some O&M drag due to performance based compensation as a result of the commercial team's exceptional execution and value creation for our owners. Our ability to optimize our generation and load positions is not limited to 2024, but has extended into our 2025 outlook as well. We increased our 2025 enhanced gross margin expectation by $250 million, some of which is from strong commercial backlog creation. All the rest is due to the higher prices from the PJM capacity auction. So turning to Slide 11. Let's get into the financial impact of last week's capacity auction results. To level set everyone from the start, the nuclear PTC is now in place. So calculating the benefit from higher capacity prices is a little more involved than just a PxQ exercise. The nuclear PTC is a means based credit and is calculated by filling the gap between gross receipts so all the market based revenues coming to a plant and the PTC threshold value that we assume is $44.75 in 2025. What this means is that gross receipts per unit were below the PTC threshold of $44.75 in 2025. We expect to receive PTC revenues to get us to that level. For those units, the uplift from higher than anticipated capacity revenues following this auction must first replace the expected PTC that was bringing us to the PTC floor level before we're able to realize upside to earnings. For units that were already above the PTC floor, the full offside of the capacity price increase will be realized. Additionally, any revenues above the CMC price will be refunded to customers. So we do not realize any upside benefit for the three CMC plants in Illinois, even though they cleared the auction. With all that clarification, capacity prices were higher than our expectations. And comparing to where power prices were for both 2025 and 2026, we are now seeing many of our PJM plants at or above the PTC floor in providing earnings upside for us. Forwards for 2025 are lower than 2026, so more of the capacity revenue upside in 2025 goes first to offset the expected PTC contribution. The net earnings impact to 2025 was approximately $0.25 per share, which we reflected as part of the enhanced gross margin increase on Slide 25 of the appendix. For 2026, assuming that we carry through the same capacity prices in the 2026, 2027 capacity auction in December and used the end of quarter forward power prices. We would expect $1.25 per share increase in earnings against the previous assumption using $100 a megawatt day for the capacity auction. As a reminder, every penny of EPS is about $4 million pretax if trying to calibrate your forecast Turning to the financing and liquidity update on Slide 12. Our investment grade balance sheet remains strong, and we continue to have constructive conversations with the ratings agencies. During the second quarter, we entered into an accelerated share repurchase program, completing $500 million of repurchases on top of the $500 million of repurchases we discussed on the first quarter call. We've now completed $1 billion year-to-date and $2 billion since the program began last year for a total of more than 16 million shares. We have roughly $1 billion remaining in our board authorized repurchase program and we have more than $2.3 billion of capital still to be allocated for 2024 and 2025, and before taking into account the improving earnings outlook for both of these years. We have considerable strategic flexibility to create further benefits for our shareholders through organic growth that meets our return thresholds or through investing directly in our company. We believe firm, clean megawatts are the most valuable commodity in the market today, and we have more nuclear generation in competitive markets than all of our peers combined. When we look at our ability to execute and create value as well as the opportunities ahead of us, we continue to view our stock as compelling and unfortunately, even more so since the last time we met. We will continue to invest directly in it through buying back our stock. I'll now turn the call back to Joe for his closing remarks."
},
{
"speaker": "Joseph Dominguez",
"content": "Thanks, Dan. Great job. Constellations like no other company. We have a unique set of existing assets that really can't be replicated that create opportunities for us that no one else has. At our core, we have a visible base earnings growth of 10% through the decade that is backstopped by the federal government through the nuclear PTC and has a built-in inflation adjusted. Backstop is a huge differentiator, especially as some investors start to become concerned about clouds in the economy. Our country needs what we have, clean and dependable power generation to drive economic growth. And the argument for that just got stronger as the year has progressed. We could support both national security and meet environmental goals. Power demand is growing and, at the same time, reliability is becoming a premium product and we have the most reliable generation in America. Increased demand, combined with the change of the electric system to more intermittent, non-dispatchable resources means that volatile power markets will continue. We have a commercial team that is very capable of addressing and earning margins from that volatility. We think Constellation is going to be a huge part of the solution for decades to come. Our clean and reliable nuclear plants, coupled with our ability to offer customers sustainability products will drive the U.S. energy transition and the growth in the data center economy. Politically, both Republicans and Democrats have consistently recognized that nuclear is both the backbone of our system from a reliability standpoint and is key to our sustainability goals. And that growth just -- that support just continues to grow, pardon me. On top of the opportunities we have from volatile power markets, we have more than 180 million megawatt hours of carbon free generation that we produced annually that can achieve additional compensation through in front of the meter deals, behind-the-meter deals, operates and other opportunities to invest in reliable clean energy and government procurements. Not many companies are growing at, at least 10% through the decade as their starting point with a federal backstop. But we're not satisfied with that. We think we will grow base earnings faster with both behind and in-front-of-meter customer deals and increasing our nuclear megawatts. On top of this, our commercial team is working to consistently create products and services that will capture additional value from the markets above our basis. That's our focus. That's what we do every day. So with that, let me turn it over back to you, Michelle to handle questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from Shar Pourreza with Guggenheim Partners."
},
{
"speaker": "Shar Pourreza",
"content": "Joe, just starting with the colocation backdrop, does the FERC technical conference -- I think you kind of alluded to this, does it kind of prolong the time line for a deal announcement at this point? And can you give us just any color on timing of a potential deal or how your potential counterpart is your view in the ISA process right now?"
},
{
"speaker": "Joseph Dominguez",
"content": "Shar, I think it could slow things down in terms of folks looking for certainty. But as we kind of think about it, right, you think about the ancillary services that people are debating here get the totality of those ancillary services is relatively small. We actually think it's zero just as PPL and Talen do in terms of the physical application we have. But even in allocation of these ancillary services is relatively a small amount. And if they're metered as PJM proposes, we're talking about really low dollars per megawatt hour $1 to $2 to $3 a megawatt hour at most. Those kinds of charges aren't going to change the economic viability of these projects even if they're imposed. And again, we think the better argument is no charge will be imposed in terms of the configuration we're talking about. So from our customers' perspective, it's about crafting provisions in the contract that allocate those contingencies to the extent they occur and we've had to kind of deal with that in the negotiations of the deal. But these things continue to march forward. I think in the long run, having clarity is going to be the most important thing and getting through this and Talen getting through its ISA and having clarity is only going to kind of speed up the process and speed up deal execution because people will then know exactly what they're contracting for. So that's kind of the way we see it. We're continuing to work forward. I don't think we need to wait until the end of a FERC process to announce a deal. Like I said, contracting provisions will handle all contingencies that might occur with regard to that FERC proceeding. And we really don't see an outcome here where the FERC is going to say, you can't do this. I mean we've outlined the four reasons in the script. I won't go through them again. But this is kind of a -- this is important on so many levels to get done. The policymakers in the states wanted to get done. And I think that message will come through loud and clear in the process. I actually think it's a good opportunity to educate and inform people and kind of get this all out there. This is, again, not a really new idea but it's new to me. And so we've got to walk through the process. Kathleen. I don't know if you have anything to add in terms of the timing of the conference what you expect to see."
},
{
"speaker": "Kathleen Barron",
"content": "No. I mean, I think you covered it, Joe. This kind of meeting is the kind of meeting that for holds from time to time, when they want to learn something about a topic. Last year, they had a technical conference on the EPA proposed 111D rule. And I've participated in these on both sides, both at the commissioner and as a stakeholder. And it really is a great opportunity for there to be interaction between stakeholders and the commissioners in an informal setting like a conference as opposed to doing solo litigation. So that we can answer questions, we can talk about the benefits as we see them and get the issues out there in the open in a setting where it's less adversarial than a litigated docket. And in terms of the Talen case, when we look at the narrowness of the deficiency letter, as Joe pointed out, it's very similar in language to other deficiency letters that have been issued on ISAs that have non-conforming language, asking very narrow question about why those provisions are necessary. You contrast that to what typically happens where there are long list of questions in deficiency letters reflecting concerns from the commission or questions from the commission. That does not occur here. So they really -- if you zoom out signaling that they intend to keep the Talen proceeding focused on the Talen fact, and then they're going to be standard tool that they have this tech conference to learn some more about the topic. So we see this as a very constructive way to move forward and, frankly, a responsible one on the FERC's behalf."
},
{
"speaker": "Shar Pourreza",
"content": "And then just lastly, BRA, I mean, I guess it's open to interpretation on whether we actually do in set new entry into the market. I guess, obviously, Joe, you're in discussions, what's your view on some of the commentary out of some of the T&D utilities and it's been topical on these calls is regarding just PPA or rate basing peakers in PJM if the market doesn't move fast enough."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, sure. I don't think that's really any different -- now have been in this business seemingly for so long that I remember these cycles over and over again. We've had these discussions before. But in states like Pennsylvania, states like Ohio, they've been pretty clear. A lot of alone places like Illinois, where I just think that conversation would be impossible. They've been very clear that they want the markets to work. And there's great evidence here that the PJM market has worked. We've seen high prices before in the PJM market. And in fact, even with these higher prices, the point I made in my opening remarks here is that we're still at a lower point than we were 15 years ago. And it's just -- it's a testament to the value of competition. I think stakeholders in those states get it. I think there is a genuine concern about the growth rates in terms of spending on the T&D system. And I don't see policymakers naturally going to the view that monopolization of the generation sector. Further monopolization of the generation sector is going to be the answer now, frankly, any more than I ever did. So we'll respond to those points. But right now, we just have a new FERC process in the capacity option. We need to give it the time to work. There's no evidence whatsoever through history or anything that's going on now, that competition isn't going to address this problem, right? So that's our view."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Arcaro with Morgan Stanley."
},
{
"speaker": "David Arcaro",
"content": "I was wondering does the outcome of the PJM auction just in terms of how high prices got, does that increase the urgency that you're hearing from potential data center counterparties to get some of these colocation deals done?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. I think it increases urgency, both in terms of that and also urgency in terms of locking down in-front-of-the-meter deals because it is a tightening market and people are saying that, and in particular, for clean and reliable megawatts, it creates a huge opportunity, I think, for Jim's business to go and meet the demand of these customers. And we're certainly seeing that. We've reshaped the team. We've refocused the team through a lot on Jim's part to go out and meet and address the needs of these customers, and we're seeing a pretty significant appetite there. I think it also signals that even with the forecasted growth, right, because the data center growth was in the forecast that PJM used when it ran the auction, its evidence that we have the supply needed in PJM to address this data center growth. So I think it was a positive on two fronts. I think now we have the forecast and the market still responded with enough generation to meet the reliability needs of the system. And -- but at the same time, we do see a tightening in the market and people need to get moving to lock up their supply. So I think it's additive."
},
{
"speaker": "David Arcaro",
"content": "And then another question that we've had is as you're working on data center deals, should we be assuming that dual unit plants make the most sense with one unit acting as backup? Or is there demand or certain structures where you could fully contract a dual unit plant? What would that structure potentially look like?"
},
{
"speaker": "Joseph Dominguez",
"content": "For us that we started with the dual units because that made the most sense, right? One, as you noted, one unit becomes the natural backup for the other unit during outages. But as we've gotten smarter in this, it really depends on the type of data center, whether it's an inference data center or a learning data center. And it really depends on what the hyperscaler intends to evolve the facility. I don't think we've seen all the configurations, and I could easily see circumstances where behind-the-meter data centers are located in the same region as on-grid data centers and effectively provide reliability through fiber as opposed to through wires and backup generation, where on-grid picks up behind-the-meter data needs when the data center is in outage mode. So we could see those configurations -- I could frankly see those configurations evolving even after the unit stations. We're learning a lot. It's -- despite the enthusiasm, we certainly feel it and we know our owners feel it. We're still fairly early innings in terms of understanding all of the different use cases and how our resources will interact with the grid, and we'll interact with these customers. Honestly, I think in talking to them, the customers are still figuring it out. So I at this point, wouldn't rule out anything. We do think the most natural place is the dual-unit site, both in terms of the volume of electricity and the natural backup, we think those are going to be the first sites to be selected. And so far, it appears to be the case."
},
{
"speaker": "Operator",
"content": "Our next question comes from Steve Fleishman with Wolfe Research."
},
{
"speaker": "Steven Fleishman",
"content": "Sorry, I wanted to just try to kind of better clarify a little bit more on the colocation kind of time line. So I think we'll have a technical conference in the fall, but I don't think we're going to get kind of any next step from that probably until sometime in 2025, most likely, policy statement [206] or whatever? And I guess, we will have a Talen outcome by the fall. So just in terms of thinking about just a realistic time frame to kind of get the -- be helpful to get clarity, as you said. I mean is this something that we should kind of not expect to hear more until sometime next year? Or is this something that we could still see something happen even this year, even as these things are still kind of in process?"
},
{
"speaker": "Joseph Dominguez",
"content": "Let me -- I think something you're referring to is a deal done, right?"
},
{
"speaker": "Steven Fleishman",
"content": "Yes."
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. So Steve, I don't think we're time bounded by ultimately clarity in the FERC process. I do think the Talen ISA is going to be instructive and folks are watching that to make sure kind of it goes through or what conditions might get attached to that. But we independently are working on contractual provisions that will allow us to manage whatever outcome comes out of those proceedings. And so, at least for the moment, we're working with our customers towards finalizing deals. And I could certainly see a circumstance where those things get announced and there's still some process going on at FERC or some discussion among stakeholders."
},
{
"speaker": "Steven Fleishman",
"content": "And then just on, one, this has been a very public kind of gotten very noisy process. And I would assume some of these customers don't really love kind of seeing that inside. So just is that in a way impacting at all the ability to kind of get things done with the customers? Is that a concern?"
},
{
"speaker": "Joseph Dominguez",
"content": "Not yet, Steve. But the customers are paying attention to this, and by the way, so are the policymakers. Look, if this stuff is happening, and I'll just -- Talen is not our deal, but I'll use it as an illustrate. Talen in that arrangement is bringing $10-plus billion maybe more than $20 billion of economic development to a region that, if we're going to be honest hasn't seen a lot of sunshine from an economic development standpoint of this dimension in a long, long time. And I think it's fair to say that policymakers around Pennsylvania like to see that for communities like this that need jobs and economic opportunities. And I think it's fair to extrapolate from that, that they won't like it very much if people interfere with those things and cause it to come off the rails. And so I think the policymaker reaction, the labor reaction, which, of course, drives policymakers in many of our jurisdictions, they're all pretty important factors. So I think we'll see that play out. I think that pushes parties to try to work these things out. The other thing is, from a customer standpoint, right, you want to be in a jurisdiction that is pro and friendly to data centers and gives these companies every option. And I think in the early innings, that probably isn't the case. And I noticed that you pointed that out in some of your research. So look, we're not at a place right now where people are signing have a circle around a particular jurisdiction with a red stripe through like ghost busters thing. But I think people are paying attention to it. Policymakers want this to happen. They want the parties to work it out. So at the end of it, we will go anywhere we need to go to have the discussion. If we could only have the discussion in proceedings state or federal, we'll have the discussions in state or federal proceedings. But we think the clear signal from what happened at FERC from the rejection of ban legislation in Maryland is to tell parties work these issues out. This economic development is important. I don't think we're the only ones hearing that message. And we'll strive and we do this every day to have conversations. You don't have to have every policy conversation in a proceeding. And frankly, if we did, regulators and lawmakers would never sleep. So we need to continue to have those discussions. I just -- in my view, Steve, it's this. If you have clean energy centers in your jurisdiction and you could offer that opportunity, that's a huge advantage for the incumbent utility to make the state a place that's friendly to the data economy. And what we've seen before is one data center attracts more because they kind of work together. So I just think the approach here of thinking about this as a zero-sum game is really just kind of the wrong mindset. And I think we just got to kind of get through that phase, and where you're working very hard to do it. Our owners expect us every day to work on the things that bring the spectacular results that our team is announcing today. And that's what we want to be working on. We don't want to be tied up in proceedings all over the place. We will if we have to, but we prefer to resolve these issues in a way that's friendly to what policymakers want and what customers want. That's what we aim to achieve."
},
{
"speaker": "Operator",
"content": "We have time for one last question, and that question comes from Paul Zimbardo with Jefferies."
},
{
"speaker": "Paul Zimbardo",
"content": "Lots of good content today. I wanted to shift and kind of run with that last one you mentioned a little bit, I know we're all focused on FERC but you mentioned Maryland. Just holistically, what are some of your state legislative priorities to support the colocation strategy? I know Maryland has Senate bill one, if you could just comment more broadly, what kind of the focuses are at the state level?"
},
{
"speaker": "Joseph Dominguez",
"content": "Well, I think we're going to be largely reactive to what we're seeing. But we will work with customers, with labor unions and others to make sure that all opportunities remain on the table for economic growth. But we're sitting here thinking about launching legislation. We think this is like the cogen stuff that I alluded to are the micro-grid stuff that we've talked about, largely handled in the regulatory arena."
},
{
"speaker": "Paul Zimbardo",
"content": "And I know in your prepared remarks, you talked about some of the customer bill impacts from the PJM auction, some of the benefits for all parties from the colocation strategy, but just curious if you have any initial estimate of like what the benefits would be in terms of rate returns for rate payers, if there was like a hypothetical 1 gigawatt data center colocation. Some of your peers have kind of put out some numbers, but curious if you've done the analysis there you're willing to share?"
},
{
"speaker": "Joseph Dominguez",
"content": "Well, I will point to either Kathleen or David Dardis, our General Counsel. We could talk certainly about some of what we've presented in our case, but we have generally seen billion dollars of costs associated with a gigawatt of load, right? And in jurisdictions where a lot of that is socialized, 90% or more and frankly, I think that's an underestimate because that just includes kind of direct substation market. It doesn't include the work behind the substation that may be necessary, but we see some jurisdictions where a lot of that is spread out to many other customers in our applications, those hyperscalers are paying for the connection. Now if not $1 billion because the connection is occurring right at the plant, which is the point, right? So what we're doing is creating switchyards and other things that are 1/10 of those costs to connect the certain amount of load. But you could see easily a factor of 10x, I actually think it's more when you talk about putting a data center out on the grid somewhere. And a lot of those costs get socialized to customers that aren't the hyperscalers. And so that's the real benefit. But the other thing that, look, Paul, when we're talking about this, we are pretending as if the grid could easily host 1 gigawatt of load. When I was at ComEd, the largest load we ever had in the system was steel mills at 150 megawatts, right? If -- when I was General Counsel at PICO, the largest -- one of the largest loads we had were the refineries in Philadelphia, 60 megawatts, 70 megawatts. The notion that you could accumulate enough power somewhere on the grid to power 1 gigawatt data center is frankly laughable to me that you could do that in anywhere that doesn't start with decades of time, right? This is an enormous amount of power to go out and try to concentrate it. Think about it. You're building 345 kV lines with all the attendant substations to create all of the redundancy, each one of those substations having to draw power from an independent source. It just it has always made sense. This is not new, it's always made sense that when you're talking about large loan, you're going to bring it closer to large generation resources. And when you're talking about large load that also wants to use your own mission energy, you're going to bring it very close to nuclear power plants. We need to make sure that policies don't inadvertently drive us to spending billions of dollars where cheaper solutions are available, quicker solutions are available. And from an electrical engineering standpoint, more prudent and, frankly, feasible solutions are available. So we're going to have those policy discussions, but I think that's what's going to be revealing in the FERC discussion. And it's powerful. If you want to take a look at one document that I think lays this out pretty clearly, Mike Formo, who for many, many years, was the leader of transmission -- all things transmission at PJM published a report. He is also Senior Vice President of Transmission for Exelon for a period of time in his career, about issues I just described, the feasibility of connecting and the cost of connecting super large loads somewhere on the grid as opposed to colocation. And he lays it out pretty succinctly in his expert report. Those are the things we'll be talking about to regulators and policymakers. There's going to be opportunities for data centers in both places, but dimensionally, the bigger we get, the closer we're going to be to the generation source if we are going to have any chance of doing this in a manner that addresses the nation's need for timely action."
},
{
"speaker": "Operator",
"content": "Thank you. I'd like to turn the call back over to Joe Dominguez for any further remarks."
},
{
"speaker": "Joseph Dominguez",
"content": "Well, thank you. We've had a great beginning to the year. And again, just want to give a shout out to all of our folks that made it happen. We really feel strongly about our performance to date, we really feel strongly about what we think we're going to be able to accomplish in the balance of the year and the work we're doing. I appreciate the robust discussions we've had today around colocation. One always gets concerned that one particular issue distracts from the overall benefits of the company that are really laid out in the last slide we have in the deck about the unique opportunities we have here. We're super excited about them. We appreciate your attention, your focus on Constellation, your ownership and I guarantee you, we'll continue to focus on the things that create value for you. With that Michelle, end the call."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day."
}
] |
ceg | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to the Constellation Energy Corporation First Quarter Earnings Call. [Operator Instructions] As a reminder, this call may be recorded. I would now like to introduce your host for today's call, Emily Duncan, Senior Vice President, Investor Relations and Strategic Growth. You may begin."
},
{
"speaker": "Emily Duncan",
"content": "Thank you, [ Towana ]. Good morning, everyone, and thank you for joining Constellation Energy Corporation's first quarter earnings conference call. Leading the call today are Joe Dominguez, Constellation's President and Chief Executive Officer; and Dan Eggers, Constellation's Chief Financial Officer. They are joined by other members of Constellation's senior management team who will be available to answer your questions following our prepared remarks."
},
{
"speaker": "",
"content": "We issued our earnings release this morning along with the presentation, all of which can be found in the Investor Relations section of Constellation's website. The earnings release and other matters, which we will discuss during today's call contain forward-looking statements and estimates regarding Constellation and its subsidiaries that are subject to various risks and uncertainties."
},
{
"speaker": "",
"content": "Actual results could differ from our forward-looking statements based on factors and assumptions discussed in today's material and comments made during this call. Please refer to today's 8-K and Constellation's other SEC filings for discussions of the risk factors and other circumstances and considerations that may cause results to differ from management's projections, forecasts and expectations."
},
{
"speaker": "",
"content": "Today's presentation also includes references to adjusted operating earnings and other non-GAAP measures. Please refer to the information contained in the appendix of our presentation and our earnings release for reconciliations between the non-GAAP measures and the nearest equivalent GAAP measures."
},
{
"speaker": "",
"content": "I'll now turn the call over to Joe Dominguez, CEO of Constellation."
},
{
"speaker": "Joseph Dominguez",
"content": "[ Towana ] thanks for getting us started this morning. And Emily, thanks for running through all that and laying out the agenda for today. Good morning, everyone. Thank you for joining us. We had an excellent first quarter operationally and financially. We're making steady progress with technology customers on transactions that will power America into the future and employ thousands. And last week, we concluded meetings with our Board where they authorized another $1 billion in stock buybacks because we believe in our strategy."
},
{
"speaker": "",
"content": "This is the second buyback announcement in less than 6 months. Dan and I will cover all of those topics and more this morning, but I want to begin today with a celebration of Chris Crane, the former CEO of Exelon, who passed suddenly last month. We appreciate all of you who reached out and shared your thoughts and fun memories of Chris. If there ever was one, Chris was a nuked through and through. And as much as anyone, Chris deserves credit for the operational excellence of our fleet and improvements in other fleets around the industry. He was an operational genius. His reach was far and he touched so many people."
},
{
"speaker": "",
"content": "He and I spoke regularly after Constellation launched. He's happy to see how we are doing but his first thoughts were always about our people. He was always so proud of folks here at Constellation, especially the women and men at the plants. They were his family. Many of us here worked with Chris for over 20 years, but you only have to be with him for about 20 minutes to know what he cared about. Safety and operational excellence was always number one, followed closely by the care and the development of the women and men who we are all privileged to lead every day. Those two things were his North Star."
},
{
"speaker": "",
"content": "He was a leader for the industry and had conviction and courage through a lot of hard times. He was an all-of-the-above energy thinker. He cared about nuclear because he was sure that you could not run a full time clean energy economy just on part-time power."
},
{
"speaker": "",
"content": "We've got a lot going for us here at Constellation, and we'll talk about that today, but one of the most important things we have is Chris Crane in our DNA. He trained and mentored Bryan Hanson and David Rhoades and a lot of our other leaders. We're going to miss him, but you can be sure that his legacy of excellence will carry on here."
},
{
"speaker": "",
"content": "In February, we gave you a very thorough update on the company and the opportunities that lie ahead of us to create value for you, our owners. So we don't have to go through all of that again in detail, but I do want to reiterate a few points. Constellation will grow base earnings by at least 10% through the decade."
},
{
"speaker": "",
"content": "And importantly, we have a number of opportunities to generate base earnings above those levels. In the coming years, the demand for clean, reliable megawatts will only grow, and we think we're best positioned to meet growing demand for clean energy to tackle the challenge of the energy transition; to unlock value through compensation for the uniquely clean and reliable attributes of our 180 million-megawatt hour fleet; and to help America power the technologies of the future whether that be EVs, electric heating and industrialization where we've got a lot to go or in the booming demand for artificial intelligence technologies and other digital infrastructure projects."
},
{
"speaker": "",
"content": "I'd like to drill down on that last point for a moment. Over the last few months, a lot has been written about power demands in the technology industry. But I want to assure you that these challenges will be overcome as they have in the past because we all know here how imperative it is for America's national security and economic competitiveness that the U.S. leads the world in the development of these technologies. And we're working hard every day to make that possible."
},
{
"speaker": "",
"content": "The data economy and constellations nuclear energy go together like peanut butter and jelly. And as such, we're in advanced conversations with multiple clients, large well-known companies that you all know about powering their needs. Speed to execution is important to them as it is to us, but these are large and complicated transactions that require diligence and time to finalize. And while we're not done yet, I do expect that we will finalize agreements that will have long-term and transformational value. They'll ensure that our fleet and the jobs and economic community benefits that we already provide will be sustainable for decades to come."
},
{
"speaker": "As demand grows, our nation's need for firm clean power grows proportionately. As we add new clean power, the role and importance of nuclear will only grow. We intend that Constellation will be a leader and adding new clean, reliable megawatts to the grid to meet the needs of American families and businesses. We're going to do that in three ways",
"content": "First, we're extending the lives of our existing sites to power the nation into 2060 and beyond, creating more clean energy than all of the renewables ever built in this country."
},
{
"speaker": "",
"content": "We've already received or have announced license extensions at 5 and have more to come, assuming supportive policy. Continuing to run these plants through license extensions is quite simply the most important thing we can do for America's clean energy future. Second, we're adding megawatts by using uprates to increase the output of our current machines."
},
{
"speaker": "",
"content": "And we already announced to you operates at Byron and Braidwood that will bring in 160 megawatts in the next few years. And we're looking at many opportunities to do that other plants. We believe that the opportunities will add up to 1,000 megawatts or perhaps more of clean, firm power to the grid. This is in addition to the many hundreds of megawatts of renewables that Constellation is adding through CORe+ deals with customers and through our wind repowerings."
},
{
"speaker": "",
"content": "Third, we're looking to partner with others to locate new technologies, including new nuclear at our existing sites. These sites already have, of course, community support and existing infrastructure for nuclear energy. And we think our simple thesis is this, if new nuclear is going to be built anywhere where we do business, it's going to be built on sites where there already is existing nuclear because that's where communities love the technology and have the capability to support more. So we believe that we're uniquely suited to provide this value and grow the industry."
},
{
"speaker": "",
"content": "Turning to the quarter. We delivered first quarter GAAP earnings of $2.78 per share, and adjusted operating earnings of $1.82 per share driven by continued strong performance from the commercial business through better than historical customer margins and through optimizing our combined generation and customer business. Given the performance, we're confident in our full year outlook, and we look forward to another strong financial year."
},
{
"speaker": "",
"content": "Our performance and creditworthiness is being recognized. Moody's upgraded our credit rating to Baa1, which is further recognition of our strong financial footing, and we issued the first green bond to fund nuclear power in the United States. I think that's really cool, think about it 5 years, the idea of using green bonds for nuclear would have been something that people would have scratched their head at, it happened. And you could see the enthusiasm in our near- and long-term outlook for our business through our continued share repurchases, buying 500 million shares to date with another 350 million of that coming since our end of the year February call."
},
{
"speaker": "",
"content": "Looking at our strong free cash flows and near-term allocation opportunities, the Board, as I mentioned, previously authorized an additional $1 billion in share repurchases, bringing our remaining authority -- authorized buyback capacity to $1.5 billion. As Dan will explain, even after this new authorization, Constellation has ample cash available for growth investments, acquisitions and returning even more value to you, our owners."
},
{
"speaker": "",
"content": "Turning to Slide 6. The importance of nuclear energy to our economy, electric system and meeting the country's environmental and clean energy goals was first recognized by states when they enacted zero-emission credit programs, and it's now been followed by the federal government through the nuclear production tax credit. Since then, the financial community has embraced nuclear energy understanding its importance to our country's success."
},
{
"speaker": "",
"content": "As I mentioned, we issued the first nuclear green bond in the U.S. There was significant demand for this product, and we were able to upsize our offering as a result. The strong demand from investors for our 30-year green bond is recognition that clean, reliable nuclear energy is critical to meeting the sustainability goals of the nation and will be beyond the present period of our current licensed lives. I mentioned that we received a credit upgrade from Moody's. Importantly, included as part of that upgrade, Moody's improved our carbon transition score to its highest level, a further recognition of the importance of nuclear energy to the energy transition."
},
{
"speaker": "",
"content": "More and more customers are acknowledging that nuclear should be part of meeting their own clean energy goals. Our customers are signing deals for hourly match carbon-free power from our existing plants, and we are talking to others about behind-the-meter opportunities at our sites. Congress has passed legislation to provide the necessary funding for bringing more of the nuclear fuel chain into our country, ultimately reducing geopolitical risks and supply. We expect DOE to issue a request for proposals imminently. And states across the country are taking action in favor of nuclear energy."
},
{
"speaker": "",
"content": "State legislatures have 130 bills out there to support nuclear energy this year compared to 5 to 10 historically. States like Michigan and Minnesota have passed laws moving renewable standards to clean energy standards, which include nuclear. I was pleased to see that Governor Shapiro in Pennsylvania recently did the same thing. They're removing barriers to nuclear by repealing moratoriums on building new nuclear and they're developing regulations to support new development in the states. In places like Indiana and South Dakota, where there currently is no nuclear, there are plans to build nuclear. And 6 states, Red and Blue have created incentives in their state budgets to attract nuclear to their state. The momentum behind nuclear energy, both existing and new, continues to build as more and more policy makers recognize exactly what Chris Crane believed that you can't power a full-time economy on clean energy that is only part time."
},
{
"speaker": "",
"content": "Turning to Slide 7. Nuclear performance was strong and ahead of plan for the quarter. We produced more than 41 million megawatt hours (sic)[ 41 million Terawatt hours ] of reliable available in carbon-free generation from our nuclear plants with an on-plan capacity factor of 93.3%. We completed 3 refueling outages during the quarter, with each lasting less than 22 days on average, and overall faster than we had planned. During our outage at Quad Cities, we anticipated a longer outage due to inspections on the low-pressure turbines that were installed as part of an upgrade in 2010."
},
{
"speaker": "",
"content": "But even with the additional work, we were able to complete that outage in 20 days, full 8 days faster than planned, kudos to nuclear and the entire team there. Our renewables and natural gas fleet also performed well with 96.3% renewable energy capture and 97.9% power dispatch match. The team is now completing our summer readiness work so that we're ready to go when the temperature turns up."
},
{
"speaker": "",
"content": "Turning to Slide 8. Our commercial team is off to another great start. We continue to see strong margins in our customer business. We talked about this in the last call, our projections being based partly on historical margins. We're continuing to see strong margins as we get into the beginning here of 2024. They're also creating value because of our integrated generation and customer business, capturing value through optimizing our positions across the fleet. I talked a moment ago about customers choosing existing nuclear to meet their energy demands and we continue to meet our customers' need for hourly match clean energy. We recently signed 2 deals with 2 of our largest customers that I just want to briefly mention. In each case, we converted these customers from a renewable-only product to a product that now uses nuclear energy to fill in the gaps when renewables don't operate. Each will ensure that our customers have full-time power, clean power each and every hour that they are consuming it. The first is with Comcast. It's a new deal that includes offtake from new solar facility."
},
{
"speaker": "",
"content": "The second, which will be announced in the coming weeks, converts an existing CORe deal, which again is Constellation's off-site renewables program to now include hourly matched carbon-free energy with energy from our nuclear plants. So our customers are recognizing that in order to meet their goals and make the difference for their business, they need full-time clean power to run their full-time businesses."
},
{
"speaker": "",
"content": "So now with that, I'll turn it over to Dan for the financial update. Dan?"
},
{
"speaker": "Daniel Eggers",
"content": "Thank you, Joe, and good morning, everyone. Beginning on Slide 9, we earned $2.78 per share in GAAP earnings and $1.82 per share in adjusted operating earnings, which is $1.04 per share higher than last year. As Joe mentioned, our commercial business has continued to perform very well. They do this through our generation to load portfolio optimization strategy, and we take advantage of our physical position in the markets to capture more value to the combined generation and customer businesses than they could if they were apart."
},
{
"speaker": "",
"content": "On the margin front, we are seeing margins come in better than planned and continue to trend higher than our long-term averages that we use in forecasting, as we discussed with you all on the last call. In addition, we had more nuclear output year-over-year and saw lower costs for our refueling outages in the quarter. And as a reminder, this was the first full quarter with contribution from our ownership share in the South Texas project. And speaking of first, this is the first quarter the nuclear production tax credit was in effect, favorably contributing to our earnings even after sharing some of the value of the PTC with our states. And as a reminder, we forecast the full year PTC value for our business based on the expected gross receipts at each plant."
},
{
"speaker": "",
"content": "So as prices realized through the year different from where we started the year, the value of the PTC can change relative to forecast, but the overall net earnings for Constellation should be the same as the mix of energy revenues and PTCs will balance to get us to the same place."
},
{
"speaker": "",
"content": "Finally, our soft performance year-to-date has resulted in higher compensation expense year-over-year due to the timing of how we book compensation expense, it results in higher O&M during the quarter, and it will for the full year as well. We remain very comfortable with our earnings guidance range of $7.23 to $8.03 per share."
},
{
"speaker": "",
"content": "Turning to the financing and liquidity update on Slide 10. I'm excited to expand upon some of the accomplishments that Joe mentioned in his opening remarks. As he said, firm clean megawatts are the most valuable commodity in the market today, and we own more nuclear generation in competitive power markets than all of our peers combined. We look at the opportunities ahead of us, continue to view our stock is compelling at the current share price, even after the strong performance we have already enjoyed this year."
},
{
"speaker": "",
"content": "In March, we entered into a $350 million accelerated share repurchase agreement, bringing our total repurchases to $500 million year-to-date. We have now executed $1.5 billion of share repurchases since the first quarter of 2023, buying back approximately 13.5 million shares in total. Having completed $0.5 billion authorization from December, we're happy to announce that our Board authorized an incremental $1 billion, bringing the total program to $3 billion. We will remain opportunistic with the remaining $1.5 billion authorization and still see our stock is attractive."
},
{
"speaker": "",
"content": "Our high investment-grade credit ratings are a core principle to our capital allocation strategy. Our ratings are further strengthened by Moody's upgrade to Baa1 in March bringing it in line with S&P's BBB+ rating. The ratings action taken by Moody's recognizes the strong financial performance of the company and the stability provided by the nuclear PTC."
},
{
"speaker": "",
"content": "Last, we issued the nation's first ever corporate green bond including nuclear with proceeds of $900 million. The funds from the 30-year issuance will be used to finance green projects such as nuclear uprates to increase the production of clean, carbon-free energy. We saw a significant demand despite pricing amid a busy window for corporate supply allowing us to upsize from our initial target to $900 million, but still within our full year issuance plan. We also achieved very tight pricing when we look at both spreads and treasuries in line with 30-year holding company debt for regulated utilities. This is the second 30-year offering we have done in between the two, we have had $10 billion in demand, demonstrating the strong investor confidence in us as a company and a belief that our assets will be a critical part of the U.S. energy mix for a long time to come."
},
{
"speaker": "",
"content": "Turning to Slide 11 and our 2-year view of free cash generation and planned use of the cash. We'll update this slide and we make meaningful updates to our allocation plans like the increased share repurchase authorization we announced today, or the STP transaction last year. As you can see from the chart, even after the increase in share buyback authorization, we still have approximately $2.3 billion of unallocated capital in 2024 and 2025, providing considerable strategic flexibility for us to further benefit our owners. I'll now turn the call back to Joe for his closing remarks."
},
{
"speaker": "Joseph Dominguez",
"content": "Thanks, Dan. Constellations like no other company. We have a unique set of existing assets that create opportunities that no one else has. At our core, we have visible base earnings growth of 10% through the decade that is backstopped by the federal government through the nuclear PTC and has a built-in inflation adjustor. We're the largest and best operator of nuclear power plants in the United States. Our plants are especially well positioned to meet the challenge of reliability and clean that U.S. electricity markets need."
},
{
"speaker": "",
"content": "Our more than 20% share of competitive C&I connects us to leaders in sustainability and the drivers of power demand, in particular, demand for sustainability products. Our country needs what we have, clean and dependable power generation to drive economic growth, support our national security and our environmental goals. Power demand is growing, and at the same time, reliability is becoming a premium product, and there is no more reliable power source than nuclear."
},
{
"speaker": "",
"content": "Increased demand, combined with the change of the electric system to be more dependent on intermittent, non-dispatchable resources means that we're going to see continued volatility and increased volatility for years to come. This presents an opportunity for us to drive additional value for our owners. In short, we think Constellation is a big part of the solution to America's energy supply. Our clean, reliable nuclear plants, coupled with our ability to offer customers what they need will support the energy transition and our national security. And that's why Republicans and Democrats recognize that nuclear is the backbone of the electric system today and will be tomorrow, and that support continues to grow."
},
{
"speaker": "",
"content": "On top of the opportunities we have from continued volatile power markets, and we've certainly seen movement in power markets. We have more than 180 million-megawatt hours of carbon-free electricity that we produce annually that can receive additional compensation through 24/7 clean attributes behind the meter opportunities, government procurements for clean energy and capturing prices above the PTC floor levels as we see increases in power prices as demand continues to ramp. These opportunities are on top of the 10% growth we have in our plan. Our task is to capture the additional opportunities as they unfold and to do better than our plan for our owners."
},
{
"speaker": "",
"content": "With that, let me open it up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of David Arcaro with Morgan Stanley."
},
{
"speaker": "David Arcaro",
"content": "I appreciate the update. Joe, you mentioned that you're exploring the potential to locate next-generation nuclear units at your sites. I was wondering if you could elaborate on that, just maybe what technology you're looking at. Where does that stand overall?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. So David, here's what we've done so far on that. There was an RFI that was issued by 3 companies: Google, Microsoft and Nucor Steel. And what these companies were looking for is power today, but also some role in building new clean power supply in the future. And so what we outlined in our response to that request for information is exactly what I said earlier on the call that we think our existing sites are in an incredibly valuable resource as we consider new firm, clean energy, in particular, from nuclear energy. And so we proposed a structure kind of a multi-tiered structure where we could begin flowing power today from our existing power plants on a long-term PPA."
},
{
"speaker": "",
"content": "As part of that long-term PPA, we would work with our customer to begin to evaluate opportunities to add new firm energy. Now big part of that is subsequent license renewal of plants in our fleet, then upgrades and other opportunities that we have organically to add additional megawatts in our fleet. And then finally, to investigate different technologies for SMRs and actually other technologies as well that can be cited at our locations. And what we would anticipate doing over time is having some work with the customer to select that technology. And then the customer, through increases in the PPA, would begin to fund site development work construction ultimately scaling up to the point where the PPA absorbs the full cost of an operating new unit."
},
{
"speaker": "",
"content": "And so we would anticipate operating the unit for the owner because obviously, it would be on our site, and we would have a slice of equity given our contribution in land and other things of value to the owners. So this is in the beginning stages, but what I could tell you is it's of great interest to a number of clients in this space that not only want to have immediate access to power today, but want to have more clean power in the future."
},
{
"speaker": "",
"content": "And so that's how we're walking through it. In terms of the technologies we're looking at, I think folks know generally that we have a small equity position in Rolls-Royce. So that would be a technology that we would look at, but we would also look at other competing SMR technologies. And we've worked with the owner to figure out which technology best meets their future need at the cost that's appropriate."
},
{
"speaker": "",
"content": "So that's the work in that area. But again, look, I want to emphasize that the most important thing right now that customers could do in this space is make sure the existing fleet we have right now is ready and funded for subsequent license renewal. These contracts allow for that, and that's an important sustainability objective for our customers, then operates and other opportunities. And finally, new incremental clean generation which I think could be brought online somewhere closer to the middle of the next decade."
},
{
"speaker": "David Arcaro",
"content": "Perfect. Yes, that's really helpful color. Very interesting. We'll stay tuned on how that opportunity develops. And then I was wondering, as you're thinking about or talking to hyperscalers, big data center developers, are you seeing any discussions or opportunities evolve related to something like a supercomputer, a major multi-gigawatt data center like the Stargate idea we'd seen in the media, something that could potentially use power from multiple nuclear plants. Is that an option that you're seeing being explored at this point?"
},
{
"speaker": "Joseph Dominguez",
"content": "I think we're just going to be careful here in terms of that because there's just a lot being reported about that in the press, and we don't want to be kind of linked to a particular project until it's time to announce something. But I think what I am comfortable saying is this, David, we're seeing interest in developing projects that are on a size and scale that presently don't exist, but will be needed for training systems and other things to kind of build out and support the need for all of these foundational models."
},
{
"speaker": "",
"content": "I think they're up to 170 plus now foundational models that are going to require training data centers. These are things could be aerodynamics or pharmaceuticals, but essentially, these very, very large computers that would do nothing more than train for a period of time on all of the learnings in every country, in every language from the beginning of time until now be positioned to answer the questions to the future to advance these different industries. So we're seeing significant increases in the number of those training modules that customers need. It's our understanding that in order to support the training, we're going to need data centers that are of size and mentioned from a megawatt standpoint, that is far beyond what currently exists out there in the market."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Shahriar Pourreza with Guggenheim Partners."
},
{
"speaker": "Shahriar Pourreza",
"content": "Maybe starting off on the disclosures. I mean, obviously, Dan, we've seen some major moves in the curves in recent weeks. You guys didn't really update the ranges on the enhanced gross margin for '24 and '25. Obviously realize you guys gave wide ranges, but I mean where are you relative to those curves, these curves?"
},
{
"speaker": "Daniel Eggers",
"content": "Yes, we gave a huge amount of disclosure as you captured on the last call. Our approach to updating those is really going to be when we do a more comprehensive revisit of our guidance, right? What goes into enhance is more than just a power price, there's a lot going on in the commercial business and other positioning. So I think when you see us assuming we update our earnings guidance or our range as the year goes on, I think that's a good opportunity to refresh the disclosures we have, including our expectations for enhanced in '24 and '25."
},
{
"speaker": "",
"content": "I think when you look at the curves, and Jim can share more thoughts on this, right, but there's been a lot of movement, depending on what day you pick. There's the price has been -- a lot of different prices, the near end of the curve, particularly in our markets has been probably more muted right at the back end where you're seeing a lot of the news largely. So I don't know that within the range you laid out that there's a lot of movement to what we shared with you for '24, '25 at this point in time. And Jim, do you want to talk about markets?"
},
{
"speaker": "James McHugh",
"content": "I think you hit it. I think that if you look out at more the '27, '28, '29 time frame, the market run-up we saw during the first quarter has kind of held on and maybe gone a little higher. The '25, '26 time frame has been a little bit more volatile in both directions, and that volatility is which Joe spoke to, right? When we see the continued baseload retirements and renewable penetration with energy demand, we're going to see volatility up and down. The out-year strength, I think, is certainly reflective of some of this increased demand that we're talking about, it's not real liquid out there. There's not a lot of trading volumes that can be done out in that time frame."
},
{
"speaker": "",
"content": "And as Dan mentioned, in our last call we provided, the attribute value side. I think that's a good proxy for how price movements, whether it's energy prices or attributes or whatever could be picked up in some of our enhanced earnings. So there's some data, I think, from the last call that you can pick up there."
},
{
"speaker": "Shahriar Pourreza",
"content": "Okay. It's perfect. So I guess, for '26, '27, '28, whatever, are you still within that 10% to 20% of consolidated range as a general rule of thumb?"
},
{
"speaker": "Daniel Eggers",
"content": "I think we use that as a rule of thumb, and I don't want to mark to market. But Shah, if you go back to the slide we had on attribute value in '28, you had $10, which is like the curve might have moved depending on market in that range. You can see those numbers get bigger and inevitably push you out of that 10% to 20% if you're just going to mark that one variable right now."
},
{
"speaker": "Shahriar Pourreza",
"content": "Okay. Perfect. And then, Joe, lastly..."
},
{
"speaker": "Joseph Dominguez",
"content": "It's Joe. I just want to reiterate the point that I think Jim and Dan are making. There's definitely -- we're certainly seeing upside if you were to freeze this moment in time in terms of the power prices later in the decade, but they're not all that liquid right now. So we'll see how it kind of evolves over time. And the right point for you to look at us is when we talk about guidance ranges, again, as we get through the year, we'll provide some more data points on that stuff. But I think it's exciting to see all of that it also is in a liquid market out there."
},
{
"speaker": "Shahriar Pourreza",
"content": "Yes. No, I appreciate you addressing that because I mean, that's one of the key questions coming in to us is why didn't you mark like some of your other peers. So I appreciate the color there, Joe. And then just lastly for me, there's been a bunch of industry chatter on this. Are you considering a TMI restart at this time? If so, can you maybe talk a little bit about the capital involved in that and the time line?"
},
{
"speaker": "Joseph Dominguez",
"content": "Shah, what we'll say is that we've obviously seen what happened with Palisades. I think that was brilliant, brilliant for the nation saw great support out of Michigan, great support out of the federal government. And we're not unaware of that, that opportunity exists for us. So we'll -- we're doing a good bit of thinking about a number of different opportunities, and that would probably be certainly one of those that we would think about. But we're not there yet to start disclosing capital and other things relating to that opportunity."
},
{
"speaker": "",
"content": "A lot of exciting things for us to do in uprate space as well. And I think you could kind of -- if these things fall into place, you could kind of see where Constellation might be the nation's leader in adding firm, clean energy to the grid. And so these things are huge, chunky things that really position America for the future. So we're going to stick with that until we have something more specific to report."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Steve Fleishman with Wolfe Research."
},
{
"speaker": "Steven Fleishman",
"content": "I'm a little more of a peanut butter and chocolate Reese's fan, but I like the peanut butter and jelly reference. The -- just on the data center opportunity, maybe you could just give us a little more color because there's a lot of utilities talking about data center growth and even some of the companies talking about data centers related to gas plants. So just first on just -- first on the demand that you're seeing, but then maybe more importantly, any sense of kind of timing and just other things to execute beyond just customer demand? Like are there hurdles you need to get through on permitting, citing other things that set timing gap?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, Steve, I think the interest is like nothing else we've seen in 20 years in terms of the number of clients that are coming to us, the size and scale of the opportunity. So I would say that kind of the -- what you're hearing in the market is certainly accurate in terms of the inbound that we're getting from an origination team perspective and frankly, some of the outreach we're doing. So that's all seems to be right. Right now, it's focused on nuclear because the clients we're dealing with aren't interested as a general rule in emitting technologies. They have sustainability goals. They have 24/7 clean goals, and they want to stay on that path. So we're focused right now on the nuclear plant opportunity and monetizing the value of the attributes that we have."
},
{
"speaker": "",
"content": "But these are, as I mentioned earlier, very complicated. What's apparent to me is that our prospective customers in this space are all in a hot competition, one against another to grow this kind of capability, and there's a clear view out there that those companies that move most quickly will be the companies that get a durable advantage in this space. So they're incented to move very quickly. And we are too. We want to get this business going and to show the results to our owners. But with that said, Steve, there is complexity to these transactions. These are transactions that are longer in duration than any of the power contracts that we're used to talking about in this business and involve notional values that are quite a bit higher."
},
{
"speaker": "",
"content": "So there's work that needs to be done diligence that needs to be done. In terms of things that are connected in front of the meter and if we're going to talk about PJM, for example, there's a load integration process that people have to get through in order to site a data center on the grid. And this is a network integration service study that could take months at best and years at worst. So a number of these customers are looking at co-location opportunities to hasten the speed in which they could become operational."
},
{
"speaker": "",
"content": "So if you're looking behind the fence line of the plan or a co-located opportunity, there's a necessary study process. It's another PJM process and PJM was clear in its amendments to its documents most recently that you could go either on the grid or behind the fence line, but there's a different process. We have become quite good at using the tools that PJM uses in their necessary study work so that we could look across our fleet at places where we think we could add the load behind the fence line. We went through a necessary study process at LaSalle. And as it so happens, we were doing that in the case of the hydrogen hub that was intended to be built out there. So we did a study for 900 megawatts and we were able to match up very closely our ability to model PJM's work and be able to simulate that here at Constellation."
},
{
"speaker": "",
"content": "So I would say that we know very well where we could co-locate data centers and get through the PJM process, but that's a necessary study process that could take anywhere from 6 months to a year to resume. And once you have that, it goes through, I don't want to say perfunctory, but a fairly routine FERC approval process. And that would be the starting point. So if you have a necessary study done, what you're really talking about is having the transformers and the infrastructure, but you could kind of break ground pretty quickly. You don't have a necessary study done. You're going to have to wait for a year to figure out where you could co-locate."
},
{
"speaker": "",
"content": "And then on the data company side, they also have the time that they need to build out the shell, the infrastructure, supporting all of the equipment inside cooling and likewise, and then actually build out the servers inside of it. So you have to anticipate a ramp rate. So from my perspective, this isn't something you're going to see people plop into service in '24, '25 [ towns ] ahead of others because they started earlier. But this is more stuff that begins in '26, '27, '28 and it ramps over time as the data centers are built. No one is plopping down a 1 gigawatt data -- and I've read reports of this. No one is plopping down a 1-gigawatt data center in 6 months to believe that completely and thoroughly misunderstands the amount of work needed to get this stuff done."
},
{
"speaker": "",
"content": "So the contracts have a scaling component to them. You saw kind of an example of that in the town, the Susquehanna deal that was done. That's similar to ramp rates that you would see in other things. And that's why I'm pretty confident we'll be able to manage the energy demands on the system because you likewise will ramp into this load. So that's what I'm seeing here. A couple of years before you're able to really start delivering the megawatts and then it ramps steadily after that. What we're trying to do is get the contracts done that lay out the gross amount of megawatts that are going to be needed, the time frame over which they're going to be needed and allows us to begin necessary infrastructure work with an understanding that we're doing the PJM study and other things on a parallel path even as we speak here this morning."
},
{
"speaker": "Steven Fleishman",
"content": "Okay. Is it -- do you think you'll be able to have something to announce by the end of the year?"
},
{
"speaker": "Joseph Dominguez",
"content": "Look, I'll stick with this. We are working fast. Our clients want to work fast. For competitive reasons, I don't want to lay out when we think announcements are going to come, and I don't think it would be fair to our clients to do that either at this point. There's work that is underway. We've got a lot of folks thinking about it and working on it, again, as this call is progressing. So I'm confident that we are going to be able to get to the finish line on these things, but we still have some work to do. And I don't want to lay out a time frame for announcement."
},
{
"speaker": "Steven Fleishman",
"content": "Okay. Just one other quick question. The law that passed on the Russia limits on nuclear enriched -- nuclear and then investing in U.S. enrichment. Can you just talk about your nuclear fuel -- update on your nuclear fuel positioning and the impact of that law?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes, Steve, I think on this one, there's not a whole lot more to report. In effect, we -- when we took the actions we took a couple of years -- over a year ago now. We were anticipating the passage of the band as we reported at the time. It took a little bit longer to get through Congress, but it's now there. It's now realized. So I think it just simply supports the strategy that we put in place a year ago. We think we are in a very solid position, kind of industry-leading solid position with regard to fuel. And we also are happy to see now investments in this domestic supply chain, which means that after this period of time where we've grown inventory, we're confident that we're going to have available and recently priced fuel to run this fleet for the next decade."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Durgesh Chopra with Evercore ISI."
},
{
"speaker": "Durgesh Chopra",
"content": "Maybe just -- you obviously authorized additional $1 billion in share buybacks. I know there is no direct answer to this, but can you just help us kind of think through what is your calculus when you're thinking about incremental investment opportunities versus deploying capital on share buybacks and considering M&A in the future?"
},
{
"speaker": "Joseph Dominguez",
"content": "Yes. I don't mind talking about it at all. It really is a summation of everything we've talked about in the call. We think we have a very good strategy here. We think as we compare that to M&A opportunities, the unrealized value in Constellation seems to be the best place for us to put our investment dollar right now. It has -- we have been buying shares of this company since we were, what, in the $80 and we saw a little bit of a drop in prices. We had some kind of negative, I would say, analyst reports at that point in time. We didn't believe it. We told you we didn't believe it. We told you we'd buy the company all day long. We still feel that way today because what we're looking at is the potential growth in our business, the opportunities that we know we're working on, the fundamentals and power markets and sustainability goals that I talked about earlier."
},
{
"speaker": "",
"content": "I think that unrealized value is the best thing out there to go buy into. And so when we have extra cash, we're going to buy into that, and that's precisely what we're doing. The only thing that will like better than that is making ourselves bigger and better. So these uprate opportunities or other things where we could add megawatts of scale give us a great positioning and are actually supportive of the work we're doing with the data companies. So that's where I think you're going to see our deployment and capital. We'll continue to look at reinvesting in ourselves and investing in these organic opportunities. Presently, I don't see an M&A opportunity on the horizon is at a scale that is going to enter into this conversation because I don't think those opportunities provide equivalent value to our owners is investing in ourselves for the growth -- organic growth opportunities that we have here."
},
{
"speaker": "Durgesh Chopra",
"content": "That's very clear, Joe. I appreciate all that color. And then can I just switch gears and quickly a follow-up in regards to the nuclear PTC guidance, what is the key -- what are the key items for us to look there? Is it the definition of gross receipts and just how do you see that playing out? Anything you can share there?"
},
{
"speaker": "Joseph Dominguez",
"content": "Well, I wish I could. We're waiting for treasury guidance as we've probably said this on [ forward ] calls. But it is not as near as we could tell a high priority item for treasury because it has a narrow application out there. It's really just nuclear owners that are looking for. We think spot is most likely going to be the thing that prevails. So the spot price over the year at the bus of the plant, that's going to be energy and capacity coupled together, are going to be the measuring stick that the treasury will use for the application of the PTC. That's kind of consistent with the vast majority of the comments in this area. That's certainly, we think that's where they're going. But we just don't know yet because they haven't announced anything, and we're waiting on that. But our planning is based on that spot interpretation as we've outlined previously."
},
{
"speaker": "Operator",
"content": "At this time, I would now like to turn the call back over to Joe for closing remarks."
},
{
"speaker": "Joseph Dominguez",
"content": "Well, again, [ Towana ] thank you for kicking us off this morning. Thanks to all of you. We very much appreciate your interest in Constellation. I want to thank our women and men for a fantastic quarter. We look for more to come as the year goes forward. You know we're working on a lot of different things here at the company. The wind is at our backs, we feel very confident about the future and the fact that our best days are ahead. So look forward to catching up with you again on next quarterly earnings call. With that, I'll close the call."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a great day."
}
] |
cf | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to CF Industries Full Year and Fourth Quarter 2024 Conference Call. All participants are in a listen-only mode. [Operator Instructions] We will facilitate a question-and-answer session towards the end of the presentation. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the presentation over to the host for today, Mr. Martin Jarosick with CF Investor Relations. Sir, please proceed."
},
{
"speaker": "Martin Jarosick",
"content": "Good morning, and thanks for joining the CF Industries earnings conference call. With me today are Tony Will, President and CEO; Chris Bohn, Executive Vice President and Chief Operating Officer; Bert Frost, Executive Vice President of Sales, Market Development and Supply Chain; and Greg Cameron, Executive Vice President and Chief Financial Officer. CF Industries reported its results for the full year and fourth quarter of 2024 yesterday afternoon. On this call, we'll review the results, discuss our outlook and then host a question-and-answer session. Statements made on this call and in the presentation on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in these statements. More detailed information about factors that may affect our performance may be found in our filings with the SEC, which are available on our website. Also, you'll find reconciliations between GAAP and non-GAAP measures in the press release and presentation posted on our website. Now, let me introduce Tony Will."
},
{
"speaker": "Tony Will",
"content": "Thanks, Martin, and good morning, everyone. Yesterday afternoon, we posted results for the fourth quarter of 2024, in which generated adjusted EBITDA of $562 million. Adjusted EBITDA for the full year was $2.3 billion. This strong performance enabled us to return $1.9 billion to our shareholders through dividends and share repurchases in 2024, which is our highest level of capital return in more than a decade. The CF team is operating at a high level, advancing our strategic initiatives and most importantly, working safely. Given our fully engaged employees, our low-cost manufacturing system with the highest onstream factors in the industry. Our expansive distribution and logistics network and very constructive nitrogen industry fundamentals. We are well-positioned to continue our track record of generating superior free cash flow that enables the company to both grow and return substantial capital to shareholders. With that, I'll turn it over to Chris to provide more details on our operating results and the status of key initiatives. Chris?"
},
{
"speaker": "Chris Bohn",
"content": "Thanks, Tony. Our production network operated extremely well through year-end. We produced over 2.6 million tons of gross ammonia in the fourth quarter, which reflects 100% ammonia utilization rate. We finished the year with 9.8 million tons of gross ammonia production. Our manufacturing network has continued to operate well to start 2025 and did not experience any significant disruptions from recent winter weather events. We expect to produce approximately 10 million tons of gross ammonia in 2025. We are making good progress on our key strategic initiatives. The completion of our carbon capture and sequestration project at our Donaldsonville complex is in sight. Commissioning activities for the carbon dioxide dehydration and compression unit have begun alongside final construction activities. We expect start-up of carbon sequestration and 45Q tax credit generation this year. Our evaluation of a greenfield low-carbon ammonia plant at our Blue Point complex in Louisiana is also nearing completion. As Greg will detail shortly, we completed the FEED study for an auto thermal reforming ammonia plant, marking a major milestone towards this strategic initiative. We continue to assess project in light of our outlook for the global nitrogen supply demand balance, customer requirements for carbon intensity and the regulatory environment. We are working to complete the partnership structure. We expect that our ownership of the project will range from 40% to 75% depending on the number of equity partners at the outset. If we were to make a positive final investment decision at a 75% ownership level, we believe we would have the option to sell down that level if we chose to give an ongoing discussions with other potential partners. We continue to target the first quarter of 2025 for final investment decision. With that, let me turn it over to Bert to discuss the global nitrogen market."
},
{
"speaker": "Bert Frost",
"content": "Thanks, Chris. CF Industries had a positive fourth quarter of 2024 that is carried over into 2025. We had a very strong fall ammonia application season and have built a strong order book for all products as retailers and wholesalers layer in product tons for what they believe will be a good spring application season. We ended the year at lower than average inventory levels in our network, and believe the North American channel is at low levels as well due to lower-than-normal imports into North America. As we move to the fourth quarter, global nitrogen market participants began to appreciate how much the global supply-demand balance has tightened. Nowhere was this more evident than India's inability to secure the volumes they targeted for the last two urea tenders. Given the high urea consumption in the country and lower-than-targeted production, we expect India issue another tender later in the first quarter just as the Northern Hemisphere demand ramps up for spring, demand that we expect to be very strong. World corn stocks and world's corn stocks-to-use ratios, excluding China, are at a 13- and 30-year low, respectively. Given the need to replenish global corn stocks and a corn to soybean ratio favorable to corn, we expect robust planted corn acres and strong nitrogen demand in the United States 2025. Longer-term, we expect the global nitrogen supply-demand balance to tighten through the end of the decade. Capital availability, long-term feedstocks and costs and global events have limited the number of new projects. As a result, projected new capacity growth is not keeping pace with demand growth for traditional fertilizer and industrial applications. We believe demand for low-carbon ammonia for low -- for new applications, such as power generation, would only further tighten the global supply-demand balance. With that, Greg will cover our financial performance."
},
{
"speaker": "Greg Cameron",
"content": "Thanks, Bert. For the full year 2024, the company reported net earnings attributable to common stockholders of approximately $1.2 billion, or $6.74 per diluted share. EBITDA and adjusted EBITDA were both approximately $2.3 billion. For the fourth quarter of 2024, the company reported net earnings attributable to common stockholders of approximately $328 million, or $1.89 per diluted share. EBITDA was $582 million, and adjusted EBITDA was $562 million. Net cash from operations was $2.3 billion, and free cash flow was approximately $1.45 billion. We continue to be efficient converters of EBITDA to free cash flow. Our cash flow to adjusted EBITDA conversion rate for the year was 63%, which far exceeds our peers, as you can see on Slide 5. We returned approximately $1.9 billion to shareholders in 2024. This included $364 million in dividend payments and over $1.5 billion in share repurchases. For the year, we repurchased 18.8 million shares, representing 10% of the outstanding shares at the beginning of 2024. Entering 2025, we had a little over $1 billion remaining on our current share repurchase authorization, which we intend to complete before its expiration in December. Based on market capitalization at the start of the year, we have the capacity to repurchase approximately 7% of our outstanding shares through the end of 2025. As Chris mentioned, we completed the FEED study for a 1.4 million metric tons per year ATR ammonia plant with carbon capture and sequestration technologies. The study estimates that the cost of a project with these attributes would be approximately $4 billion, which will be divided among the equity partners. At this level of capital investment with the incentives of carbon capture, and an ammonia price of $450 per metric tonne, we'd expect to earn a return above our cost of capital. There is an additional $500 million required for scalable common infrastructure, which would be CF Industries sole responsibility and can be leveraged for future growth at the Blue Point complex. Should we move forward, we'd expect the common infrastructure would also earn a rate of return above our cost of capital due to the payments from the ammonia plant owners for the use of the facilities. With that, Tony will provide some closing remarks before we open up the call to Q&A."
},
{
"speaker": "Tony Will",
"content": "Thanks, Greg. Before move on to your questions, I want to thank everyone at CF Industries for their contributions in the fourth quarter and for the full year. As a company, we have a lot to look forward to in 2025. From constructive global nitrogen industry dynamics to the start-up of our first CCS project and a final investment decision on our Blue Point complex. We're excited for what's ahead. Investing in our business to increase cash generation, while dramatically reducing our share count has served our shareholders well. As you can see on Slide 8, in the last decade, since most of this team has been together running CS, we have increased production capacity by almost 20%, while reducing our shares outstanding by almost 30%. What this drives is clearly shown on Slide 5 of our deck, and we have boxed the most relevant data. And this is how we run our business to generate more free cash flow while reducing our share count. It is exactly this ratio that demonstrates the superiority of our business model. In the very near-term, in this year of 2025, we have a couple of initiatives that we'll continue to build on this track record. The 45Q tax credit is expected to begin this year as we sequester CO2 from Donaldsonville. We will also complete our share repurchase authorization, which, as Greg mentioned, should take out another roughly 7% of our outstanding shares pro forma. Over the longer term, we expect investments in our network and low-carbon ammonia production capacity will provide a robust growth platform for the company, add to our cash generation and continue to drive that all-important golden ratio shown on Slide 5, creating substantial value for our long-term shareholders. With that, operator, we will now open the call to your questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joel Jackson with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Joel Jackson",
"content": "Hi. Good morning. I wanted to ask you about your hedging. You talked about in the past couple of quarters that maybe you weren't layering on as many strips or hedging as you had this past, looks like you quite well in Q4 to get ahead of the higher gas prices. We've now seen, of course, US gas prices surge. Talk about how open you are what your GAAP or like for Q1, Q2 for the rest of the year? And what we're seeing, the more volatility, Tony and team, is this making you rethink your DAS hedging strategy going forward? Thanks."
},
{
"speaker": "Bert Frost",
"content": "Hey, good morning. Joel, this is Bert. And how we look at gas is how we look at the dynamic nature of our business, and it's just one reflection of that. In terms of how we manage margin, how we manage costs, how we manage CapEx, Gas is a substantial cost for us, and we look at it holistically. And so we have been much more in the cash market in 2024. We do hedge front month for our gas contracts, but we've been much more opportunistic in 2024, believing in the resource base that exists in North America for our system. How we're looking at 2025 is we've approached it very similarly where we were and have been hedging front month for our commitments and then just for the weather volatility of January and February as well. And we anticipate that the gas team will continue to perform very well and position CF in a great place."
},
{
"speaker": "Tony Will",
"content": "And Joel, relative to the second half of your question, I would just say we operate the vast, vast majority of our production capacity in the best place on earth to operate it, which is North America with some of the largest resource, most dependable production and quickest to respond. And so while we'll continue to evolve our thinking around hedging and Burton and team continue to do that actively. I think that the most important thing is where we built our plans."
},
{
"speaker": "Joel Jackson",
"content": "And then if I can ask a second question. An observation I had last night, and I'd like you to maybe comment on it is you gave -- and I appreciated a new sensitivity table you do every year around now based on 2024 numbers, where you show what your EBITDA level is in a grid for different gas price realizations and different urea price realization. It looks like when you look at the 2024 table versus 2023 table on a similar volume around 90 million tons at any given cell in that grid to any combination of urea and gas prices, you're pointing to EBITDA being maybe $200 million or $300 million lower. Can you talk about what that means, if it means anything?"
},
{
"speaker": "Tony Will",
"content": "Yes. So let me just describe how that grid is put together. And it is not meant to be strictly speaking, instructive about what the future holds. It's based on last year's actual product price differentials between ammonia and urea, UAN, ammonium nitrate and the rest of the products and how they fit in there. And so to the extent that in any given year, you see the differential between urea and say, UAN move one direction or the other, that's going to change how that grid is created because there's more or less value than across the system based on selling one ton of urea. So it's purely a heuristic, it's just a way to sanity check the numbers. It's not a pinpoint estimate of where we're at. To do that, you'd really have to get into the details of where gas is really moving across the network, not just in the aggregate because, of course, we're consuming vast majority of our gas and the combination of Henry Hub and AECO. And so what the other ones with the other pricing points, trade out matters, but it's very specific to the year movements and the product movements. And so you have to get a little more granular, but at the very high level, that gives you directional information of where it is. And that's why it tends to move one year to the next. It's strictly based on the previous year's differentials."
},
{
"speaker": "Chris Bohn",
"content": "Yeah, Joel, this is Chris. The other thing I would add, Tony talked about the price and basically the relationship between each of the products. But additionally, since we are using a look back to 2024, our cost structure is also the 2024 cost structure. And if you recall, in Q1, we had pretty heavy maintenance events where at one point, 15 of the 17 ammonia plants needed maintenance, and that was about $100 million to $150 million. So as Tony said, it's really indicative of what you could see for the year, but it is based off of empirical data rather than what we expect for the go forward."
},
{
"speaker": "Joel Jackson",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Parkinson with Wolfe Research. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Hey guys, good morning. It's actually Andrew [ph] sitting in for Chris. How should -- the Street think about 2025 cash conversion and the balance of uses between buybacks and then future CapEx, and then on top of that, would you be able to talk about the potential for long-term offtakes in conjunction with any BluePoint FID. And how does that fit into the picture here as well?"
},
{
"speaker": "Greg Cameron",
"content": "Yeah. Andrew, thanks for the question. It's Greg. I'll start and pass it over to Chris. On the capital allocation for the year, we've outlined where our CapEx is expected be over $500 million of our normal run. That would, obviously, change if we went to a positive FID and we'd update you on those numbers when we made that decision. On the capital allocation, we came into the year with $1.6 billion of share repurchase that we expect to expect to get done by the end of the year. And those would be our primary uses of cash. Don't expect any change in difference on our EBITDA conversion rate. We still expect to be above our peer group on our ability to convert that EBITDA free cash flow. So no change in that at all. But we'll update you on the CapEx number when and if we make a positive FID and we've already laid out the share repurchase we expect to do for the year."
},
{
"speaker": "Chris Bohn",
"content": "Yeah, Andrew. And in relation to long-term supply offtake related to the BluePoint project, I think a lot of that's going to be dependent on where we end up from a partnership equity share piece. If we're at the 75% that CF has as we go through, as I mentioned, we are having discussions with other global partners who are interested in this particular facility with an offtake agreement that would happen there. But if we go with the 40% where we have the Mitsui JERA and CF themselves. A large portion of our product, given that we purchased ammonia already for the U.K. could find its way going to the U.K. and that that incremental amount that we would have for a long-term offtake contract would probably be smaller. So a lot of it's going to be dependent on what is the final ownership structure that we'll know here in the next couple of weeks."
},
{
"speaker": "Tony Will",
"content": "But I would say, back to Chris' point, there's a lot of interest out there. And I think what you've seen is a bunch of these kind of people waiting in or making initial announcements and then getting cold sheet backing of has led a bit of pent-up demand out there. And so if we ultimately do go forward with a positive FID decision here, I would expect there to be more than adequate demand for the production that's that we have left."
},
{
"speaker": "Operator",
"content": "The next question comes from Richard Garchitorena with Wells Fargo. Please go ahead."
},
{
"speaker": "Richard Garchitorena",
"content": "Great. Thanks for taking my question. Just to follow-up on the Blue Point. Obviously, FEED study completed negotiating with the partners, still nothing determined yet. But I mean it sounds that basically the outlook from a demand and market perspective, you've found to be, I guess, positive for the project. So I guess in terms of final decision, how much does the potential for 45Q to be changed. I don't have any impact at all? Is it really just a function of marking down where you want to stay in terms of your equity stake whether it's 40% to 75%. And then in terms of just all the final decisions with the partners getting ratified?"
},
{
"speaker": "Tony Will",
"content": "Yes. I mean, I think the big issue there -- obviously, the 45Q is a benefit to the project and the required ammonia price to earn above cost of capital return would go up if we didn't have the 45Q. But there's nothing really that we're seeing on our end when our government folks talk to people in Washington that indicates to us that the 45Q is in jeopardy. I think if you were banking on an EV subsidy or credit, then you'd have to think twice about it. I the 45Z and 45V potentially have a little more risk, but there's really been no news from our perspective that jeopardizes the 45Q. So we're pretty confident that, that's going to stay in place and we're making plans accordingly. But there's a lot of moving pieces out there, and there's a lot of policy things that are uncertain at the moment. Of all the policy issues, I think that one we feel probably the most certain of. And I do think what is kind not delaying, but the process that we're going through is really dotting eyes and crossing teas on all of the subsidiary contracts that go along with being able to actually build and move the thing forward. It's not so much with the partnership structure themselves because we feel really good about that. It's just kind of getting all of the other EPC kind of stuff done."
},
{
"speaker": "Operator",
"content": "The next question comes from Lucas Beaumont with UBS. Please go ahead."
},
{
"speaker": "Lucas Beaumont",
"content": "Good morning. So I just want to continue on the Blue Point project. So depending on what you guys kind of come in there on that equity range, if you guy ahead it could be quite -- it's a pretty wide range from sort of $2 billion up to maybe $3.5 billion or so. I think what we previously sort of discussed the outlook there, it was assumed it would probably get built over the four years in the capital commitments more sort of back half weighted. So, just given the kind of the range you're putting out there now, I was just wondering how you'd look to kind of fund that? Would you sort of add some more debt in there to do that? I mean, it looks like potentially depending where sort of market prices are, you could do it out of cash flow if you sort of didn't have any repurchases anymore, but just wanted to kind of get your latest thoughts on sort of how that progress?"
},
{
"speaker": "Greg Cameron",
"content": "Yes. Thanks for the question, Luc. It's Greg. So, when we look forward and look at the commitment, you're right, it's going to be determined by the size of the equity we have commitment and where that ultimately ends up. If you looked at it at the 40% and you thought about it over four years, and even including the common facilities, it's roughly about $500 million that we would need to create in addition. Given where we are on a free cash flow basis and the investments that we tend to make within our network on a year-to-year basis, including the growth CapEx that we put in it's not dramatically larger. It's obviously larger, but not dramatically larger. So as we think about where we are from a capital standpoint, we've got $3 billion of debt. We've obviously got some of that coming due next year that we'll have to look into. But there's a bunch of options as we think about how we would fund it, first, starting with the cash that we have on the balance sheet and go to cash from operations. And to the extent we would want to think about building some more security, there's a number of instruments we could look at to pull in, and we're in the process of evaluating that all right now."
},
{
"speaker": "Tony Will",
"content": "I mean I think if you just look at last year, we generated $1.4 billion of free cash. And we're going to spend $1 billion as Greg said on or a little over on share repo. That still leaves a big chunk to be able to deploy against the other uses of cash, and we ended the year with over $1.6 billion of cash on the balance sheet. So, our uses of cash this year, even though we're going to buy $1 billion of shares back out of the market is not going to dip very hard into our cash on the balance sheet and during this period of time. we have indications that the pricing environment today is stronger than it was a year ago. And so that portends very well for cash gen in 2025 versus 2024. So, I think all of that is a way of saying we think the business model is kind of hitting really well, and it gives us a lot of flexibility in terms of how we think about financing a potential project should we go forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Wong with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Andrew Wong",
"content": "Hey good morning. Thanks for taking my questions. So, long-term focus for CF has been on increasing nitrogen production or participation per share over time, which has gone up pretty significantly. When you look at Blue Point, given the increase in CapEx, while the shares are roughly flat year-over-year right now, like how would you compare the project versus potentially using that cash for more of buybacks in terms of raising that nitrogen per share metric? And how does that factor into your decision on Blue Point."
},
{
"speaker": "Tony Will",
"content": "Yes. I mean, Andrew, I think throughout our this management team's time together, you could have made that comment about anything that's gone on, whether it was the acquisition of Terra back in 2009, 2010, whether it was the construction of our capacity expansion projects back in the 2012 to 2016 time frame, the acquisition of the one-third of Medicine Hat that we didn't own or the 15% of the Verdigris plant that was traded as an MLP. I mean, any of those things you could have made that same argument for and yet look at the share growth in terms of value we've created over that period time. And so I think the general strategy and philosophy of if we can deploy capital in our core business and earn above the cost of capital rate of return. And then for capital that is in excess of that, we take down share count. That is a winning formula. And if you look at our one, three, five, seven, 10 year TSR against all of our competitive set, we blow them out of the water. So it's just -- it's a winning formula. If we can stick on it and be very focused to deploy capital in things that we do better than anyone else, which is running ammonia plants. We're going to perform better over the long run, and that's how we're focused on running this company."
},
{
"speaker": "Andrew Wong",
"content": "Okay. Great. And maybe just one more on Blue Point. The commentary in the past would highlight how the project can make a good. Even now till we can make a good risk-adjusted return even without an off-take or some sort of blue ammonia premium. And I understand you're looking at that and you're still thinking that, that's going to be the case. But CapEx has gone up quite significantly from the beginning of when we started seeing some of the numbers like last year, like -- what's changed on that return profile, so that's still the case."
},
{
"speaker": "Tony Will",
"content": "Well, I mean, it's really based on where ammonia pricing is in the market. And as Greg mentioned earlier, the -- what we need is an ammonia price of 4.50 per met, so call it 4.10 per short. And the average selling price we had in last year was above that. And so where the market is right now would support a project with and above the cost of capital rate of return. And we expect, as Chris mentioned, the market to tighten rather than get slack. And so there's a lot about just the industry fundamentals that we feel we're in the best place to really be able to exploit, again, given our operating history with these kind of assets. The other thing I would say is Bert has done a great job of being out there working with customers on the low carbon intensity or Blue product coming out of Donaldsonville that we're going to be generating here later this year. And he is seeing an ability for the market to pay a premium on that. So that's before we even get into the premium, we're just saying we can -- this project is an interesting investment for us before the premium."
},
{
"speaker": "Chris Bohn",
"content": "The other thing I would add, this is Chris, is that when we were looking at some of those CapEx numbers about a year ago, those CapEx were based on SMR technology, so existing what we have in our plants. The ATR technology will give us two different things; one, about 10% more in production, even just that nameplate than what we're producing on our other units. And then also 50% greater carbon capture with the 45Q that allows a significant benefit there. So with those two additional pieces put in, I would say, if you've been falling CF long enough, you would understand that we're a pretty conservative company and we model things straight. So we haven't taken into account increased utilization rates, which we've been able to perform on not only assets we built, but assets we've acquired. Additionally, if there is any low carbon premium that Tony announced or it suggested there. And then lastly would be anything related to the CBAM that would give us a bit of a fast mover advantage where we'd see additional margin. And then lastly, I'd just add this new technology and what we'd be doing is why we have the partners we have. It's fostering new demand that just makes that balance that we believe is tight enough just with conventional ammonia all the tighter by the time this particular plant comes online."
},
{
"speaker": "Andrew Wong",
"content": "Okay. Thank you. Very helpful."
},
{
"speaker": "Operator",
"content": "The next question comes from Kristen Owen with Oppenheimer. Please go ahead."
},
{
"speaker": "Kristen Owen",
"content": "Hi, good morning. Thank you for taking the question. I wanted to ask a little bit more on some of the fundamentals for 2025. Specifically, your expectation of things really remaining quite tight. The cost curve has changed or at least been fairly volatile over the last several weeks. I'm just wondering, can you speak to what your expectations are in terms of the cost curve now with a potential resolution between US and Ukraine on the table? And then I have follow-up question."
},
{
"speaker": "Bert Frost",
"content": "Yeah, good morning. This is Bert. And we do see the fundamentals. They have improved and they are improving. When you look at what has transpired globally, you do have a tight nitrogen balance. And that's driven by very healthy demand in India and Brazil and a lot of secondary countries like secondary in terms of demand of urea. Australia, Argentina, South Africa, Thailand, Turkey had pulled more in 2024 than they have historically. And then you look at the tight corn balance that we've talked about for stock to use ratios whether that's domestic or globally and where we are, it's very comparison to 2012 or 2013, where we saw a very nice rally in the price of corn, that's driving acres and additional acres to corn. And I would have said a couple of months ago, we would have expected 90 million, 91 million acres of corn. And today, we've talked about 93 million, but I would say that's to the positive. And every one million acres that comes in is just additional nitrogen demand that has to be satisfied. And to date, we're behind in North America, we're behind on imports of urea or UAN, and we're very close to the beginning spring application season that could begin as early as March, and so that product has to be put into position for supply. So tight North America, tight globally and the fundamentals of where we are with gas in Europe. Europe production is down or some of it, 20% to 30% of it is. And so you have a tight demand market for the products that use nitrogen being corn, you have a tight supply market with product needed in a number of places, and if there's an India tender in the next couple of weeks, it gets even tighter. And so relative to the cost curve then, we're at $3 to $4 gas in North America and the world for LNG or JKM-TTF being Japan and Europe are at $14 to $15. So your cost curve, you need to bid in very expensive tons to satisfy this global demand that's coming. And your last question about Russia and Ukraine, I would say, it really doesn't matter right now. Those Russian tons have been making them out throughout the last couple of years even with sanctions."
},
{
"speaker": "Tony Will",
"content": "And I would just say, we certainly all hope for a resolution to the conflict and ending the suffering and damage going on over there. To Bert's point, all of the Russian production is making its way out into the global marketplace. So that doesn't change. And our expectation is it would take quite some time to get additional production, whether that be Eastern Europe or Western Europe or even Ukraine kind of back up and running, and it's going to miss the first half of the application season in the Northern Hemisphere anyway. And so from our perspective, the first half, while I wouldn't call it baked yet is looking very positive based on the factors that Bert just highlighted there. But we're certainly all hoping for peaceful resolution to that and other conflicts going on."
},
{
"speaker": "Kristen Owen",
"content": "Thanks for that color. One follow-up question related to your own production. You did call out some of the maintenance costs last year, some of the shutdown time that you experienced in Q1. Just anything we should be thinking about here in the first quarter in some of the earlier ice storms across Southeast and how that will compare or influence your ton-ton to outlook?"
},
{
"speaker": "Chris Bohn",
"content": "Yes. So as I mentioned in the prepared remarks, through Q1, so far, the manufacturing operations have been operating just as well as they were in Q4, even with some of the significant weather events, some of that's from the learnings that we had last year. And just the team is doing an outstanding job at the particular sites. So the 10 million-ton gross ammonia number, which is higher than the 9.8 million we did this year is still our expectation for full year 2025."
},
{
"speaker": "Kristen Owen",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Stephen Byrne with Bank of America Securities. Please go ahead."
},
{
"speaker": "Stephen Byrne",
"content": "Yes. Thank you. Bert, I'd like to hear your view on your order book through the rest of the first quarter and what that order book looks like for the second quarter? How would you compare it to historical levels as of mid-February? And does this reflect your views for being -- the U.S. being behind on imports?"
},
{
"speaker": "Bert Frost",
"content": "Yes. Thanks for the question, Steve. And we're pleased with our order book. I think the team has done a great job of watching participating and layering in. Normally, in this time of year, we try to be -- I'd say most periods were one to two months sold or with orders on the books. I think this year has been a little bit different because of the positive anticipation that we saw with -- relative to the last question on a tight market and some dynamics globally that are taking place. And we positioned ourselves well and have been capturing as the market has escalated. What you've seen over the last eight weeks has been pretty amazing. We've seen $100 rally in urea at NOLA from about $320 to $420, which is since doled out. But we believe that you're going to see additional demand. We're behind on imports, as I said earlier, and we believe you need to bring in 700,000 to 800,000 tons per month, March, April, May to satisfy demand as well as domestic production to remain fully operating. And so as we look to Q2, we've got a lot of open orders to satisfy, and we'll be executing that into the market. And as Chris said earlier, our plans are operating at 100% and we're positioning product now for that eventual demand. So that gives you the Q1, Q2 outlook."
},
{
"speaker": "Stephen Byrne",
"content": "Very good. Thank you. And I just wanted to follow-up a little bit on the brownfield project, a diesel for the blue ammonia. Do you have any -- any idea when that actually could start up. I'm not sure whether you're still in installation or whether you are in commissioning mode, but do you have a better idea when that might start? And perhaps more importantly, do you have an order book for that blue ammonia that you could be selling some time this year? And does it not make some sense to wait for that to be on stream and to see what demand really looks like when you have that product available before you commit to FID on the greenfield project."
},
{
"speaker": "Tony Will",
"content": "I think, there's a bunch of questions in there. We'll start off with how the dehydration compression plant coming, when you go on and then what's the what's the premium or demand profile look like. And then I'll finish up with the answer to -- to the last one. But"
},
{
"speaker": "Chris Bohn",
"content": "Steve, this is Chris. So we're continuing. We are not in commissioning yet, so we're still in installation, but our expectation is that we will finish that here in the second quarter. And what we're looking at is that we're being commissioning and ready begin sequestering it really second quarter, first half -- second half of the year here as we look at that we continue to work with Exxon as they're evaluating different areas for their Class 6 permit that they have in there, given the flexibility they have with the Denbury pipeline. So all that continues to move well. And so I would say our estimation is by second half of this year, we'll have low carbon product that we can feed to Bert his team."
},
{
"speaker": "Bert Frost",
"content": "And regarding the premium, we've been actively discussing marketing and preparing for that, whether that be ammonia or an upgraded product. And I think the first mover, it looks to be industrial where we have a number of participants or customers desiring to have low carbon products in their system. And then we're working, obviously, agriculturally with our co-op and retail customers to market a whole package to the farming community of how that can benefit their system and their carbon scores. And so yes, I do believe there will be a premium. And yes, that product is coming for the back half of the year."
},
{
"speaker": "Tony Will",
"content": "And finally, Steve, because of the success Bird has had and the level of interest that he's had, we don't need to wait until we're producing it. We've already got registration of interest from more parties than we have tons to be able to sell at this point. And again, let me just remind you of the kind of the math on the new project. So, if it's 1.4 million tons, and we get a 50% share, just say, as a as a number. We're looking at 700,000 Chris mentioned, we're going to consume 350,000 tons of that in our upgrade at plants in the U.K. So, we'll have low-carbon AN product in the U.K. with access to the European market. that only leaves us 300,000, 350,000 tons left to go in terms of places to sell it, and we have more than enough interest to be able to move that because we've already got expressions of interest that can consume the full 2 million tons coming out of Deville."
},
{
"speaker": "Stephen Byrne",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Vincent Andrews with Morgan Stanley. Please go ahead."
},
{
"speaker": "Vincent Andrews",
"content": "Thank you and good morning everyone. Just on Blue Point, if I could ask you, Tony, the $4 billion and the $500 million, I assume that's the standard midpoint of -- there's plus or minus 15% on that? Or is there something different about this? And is there any part of that, that you think you can really lock in, whether it's labor, equipment, what have you to really sort of ring-fence the risk around that estimate moving too far in the wrong direction?"
},
{
"speaker": "Tony Will",
"content": "Yes, Vincent, thanks for the question. This is a little bit different than the midpoint of the estimate. We sort of learned our lesson last time when we began this -- the projects back in 2012, which was more or less the midpoint. And then we saw escalation happen and it was a painful process to have to get out there on conference calls and talk about both delays and overruns. So, I would call this a number that we're putting forward to the marketplace that we feel highly confident in our ability to achieve and there's quite a bit of contingency baked into that. So, if you just think about the $4 billion for the plant itself, we are taking a different approach. The previous projects were what I would call stick construction where everything was individually built. And in this approach, we're doing more modular construction where large sections of the plant will be constructed overseas shipped here, and then they're basically positioned and put together. Because of that, we can take almost $2 billion of the production and have it be lump-sum fixed in terms of these module construction. So the amount of kind of potential open to overrun is dramatically reduced in this instance relative to the way we approach these in the past. And then there's other sections whether it's the ammonia storage tanks or the docs or a variety of other things that we can convert into fixed fee kind of arrangements as well. So, there's much less, I would call at risk in that quote, which is why we're highly confident we can deliver the project."
},
{
"speaker": "Chris Bohn",
"content": "And the only thing I would add to that is, on those last projects, what really caused the cost overrun was the labor expense. And as Tony mentioned, with process modules, a lot of that labor percentage is going to be significantly lower than what we've seen in the past. So for instance, on those particular projects, we may have had 5,000 contractors on site at one point. In this particular one, maybe at peak, we had had 1,500 because so much of it would already be modularized, and that we feel comfortable within that contingency. The other part I would say that is probably one of the primary differences just beyond the experience the team has with doing the last projects is, we did a complete FEED study this time. We've been analyzing this for over two years, what would be the best technology, understanding exactly how we would go about doing this. If you think about the last project, our speed to move as fast as we could, we didn't even have full FEED studies on those particulars. So I think the planning process, the reduction in actual construction labor time is going to be helpful in this as well."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. And just as a follow-up on the 40% versus 75%. I mean, it sounds like you're very confident in terms of the demand outlook and so forth. So I'm just curious why -- what's going to drive the delta for you between the 40% and 75%? I mean, in one case, you have complete control over the project. In the other case, you don't. So what makes it in your best interest to bring it down to 40% versus just going out at 75%?"
},
{
"speaker": "Tony Will",
"content": "Yeah. I think to be perfectly honest, whether it's with one partner or two, and we have received very strong degree of confidence that it's going to be both partners. And because we have been on this journey for such a long time, we've made a commitment to them that they're in if they want to be in. And so -- but you're not over the finish line until everyone signs on the dotted line and you make an announcement, but that's the difference. And at the end of the day, Vincent, part of what we're trying to do with this first plant is to help spur development of new applications for clean ammonia, because we think that's just good for our business in general, good for the world from an environment standpoint. And having more people involved that are going to be direct to consumers and take this all the way to its final use, it’s I think, good in helping develop this marketplace. And so we're doing a little, I would call primary demand stimulation by having these people participate with us."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "The next question comes from Edlain Rodriguez with Mizuho. Please go ahead."
},
{
"speaker": "Edlain Rodriguez",
"content": "Thank you. Good morning, everyone. Quick one for me. I think earlier, Bert, you talked about the positive drivers for the nitrogen market. Like do you see any risk at all that could have an impact on supply demand and prices? Like any concerns whatsoever that we should be thinking of?"
},
{
"speaker": "Bert Frost",
"content": "Thanks for the question, Edlain. And I always look at the risks. And I always probably pay to -- I'm probably a nitrogen nerd when it comes to following the global markets and the users, suppliers, consumers and where that's going to go and how it's going to go. And we modeled that out on a continual basis with what's going on in the world and feathering in the geopolitical impacts. And so where we are on the drivers, it is a strict supply and demand market today as we're quickly approaching the Northern Hemisphere demand, we believe Europe is undersupplied or the Northern Hemisphere over there. And we believe North America in the United States is undersupplied with the positive dynamic of the nitrogen consuming crops, not only prices increasing, which is profitability to the farmer, which is then willingness to further utilize nitrogen capabilities for crop yields, you have that dynamic that maybe a couple of years with the stock use ratios that we talked about earlier on corn. And so there are always risks on the up and down side, where I'd say on the supply side with potential outages due to gas or geopolitical issues that we've seen in Ukraine or just limits or -- and then it's economic. Do customers purchase at the right time, have it right place when it's needed and are there spot differentials that take place. And we believe that will happen in the United States with the different -- the normal differentials to NOLA to the Midwest to Canada have already expanded and may expand even more. So we do see a positive first half. And as Tony said, earlier in the second half, we'll cross that bridge when we come to it."
},
{
"speaker": "Edlain Rodriguez",
"content": "Yes. Thank you very much."
},
{
"speaker": "Operator",
"content": "The next question comes from Jeff Zekauskas with JPMorgan. Please go ahead."
},
{
"speaker": "Jeff Zekauskas",
"content": "Thanks very much. Still a little puzzled about the sequestration of carbon dioxide from Donaldsonville, I don't think any bundy has been granted a Class 6 permit to sequester carbon dioxide. And even if you are granted a Class 6 permit, then you have to build the well. So how is it that you can sequester carbon dioxide sometime in 2025 or by sequester, do you mean enhanced oil recovery?"
},
{
"speaker": "Chris Bohn",
"content": "Hey, Jeff, this is Chris. I think in both instances, it's not as if they're things that are not moving in parallel. You are correct, there would take some time for the well piece to be implemented. However, most of the pipeline work towards the areas where we're looking to sequester, given some of the acquisition work that Exxon has done. We believe that we will be able to. I think EOR is always an opportunity. However, our agreement is for Class 6 permitted wells. So one of the reasons we went with Exxon is our confidence in the work that they've done not only at the sequestration points that they have listed themselves but some of the partnerships that they're looking at as well. So we still feel confident that second half of the year, we will be sequestering CO2 from the Donaldsonville project."
},
{
"speaker": "Jeff Zekauskas",
"content": "Okay. And then as a second question, the value of CF Industries goes up and down. I guess, more recently, it's come in. And it seems to be because people believe that the probability of there being a resolution in Ukraine is higher. When you think over a longer period of time, and you think about what the gas price in Europe might be or what nitrogen production in Russia might be. Is it the case that for North American companies sort of a more peaceful globe is negative for profits and profitability over a longer period of time? Or do you think that it really doesn't matter and the market has it grown?"
},
{
"speaker": "Chris Bohn",
"content": "Yes. Well, I would start with the fact that, as Bert mentioned, product is getting out. If you even look at what your Russian urea exports for this past year in 2024, they were up over 1 million tons from the prior year. So over 9 million tons were being exported. So similar to the Iran sanctions, product is moving globally. It's just moving to different locations and maybe at lower margins for those particular producers in that area. As far as the European gas movement, if you look at Russia's gas prewar and where they exist today, gas is still flowing into Europe via pipeline, about 4 Bcf per day. And it's mainly going to those particular countries that are willing to take Russian gas post the resolution or even pre the resolution that would happen. I think the availability of gas, the actual volume quantity has been sell by Europe, and it's been pretty remarkable how quickly they were able to do that through LNG imports from the US and from the Middle East as well. So while we do see maybe some contraction that may happen with TTF as if a cease-fire were to be announced, there's still that spread there. And then I think you're talking about the timing in which that would occur. These plants, as Bert mentioned, you have 25% of the ammonia production down already. I think what we've seen is continually as these turnarounds come up where you have $50 million maintenance decisions to make. Our expectation is that the plants that are down will not start back up and other plants will continue to come down. So even post the resolution, you're still going to have that short that we show in our earnings slides in Europe for ammonia that's going to have to be sourced from other places around the globe."
},
{
"speaker": "Bert Frost",
"content": "Yes. Jeff, this is Bert. And further comments to that is what Tony said earlier is the principal position of we want peace everywhere. We -- there is no need to have a war, and there's no need to be fighting over some of the things that are being fought over. That's the tragedy. But moving forward and the Russian tons are making their way out to the market. They're fully supplied, whether that's urea, UAN. The limit has been ammonia, which Chris referenced, even if there's pieces declared, ammonia is not going to be loaded out of use anytime soon. And maybe that's Tayman, maybe that's the Baltic ports of Ust-Luga okay. So that can happen. Maybe the Ukrainian tons come back up, but they weren't that big of a supplier to the world. But you have to take a step back and remember, this is a global market of 200 million tons of products that's produced and demanded every year. And we've had gas limitations in Europe, gas limitations in Trinidad, Egypt, Iran, and we've had product export limitations China. So there are different places in the world where this is, again, back to the puts and takes to how we get to the markets that we get to. And it's not necessarily determinant by one company or a country being sanctioned or inability to move. And again, that's where I think the benefit of CF and our global look, global reach and team and how we're able to execute against these continued changes."
},
{
"speaker": "Tony Will",
"content": "I would echo kind of both those things, and in particular, what Chris said about once the European plants have been offline and curtailed for a period of time, they're not coming back. I mean, we had two manufacturing facilities, two ammonia plants in the UK. And we talked long and hard about whether it was worth kind of the option value of being able to bring them back online if gas costs in the UK came down. And our conclusion was the cost of doing that was fairly high to maintain their ability to be brought back. And even so the plan would still be operating on the third or fourth quartile as opposed to deploying capital in the US, where we've got first quartile kind of cost structure, and that was one of the reasons we went kind of down the road of wage in and closing the U.K. ammonia plants. And so I think again, it's where your plants are located, and I'm really happy with where ours are. And on the volatility of our share price, I mean, yes, it is unreasonably volatile for all kinds of reasons that I don't pretend to understand. But what that does is it gives us the opportunity to be very opportunistic on our share repurchases. And as Greg mentioned earlier, coming into this year, we had a little over $1 billion to spend. And at that time, it was 7%. The way the volatility is when we disproportionately buy on the dips, we can probably do well better than that. So it really does benefit our long-term shareholders that there is that volatility because it allows us to opportunistically take shares from people that don't see the fundamentals and the value the way that we do."
},
{
"speaker": "Jeff Zekauskas",
"content": "Thank you so much."
},
{
"speaker": "Operator",
"content": "The next question comes from Aron Ceccarelli with Berenberg. Please go ahead."
},
{
"speaker": "Aron Ceccarelli",
"content": "Hello. Thanks for taking my question. I have one on Blue Point and you clearly mentioned strong interest in the asset. And I remember the 1.4 million tons was the plant with JERA. And incremental to that was a valuation for another plant of at least 1 million tons with Mitsui. So maybe can you help me understand the announcement you made yesterday. Does it include potentially Mitsui as well and therefore, you are not going to go ahead with the second plant? How do I relate this considering the comments you made on really strong demand. Is it just a risk management approach where you want to start maybe a little bit smaller? How can I think about that? Thank you."
},
{
"speaker": "Tony Will",
"content": "Yes. So the -- we're thinking about or you're thinking about two different plants. The first plant that we began to do the analysis around that we had announced in conjunction that we were evaluating it with Mitsui was a conventional steam methane reformer SMR plant, very similar to our Donaldsonville number 6 plant. And that's a bit of a smaller plant compared to the ATR, the auto thermal reformer that Chris talked about today, and Greg talked about today. And so we were evaluating two different technologies. And in between those two technologies, we also brought -- Mitsui is still part of the evaluation process and part of the partnership, but JERA has also joined as well. And so what we've done is we've gone from at the time what was one partner looking an SMR of a little over 1 million tons or $1.2 million to two partners looking at an auto thermal reformer of 1.4 million. So the SMR, the kind of the smaller, more conventional plant is not being actively considered at this time. It is really the auto thermal that we're focused on, and that's with both JERA and Mitsui's potential partners."
},
{
"speaker": "Aron Ceccarelli",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that is all the time we have for questions for today. I would like to turn the call back to Martin Jarosick for closing remarks."
},
{
"speaker": "Martin Jarosick",
"content": "Thanks, everyone, for joining us, and we look forward to seeing you at upcoming conferences."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cf | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to CF Industries First Nine Months and Third Quarter 2024. All participants are in a listen-only mode [Operator Instructions]. We will facilitate a question-and-answer session towards the end of this presentation. [Operator Instructions] I would now like to turn the presentation over to your host for today, Mr. Martin Jarosick with CF Investor Relations. Sir, please proceed."
},
{
"speaker": "Martin Jarosick",
"content": "Good morning, and thanks for joining the CF Industries Earnings Conference Call. With me today are Tony Will, President and CEO; Chris Bohn, Executive Vice President and Chief Operating Officer; Bert Frost, Executive Vice President of Sales, Market Development and Supply Chain; and Greg Cameron, Executive Vice President and Chief Financial Officer. CF Industries reported its results for the first nine months and third quarter of 2024 yesterday afternoon. On this call, we'll review the results, discuss our outlook and then host a question-and-answer session. Statements made on this call and in the presentation on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statements. More detailed information about factors that may affect our performance may be found in our filings with the SEC, which are available on our website. Also, you will find reconciliations between GAAP and non-GAAP measures in the press release and presentation posted on our website. Now let me introduce Tony Will."
},
{
"speaker": "Anthony Will",
"content": "Thanks, Martin, and good morning, everyone. We are an organization that prides itself on unparalleled operational excellence. Our asset utilization and our safety statistics are truly world-class. And so it is with great sadness that I have to report in early October, we lost a member of our team at Donaldsonville, Louisiana due to a fatal vehicular accident. Our thoughts are with and our hearts go out to his family, friends and colleagues. This is a tragic reminder about why we put safety first, and the importance of not being satisfied who are becoming complacent with historical performance, but our need to remain focused on the present in everything that we do. I am confident our team will learn from the strategy as we work together to ensure all our colleagues remain safe every day. Turning to earnings. Yesterday afternoon, we posted results for the third quarter of 2024 in, which we generated adjusted EBITDA of $511 million. This brought adjusted EBITDA for the first nine months of the year to $1.7 billion. Additionally, our EBITDA to cash flow conversion efficiency remains strong, and we ended the quarter with more cash on the balance sheet that we began with even after returning $580 million to shareholders through share repurchases and dividends. We are very pleased with where our business is today. Our team is operating well global nitrogen demand remains consistently strong, and we continue to make progress on our strategic initiatives. With that, I'll turn it over to Chris to provide more details on our operating results. Chris?"
},
{
"speaker": "Christopher Bohn",
"content": "Thanks, Tony. Our manufacturing and distribution teams managed operations well through an event-filled third quarter, as we performed our highest level of planned turnaround activities for the year. We also experienced minor production impacts in Louisiana from Hurricane Francine in September. Our Donaldsonville and Waggaman teams did an outstanding job, safely shutting down and starting up those facilities, limiting the downtime from the storm. Despite these events, our ammonia utilization rate for the third quarter was 93%. For the full year, we continue to expect to produce approximately 9.8 million tons of gross ammonia, our strategic initiatives continue to advance construction of the dehydration and compression unit for our Donaldsonville carbon capture and sequestration project is on track start-up for sequestration by ExxonMobil and 45Q tax credit generation is expected in 2025. Additionally, commissioning of our green ammonia project at Donaldsonville continues. Finally, our evaluation of the Greenfield low-carbon ammonia plant is advancing well with a final investment decision expected in early 2025, we are nearing completion of our auto thermal reforming ammonia plant FEED study, giving us greater clarity on the capital required to construct new capacity. Alongside this, we continue to have productive discussions with our potential equity partners other interested parties that continue to emerge and prospective long-term offtake partners. We continue to assess where the global nitrogen supply demand balance will be when a new plant would come online. As we look at it today, we expect a tightening global market over the next few years, as projected new capacity growth does not keep pace, with demand growth for traditional applications much less for new clean energy applications. With that, let me turn it over to Bert to discuss the global nitrogen market."
},
{
"speaker": "Bert Frost",
"content": "Thanks, Chris. Our team had an active quarter that has positioned us well for the rest of 2024. Our UAN and ammonia fill programs were well received by customers and achieved our targets. We then continue to take new orders as global prices rose pushing the order book well into fourth quarter. This has resulted in much lower than normal inventory in our system, and we believe inventory is low throughout the North American nitrogen channel as well. Strong uptake and our fill program suggests good demand for nitrogen in the months ahead, including for fall ammonia applications if weather cooperates. Despite U.S. crop prices that are under pressure from projected large harvests. Today's nitrogen prices continue to represent good value for farmers. As a result, we currently expect North American planted acres in 2025, across all major crops will be similar to this year. Globally, the nitrogen supply-demand balance continues to be constructive. Urea exports from China are 90% lower through September than the prior year and is unclear when Chinese producers, will be allowed to resume exports. Additionally, lack of natural gas for nitrogen producers in Trinidad and Egypt reduced available supply in the third quarter at a time when we typically see length in the global market. At the same time, demand has been robust. Brazil and India both appeared to have significant urea import requirements, to be met through the first quarter of 2025. We also have seen strong demand from smaller importing countries - these include Australia, Thailand, Mexico and Turkey, among others, that have increased consumption over their three-year averages. Against this backdrop, our manufacturing network remains firmly positioned in the low end of the global cost curve. Forward energy curves continue to suggest substantial energy spreads between North America and Europe, where the industry's marginal high-cost production is located. As a result, we expect attractive margin opportunities globally for our business in the near and longer term. With that, Greg will cover our financial performance."
},
{
"speaker": "Gregory Cameron",
"content": "Thanks, Bert. For the first nine months of 2024, the company reported net earnings attributable to common stockholders of approximately $890 million or $4.86 per diluted share. EBITDA and adjusted EBITDA were both over $1.7 billion. For the third quarter of 2024, the company reported net earnings attributable to common stockholders of approximately $276 million or $1.55 per diluted share. EBITDA and adjusted EBITDA were approximately $510 million. As you can see on Slide 5, our third quarter results benefited from higher average selling prices, which were driven by our ammonia segment and lower realized gas costs when compared to the third quarter of 2023. Over the past 12 months, our net cash from operations was $2.3 billion and free cash flow was approximately $1.5 billion. Our free cash flow to adjusted EBITDA conversion rate, remains strong at approximately 65%. This cash flow enables us to return substantial capital to our shareholders, through share repurchases and dividends. Since the start of 2024, we have repurchased nearly 15 million shares, for more than $1.1 billion reducing our share count by 7.5% over that time. We have just under $1.5 billion remaining on our current share repurchase authorization, which we intend to complete before its expiration in December of 2025. Based on our current market capitalization, this gives us the capacity to repurchase about 10% of our outstanding shares through the end of next year. With that, Tony will provide some closing remarks before we open the call to Q&A."
},
{
"speaker": "Anthony Will",
"content": "Thanks, Greg. Before I move on to your questions, I want to thank the entire team here at CF for their hard work and contributions in the third quarter. In what is typically our seasonally lowest volume and price quarter, their efforts enabled us to generate enough cash to cover capital expenditures, return nearly $600 million to shareholders through share repurchases and dividends, and end the quarter with more cash than we began. We remain positive about the near and longer-term outlook for the company. Global nitrogen dynamics remained consistently strong. Longer-term disciplined investments in low carbon ammonia production, provide a robust growth platform for the company. Taken together, we expect to continue to drive strong cash generation and create substantial value for shareholders. With that, operator, we will now open the call to questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] The first question comes from Chris Parkinson with Credit Suisse. Please go ahead."
},
{
"speaker": "Chris Parkinson",
"content": "Credit Suisse that one's interesting. So Tony you guys -- when I take a step back and look at the supply-demand dynamics, you've lowered supply out of China, Europe, some gas issues in Trinidad, Egypt, et cetera, et cetera. Demand is pretty solid. Tony, when you take a step back and look at the current dynamics in the 2025 and your prospective cash flow, versus, obviously, some uncertainty regarding U.S. LNG Qatari LNG towards the end of the decade. How do you calibrate your own thought process in terms of allocating that capital in terms of look at cash prospectively generating over the next, let's say, in six to 12 months to basically build out your network for the rest of the decade. Just any thoughts there would be very helpful?"
},
{
"speaker": "Anthony Will",
"content": "Yes, Chris, I would say we have a bias towards deploying capital back into the business for growth if we find projects that we think can earn a rate of return that's above our cost of capital. And so our bias is definitely toward growth as a first step, and then certainly returning excess cash to shareholders. As Greg said, during his remarks, we have just under $1.5 billion left under our share repurchase authorization. And we expect to be able to complete that by the end of next year, and that should drive an incremental approximately 10% accretion in terms of our shares. And so, we're excited about both the growth aspect as well as our ability to take shares out of the marketplace. And both of those things, we think, will drive value for shareholders."
},
{
"speaker": "Chris Parkinson",
"content": "Got it. And just a quick follow-up. Once again, just taking a step back. The first quarter, obviously, you had some winter storms of third quarter, so obviously, hurricanes are at unavoidable times. When I look into 2025 and 2026, do you think turnaround activity will be the same level, slightly lower in terms of like how much more you have maximized profitability based on the current nitrogen price deck without all those outages, and how we should think about that framework heading into next year?"
},
{
"speaker": "Anthony Will",
"content": "Well, I mean, certainly, our hope is that we don't repeat the winter storm freeze off that we had in the first quarter, or the hurricane outages that we had in the third quarter. But the operations team tries, to manage our turnaround activity to be relatively consistent year on year-on-year. So we're not throw in the system way up and way down, but we're trying to level load it. Now that's not always possible because of the timing of when things come. And we do have a couple of larger plants that when they go through turnaround, have a noticeably bigger impact. But I would say we pretty much year in and year out going forward should be producing in the neighborhood of about 10 million tons of ammonia, and then we'll upgrade as much of that as our upgrade system can manage. And then the other piece of it to think about as we get into next year is we'll begin generating on an annualized basis, an incremental roughly $100 million of cash through the 45Q tax credit as we start sequestering CO2. So that's on top of the base business. And again, we're pretty excited about what that looks like."
},
{
"speaker": "Chris Parkinson",
"content": "Thank you so much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Steve Byrne with Bank of America. Please go ahead."
},
{
"speaker": "Steve Byrne",
"content": "Yes, thank you. Your press release provides this gross margin per nutrient tons for product. It's always very interesting. And the one that just jumps out is your DEF. And I was just curious whether what your view is on the outlook for DEF? And maybe more specifically, this problem that occurs with crystallization and so forth. Is that poor-quality DEF? Is that all DF? Does that affect you? And is there a resolution of that down the road?"
},
{
"speaker": "Bert Frost",
"content": "Good morning Steve, this is Bert. And regarding your question on DEF and the opportunity for CF, we've continued to invest in that business since we acquired Terra in 2010, and it has been an exciting path and growth vehicle for us where we're projecting to be close to 800,000 tons of urea equivalent product that, trades at a substantial margin increase over granular urea. So what we've done is when we looked at our platform, we have capacity in several of our plants, Courtright, Yazoo City, Woodward and the substantial capacity in Donaldsonville and which we're augmenting and have added to the system with railcars. So the exciting part about DEF is the dosage rate, because when we first acquired this business, it was at a fairly low percentage and what it was cutting out in terms of pollution where today. The projections on dosing rate increases to five and even higher than that percent just looks at the doubling where we're projecting that the DEF demand, just in North America could be in excess of 3 million urea equivalent tons, and that's from zero in 2010. So for us, this is a good platform that works very well into our system, and we're going to continue to grow with it. Regarding the crystallization, I'll have Chris answer that."
},
{
"speaker": "Christopher Bohn",
"content": "Yes, Steve, related to that, we - there's very high specs required for DEF in the product and we haven't experienced any of that. I think the one thing that we've seen is we've always been very diligent about our testing requirements for that. So the issue you bring up, we're not all that familiar with because it hasn't affected any of our product."
},
{
"speaker": "Steve Byrne",
"content": "Very good. And I'd like to ask a little bit about the Donaldsonville project that you're working with Exxon and with - do you have any visibility on when they could get a classic injection well? Is that just an unknown? And does that prevent you from essentially lining up customers for this and/or do your customers need to invest on their own site, either for storage or to use it as a fuel. I'm just curious. If something if this moves forward in sometime in 2025, are you going to be in a position where you could start loading a marine ship in other words? Thanks."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So we are confident that in 2025 will be one sequestering CO2 and to receiving the 45Q tax benefit. One of the reasons we chose Exxon as our partner is really just the vast flexibility and alternatives they have, if you recall, their acquisition of the former Denbury pipeline, which is almost 1,000 miles of CO2 pipeline, gives them quite a bit of access to more than a point-to-point storage well. So they could have wells that they have in the queue right now from Louisiana all the way to Texas and all along that route. So our confidence level still remains very high. As I said, we're doing a lot of work on our side of the fence, and Exxon is actually doing a lot of work in piping on their side of the fence to connect. So our confidence level remains high there, as far as being prepared to load vessels and ship out, whether it be to Europe or Asia, we yes, I expect that to be occurring next year based on what Bert's team decides, is the best use for that particular low-carbon product."
},
{
"speaker": "Anthony Will",
"content": "And I would add to that, Steve, that on the systems side, we've spent a lot of time and effort putting in place all of the necessary system and controls and accounting procedures to be able to not only get the credit, but be able to accurately score and certify a carbon intensity on our production. And so that will be kind of among the first tons out there, with an actual carbon score associated with that."
},
{
"speaker": "Steve Byrne",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We have Josh Spector from UBS with the next question. Please proceed."
},
{
"speaker": "Josh Spector",
"content": "Yes, hi. Good morning. I was wondering if you could talk a little bit about current nitrogen dynamics. There were some comments the other day about warmer weather being an issue for ammonia applications in the U.S. later in the quarter. And some comments that activity today is slow. I don't know if you had any different characterization of the market today. And when you talk about tighter inventory in North America, is that something we should expect to materialize in higher prices in the spring? Or do you have any different view about how that impacts the market? Thanks."
},
{
"speaker": "Bert Frost",
"content": "Good morning, Josh. So regarding the current dynamics, they're, I would say, constructive in that when you go around the world, where we are on supply, is, as I mentioned earlier, the absence of Chinese tons available to the market is a 3 million to five million-ton pool, which could be up to 10% of global seaborne traded product. And then you go through different places that have experienced gas issues or high-cost gas issues like in Europe, where we've seen Yara and others take production offline, you have. I would say, an appropriate or a limited supply basis right now. And then when you look at demand with India stepping in for another tender and asking for 1 million tons to be shipped by middle December, and then continued demand in South America and Brazil and Argentina, then you'll roll into Q1 for the Northern Hemisphere, and we believe that the U.S. and Europe are behind. And so where we are as a company - I mentioned in my prepared remarks that our inventory is limited. It is. When you look at what has been imported and what has been exported for a net balance and then what we think others lost in production, we think the nitrogen supply and inventories, whether that be with retailers or with producers is limited. And so that sets up a positive environment as we head into application season for the spring. Now regarding your question about fall application, that is due to start about now, fall application of ammonia. Our ambient temperature and soil temperature around 50 degrees. We're hitting close to that in the northern tier. We've had a very good season in Canada. And that as it moves -- the weather moves south and gets cooler, we'll see those applications pick up. The commentary about limited or limiting applications possibly has been soil moisture not necessarily temperature. And so what you need for a healthy ammonia season is appropriate soil moisture for the ammonia to bind in the soil. And that is what we're looking for as these rain patterns sweep across the northern tier and Iowa, then you'll see applications take off. Over the last several years, applications have gone well into December. And if that's the case, our order book, which we believe is in a very good position. And we've positioned product in our terminals. They're ready to go. That will have a good season, probably a better season than last year. And so -- and we have those orders already in the system."
},
{
"speaker": "Josh Spector",
"content": "Thanks, that's helpful context. I'll pass it on."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Joel Jackson with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Joel Jackson",
"content": "Just a couple of questions. First, a little short term, maybe dovetailing with this last question. Typically, you do more sales in Q4 than in Q3, I think in five years in a row of a higher Q4 than Q3. Any reason not to expect that this year?"
},
{
"speaker": "Bert Frost",
"content": "In terms of how we take orders and then move that to - those tons through the system and as sales, each year is different. And so the fill programs tend to take place either in late Q2 or early Q3. This year was early Q3. We built our order book and then continue to take additional orders on top of that fill program. So today, our order book, as I said in my prepared remarks, is healthy through Q4. And we're going to start taking Q1 orders shortly based on our price expectations. And so, regarding whether it's bigger or smaller Q4, Q3, we don't look at it that way. We look at what we've got, our production rates, our allocations to tons and we move the tons out in an orderly fashion."
},
{
"speaker": "Joel Jackson",
"content": "And then on the Greenfield blue ammonia project that you're expecting the feed study done by the end of the year, any color you can give, maybe higher level, what you need to still to get this approved with your partners, capital running $3 billion or $4 billion, do you think that's still reasonable? Anything sort of pick up incremental in the last couple of months, to give us an idea of what we could expect early next year in some of your decision-making processes?"
},
{
"speaker": "Anthony Will",
"content": "Yes. I mean I think the number in the neighborhood of $4 billion all in is an approximate number. We're finalizing the FEED study, and that should narrowed the range a little bit to kind of a plus/minus 10% range. But I think as the numbers are kind of rolling up with a bit more uncertainty ranging $4 billion is where we think it's going to come in. And at that kind of number. We do think that that it is a project that makes sense, particularly given what Chris was saying about longer-term the projected growth of nitrogen demand even in traditional applications exceeds what the new capacity brought online is. And that's before you get into some of the capacity shutdowns. So we're expecting to continue to happen in Europe and some other places. And the partners that we're having conversations with I think are similarly comfortable being able to invest in a project in that kind of range and look at a return profile that is favorable. So for us to get there. We need to finish up the FEED study. We need to try to get the partnership agreements and all of the ongoing governance. And everything kind of put together and then it's going to be a decision for the board ultimately to make. But we're targeting kind of middle first quarter of next year to be in a position to make that decision."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. The only thing I would add to that, Joel, this is Chris, is that as we look at our partnership selection, you had brought that up in part of the question, we actually have a lot of benefits related to that. We have our Japanese equity counterparts that we're in discussions with. But as Tony mentioned, recently, even more industrial primarily due to some of the energy issues going on, primarily in Europe. Are also stepping in to understand the project dynamics. And in all cases, sort of the capital number or range that Tony is putting out there, they all seem ready to move forward with the project as well on those type of capital parameters."
},
{
"speaker": "Joel Jackson",
"content": "Tony, if I could just fit one more in on that. I may have missed totally misunderstood that. But are you suggesting that the economics of the plant around $4 billion might be justifiable even if some of the clean ammonia math and benefits weren't there? I may have misunderstood that, if that's what you're trying to get at?"
},
{
"speaker": "Anthony Will",
"content": "Yes. I mean I think the way that we're looking at it, Chris, is - Joel, I'm sorry, is that with the average sale price in the neighborhood of 450 a metric ton along with the 45Q benefit that we would expect to be able to generate. That should earn a reasonable rate of return on the kind of investment that we're looking at making here. And we believe - I mean, if you look at the market today, it's well above that. Now is it does move around. And when you see a new plant come on like Gulf Coast ammonia or whatever, there is going to be some lumpiness and some volatility. But as we project forward, we expect a tightening in the S&D balance even in traditional applications. And we think the market is going to support that kind of a price. And so even before you get to new applications for clean ammonia there's an argument to be made that, that plant is justifiable. I think if we are successful in bringing on a couple of the potential partners that we are deeply in discussions with that want to take some of that production into brand-new applications, it even justifies it further. So again, we're very optimistic about the return profile of what this plant looks like."
},
{
"speaker": "Joel Jackson",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We have the next question from Richard Garchitorena with Wells Fargo. Please go ahead."
},
{
"speaker": "Richard Garchitorena",
"content": "All right, thanks. Good morning, everyone. First question on the nitrogen market outlook. You pointed out Chinese urea exports basically now expected less than 1 million tonnes this year. What do you think is going on there in terms of how the China government is thinking? Is this something that may be extended indefinitely and that supports your comments on the much more, tighter outlook going forward? Maybe that's the first question?"
},
{
"speaker": "Bert Frost",
"content": "When you look at China over the last 20, 25 years, we've seen many different Chinas in terms of being the world's largest importer of urea in the '90s to entering the export market in the early 2000s to overwhelming the world market with almost 14 million tons of exportable tons in 2015, '16 to slowly ramping that down to nine to seven to five to three to two, and now eliminated, it's been a surprise and something is not easy to predict because as many things are happening in China. Some of those are opaque or governmental decisions. Today, the expectation is, at least from the investor community has been the next quarter, they're coming the next quarter, they're coming. Well, they haven't. And I think part of that's a reflection of what's going on in China. You're seeing growth in demand. Today, it looks like demand for industrial and ag applications are close to 60 million tons, that's 6-0. That's a gigantic consumer of urea and most of that is produced using coal or imported -- domestic coal or imported coal. So I think for the Chinese government, they want to keep that product available for their consumers, their farmers to make the food that they want to make and make that at a reasonable cost. To me, that's a rational decision-making process. When you're exporting for almost zero value to the - or at least to China and subsidizing the world with cheap urea. And so another parallel path on this has been the exported tons of ammonium sulfate out of China that have grown substantially from several million tons to, I think, close to 16 million, 17 million tons, a lot of that going to Brazil and secondary markets. That's a lot of nitrogen that's still going out of China. And so I think it's - the market is seeming to project that they'll be able to export tons in 2025. That remains to be seen, and we'll cross that bridge when we come to it."
},
{
"speaker": "Richard Garchitorena",
"content": "Great. Thanks. And then as a follow-up, just on the clean energy projects, I was just curious, as you work through the FEED study and you look at the environment right now, what's your view in terms of the announced proposed capacity that's supposed to be coming out from various different companies and start-ups. The proposed capacity is supposed to be out there for clean ammonia. What do you think is the likelihood that maybe half that comes online in the quarter? Sorry, any high-level views on that? Thank you."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. I think as we look at those announcements, you have to look at them and assess probabilities related to them. So it was -- two years ago, we ran all the projects that had been announced globally that were low carbon. And there was over 107 projects, of which we thought maybe less than 10 would actually be built. I would say, out of that list, I would say it's probably even fewer than that going forward. So those projects - the nice thing about our industry is you have pretty good visibility into new projects starting, given the engineering firms that have worked on them. And then also the time line to build one is four to 4.5 years. So that also provides you an understanding of what happens with the S&D balances that develops. And really, what we're seeing between now and when we would have a new project come online is there is a limited net ammonia production that's coming online. You're seeing here in the U.S., you have the Gulf Coast ammonia that Bert mentioned, which is not a low carbon, but you have the Woodside OCI plant, which we're expecting early '26. And then outside of that, it's really not until 2028 where Qatar has a project that's announced. So a long way to say, we don't believe that the true projects that are moving forward is really building that supply side. And that's why Tony talks about, as we see longer term a tightening in the S&D market just under traditional application let alone if we add in any type of clean energy demand to that."
},
{
"speaker": "Richard Garchitorena",
"content": "Great, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Ben Theurer with Barclays. Please go ahead."
},
{
"speaker": "Ben Theurer",
"content": "Good morning and thanks for taking my question. Congrats on another very strong quarter. Just a quick follow-up. As you think about the ammonia segment and the strength that you had in the quarter, which kind of was a little bit of a surprise on the volume side, I think at least versus ours and consensus estimate. So how do you think about just segment itself, like not the fervor process, but the ammonia piece and the demand for that as you go into the fourth quarter. And maybe a little bit related to Joel's question, just like the revenue piece that then translates into 4Q and as you move into it. How much volume, can you actually produce and sell as ammonia now that you have Vagamon?"
},
{
"speaker": "Bert Frost",
"content": "Well, I would compare our products, ammonia, urea, UAN, DEF, ammonium nitrate. We love all our children. And so ammonia is 1 of those segments. And I got to give a shout out to the ammonia team of Amanda and Bob and Chello that have done a great job in the rest of the sales team this year. The interesting thing about CF, and I think this is one of the undervalued aspects of our company is the flexibility we have in our production locations, the flexibility we have with our modes, which is truck, rail, pipe, barge vessel and then our distribution system. And so it's by leveraging all those points, then you could become agnostic on the product and focused on the margin and what product creates the most margin at that time, because our team is rewarded on the company's performance, we move tons freely between the segments. And if that segment -- 1 segment is profiting more than the other and that's what you saw in ammonia with good demand globally. So we've been a fairly large exporter of tons out of Donaldsonville. And then that creates, again, optionality for the rest of the team. So our volume I think it's the exported ton, that's the incremental increase. And then as we go into Q4, that is the ammonia application season and weather permitting, our volume will be higher than Q3. And we have a substantial book already built and those values are in the publications. We're well within those ranges. And I think this year could be a fairly big year for fall ammonia because it's a very good agronomic product for a corn farmer in these dense organic soils of the Midwest. So I think the ammonia position for CF is solid and how much can be -- how much product can we put in that segment. It's - traditionally, it's been around 4 million tons, but it could be 3.5 million to 4 million tons in any given year."
},
{
"speaker": "Ben Theurer",
"content": "Okay. Perfect. Thanks for that clarification."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Andrew Wong with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Andrew Wong",
"content": "Hi, good morning. Thanks for taking my questions. So today, if we look at Europe generally as the marginal cost producer, but we're also seeing some changes in that region. There's capacity that's maybe shutting down and that could reduce how much to contribute to that cost curve, but there's also C-band that gets implemented in 2026, which raises our cost position. So I'm just kind of curious how you think about Europe as that marginal cost producer as you kind of go forward and look out a couple of years from now?"
},
{
"speaker": "Christopher Bohn",
"content": "So Andrew, as we've talked about before, this past summer, we did a pretty in-depth analysis of what's happening in Europe because we're seeing it much the way you described it that given the cost of energy and the differential, which now sits at $10 and really goes there through 2026, that it's going to be very difficult for European producers who are not integrated to continue to produce ammonia. And you saw that last week with 1 of our peers shutting down in ammonia plant just to do upgrade very similar to what we did with our U.K. ammonia plants. So we expect that to continue. And by 2030, we would see that there'd probably be another 3 million to 4 million nutrient tons of imports required into Europe. Now some of that will take the form of upgraded products. Some of it will be just gross ammonia that's going over there for upgrades through their terminaling system into those products. So we see that specifically with our low carbon because with the CBAM, as you mentioned, if we have a low-carbon product and we're competing against conventional, the conventional cost is going to be higher, and that will provide us a margin advantage as the CBAM goes into effect at the end of next year. And really, by 2034, where there's no free allowances offered anymore. You could see that differential between someone who has an ATR that's sequestering 95% in conventional be something that could be $150 per metric ton benefit. So it's a really sort of look, although we don't bring - build that into our modeling, it is something that provides, as Tony talked about us being a fast mover and having that carbon arbitrage opportunity as we see Europe begin to contract some on production."
},
{
"speaker": "Andrew Wong",
"content": "Okay. That's really helpful in Europe. And then I guess - and that kind of brings in another question on just how does that global cost look like three or four years from now with the changes in Europe, Chinese exports, impacts from clean ammonia given how the S&D looks like? Like how does that change? Because we've seen different changes in the past decade or so, like how does that look like three or four years from now?"
},
{
"speaker": "Christopher Bohn",
"content": "Well, if price doesn't bid in that higher cost production and there's new demand coming on, you'll see probably a lowering of the cost curve to some extent. And that's really why when we look at our particular project, we wanted to be integrated because we think having the lowest OpEx related to some of these projects where you're buying hydrogen over the fence and then upgrading it later puts you in the third or fourth quartile of production. So you're no different than a European producer. But we do see that demand growth. So you're going to continue to need to see new supply come on, and we do not believe that new supply meets demand. So some of these high-cost assets that you may think are going away are probably going to remain online until we have some sort of balance between S&D."
},
{
"speaker": "Andrew Wong",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Vincent Andrews with Morgan Stanley. Please go ahead."
},
{
"speaker": "Vincent Andrews",
"content": "Thank you and good morning everyone. Tony, I just wanted to follow-up with you on the prospective blue ammonia facility and just get your latest thoughts in terms of what you're seeking in terms of terms. I recall you want to own at least 50% of it. But is anything changing in terms of how many partners you want to bring in both in terms of the amount of equity they would want to provide or do you have more of a willingness now maybe to fund it yourself, but just have offtake for a very large percentage of the plant? Or is there anything evolving in sort of your own thought process or what the other - what the counterparties are interested in doing?"
},
{
"speaker": "Anthony Will",
"content": "Yes. I would say, in general, we have more interest than probably a percentage of equity to go out. And initially, we were focused on or structured an agreement around 52% equity. I could see a scenario that would have us take less than 50% total equity based on the desires, of a couple of the partners we're talking to. We would want operating control and voting control in that kind of joint venture scenario. But it's entirely possible that we would end up kind of at or below 50% of the total equity I wouldn't want to go too much lower than that, because we are putting our organizational expertise and effort to really take on the design and the build and the construction and then the ongoing operation of the plant. So, we want there to be enough kind of participation in a project like that to make it worth our while to put all that time and effort into it. But I think from a standpoint of having strong partners that want the offtake that bring good expertise, and capital into the project, and reduce our risk profile. We're really optimistic about this project, and what it looks like going forward."
},
{
"speaker": "Vincent Andrews",
"content": "Okay. And just as a follow-up, how are you thinking about Henry Hub prices, not near much the next 12 months, but if you look out 12, 24, 36 months, you got all this LNG coming in the U.S. We've got electricity increasing demand-wise from data centers, and everything else. Any thoughts there?"
},
{
"speaker": "Bert Frost",
"content": "When you look at the spreads or actual the strip, you're well into 2026 and you're still at $3. And so the differential to the world, not necessarily the Henry Hub price because if the Henry Hub goes to $6, but the spread goes to 10 or five continues in the $10 to $15 range, that just makes those other producers that are having to use imported LNG that much more expensive. And so when you look around the world where gas is, where gas is available and how that gas is going to move, the United States plays a substantial role in that. And we've demonstrated we as a country that when it was going from 70 to 90 to 100 to 105 Bcf per day of production that there's additional capacity out there to grow as the LNG demand grows. Yes, LNG is going to go from let's say, 14, 15, 16 Bcf a day up into the 20s. But we anticipate that supply to be there as well. And the cost structure today to tap those wells into bring that production online is still very attractive. And so yes, I think energy demand, you're seeing that spread apart are spread across, whether it's renewable or now bringing nuclear back. So it's going to be something interesting to watch, I think, more as we get later in the decade."
},
{
"speaker": "Vincent Andrews",
"content": "Thanks, guys."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Jeff Zekauskas with JPMorgan. Please go ahead."
},
{
"speaker": "Jeff Zekauskas",
"content": "Thanks very much. When you think about the Donaldsonville dehydration and compression unit, and the 45Q credits that you might get in '25, is your base case that the credits would come from enhanced oil recovery?"
},
{
"speaker": "Christopher Bohn",
"content": "So our agreement with Exxon is for CCS. So it is not for enhanced oil recovery. So it's for a Class 6 permit in which it would be sequestered and we had received the $8 per metric ton tax grant related to that. And as I said earlier, we still feel confident that next year will be sequestering in Class 6 permits given the flexibility and really the alternatives that Exxon has across both Louisiana and Texas with different sequestration permits that are in process right now, both with the State of Louisiana, but also with the EPA and the federal government."
},
{
"speaker": "Jeff Zekauskas",
"content": "So I don't think ExxonMobil has completed any permit filings in Louisiana just yet. So why are you - and in Texas, you need EPA approval. And this is just for the permits itself. I mean there have been no Class 6 permits that have even been issued. Are you really so confident that you can achieve this in 2025, on EOR area?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So what I would say is, Jeff, is, as you point out, there is - in Texas, it is federal, and they do have sequestration wells that they have permits put in place for Texas as well. And that's really where the optionality of that almost 1,000-mile CO2 pipeline that Denbury, they acquired from Denbury allows them to work different paths, and different alternatives to get there. All our discussions with Exxon suggests that they will have Class 6 permitting. So that's what I'm basing it on."
},
{
"speaker": "Jeff Zekauskas",
"content": "Okay. And when you contemplate the building of a new blue ammonia facility, and you look at an ATR versus an SMR with flue gas capture. Are those very different costs? Like is there a, I don't know, a $1 billion difference between doing one or doing the other? Or is it much smaller?"
},
{
"speaker": "Anthony Will",
"content": "It's much smaller by the time you add on potential flue gas capture. I think what you'd end up seeing is numbers of would kind of be in the approximate range of each other. I think 1 of the big differences that you end up with is more tonnage of production coming out of an ATR in general than the SMR. The largest one plant in the world is Donaldsonville number 6. And even though it's nameplate is the same size as a number of other plants that are out there, we're getting about 10% or a little over 10% additional production above nameplate. And so that is currently the largest plant in the world and the ATR would be quite a bit larger than that plant even. And so, one of the benefits is of the ATR is compared to the SMR, with flue gas is on a comparable capital basis. You get more tonnage of production and all those incremental tons are really at variable cost. And so, the return profile looks really attractive, against those incremental tons. So that's kind of the direction that we're targeting"
},
{
"speaker": "Christopher Bohn",
"content": "The other part I would add, Jeff, is based on that incremental tons, which could be 10% higher than our ammonia 6 is, you're now also capturing probably about 50% more CO2 than you would on a comparable conventional SMR. And you'd be obtaining the 45Q, whether it be through the Class 6 or in EOR, you would have a benefit that would be significant over what a traditional SMR plant would be."
},
{
"speaker": "Jeff Zekauskas",
"content": "Okay. Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Edlain Rodriguez with Mizuho. Please go ahead. Edlaine Rodriguez, your line has been unmuted. You may proceed with your question."
},
{
"speaker": "Edlain Rodriguez",
"content": "Yes, sorry about that. Good morning, everyone. Tony, a quick one for you. Can you talk about changes if any, you see informers or retailers' behavior given the more challenging applies we have now? And how has that changed go-to market behavior has changed accordingly?"
},
{
"speaker": "Anthony Will",
"content": "Yes. I'll give a real quick high-level answer, and I'll hand it over to Bert to give some additional color. But in general, because nitrogen is a nondiscretionary nutrient. We've seen strong demand for our product globally even though crop prices are a little more muted today than they were a year ago or two years ago. I think generally, where you see farmer behavior looking to be different in an evolving crop price marketplace has to do with some of the other inputs. So whether it's P&K that you might cut back on a little bit, or you end up going with a generic seed and chemicals as opposed to some of the ones that are still on patent, et cetera. You see the reduction in cost in other places, but nitrogen really doesn't provide an option for farmers to reduce otherwise, you see a direct year one impact on yield. And so, that's why we continue to see very strong demand for our product."
},
{
"speaker": "Bert Frost",
"content": "Yes, I agree with Tony. And some of the interesting things that are going on in the farm community, and we're very well connected with our customers. We don't sell to farmers, but the co-ops that we work with Growmark, CHS, Wind Field and some of the others as well as our public companies and private companies, Simplot and ADM and people like that. We have a lot of conversations. And I think one of the issues is that it needs to be managed on the farmer side is debt, and cash management. And so, you're seeing delayed purchases, delayed purchases and positioning for the spring. And I think one of the things like Tony talked about, all the ancillary issues of products that are used for planting and growing a crop, it's land values as well. So we're going to have to watch that over time. But for us, it's - we focus on what we can control, and that's lowering our costs, keeping our costs attractive as related to the market in terms of our production mix, running the plants very well and efficient. And utilizing the export capabilities that we have. So we're a global participant. We're active in Brazil, Argentina, Australia and Europe, and that gives us insight into global farming practices and needs. And then we manage our book. We always have a healthy book on. And the management of the pricing that's available to us, so we're capturing a good value, and the gas team and keeping our gas costs low, which have been - they've done a very good job. So in conjunction with our insight in the market, our relationships in the market, our capabilities that we - are able to leverage, we're positioned very well. And I think the farmer with some of the droughts that are going on in Brazil, and some of the demand and low prices tend to help demand increase, the pricing will recover, hopefully in the forward market."
},
{
"speaker": "Edlain Rodriguez",
"content": "Okay. That makes sense. And a related question. As we exit 2024 and enter in 2025, again, it seems like the way you talk about the outlook for nitrogen, that's very encouraging. Is there anything that concerns you at all like anything that makes you think keeps you wait?"
},
{
"speaker": "Bert Frost",
"content": "I sleep very well, but there are things in this market that I do think about, and I'm always looking over the horizon on I think there are issues with currencies on what countries are devaluing their currency in order to participate. I think some of the things that are coming out of China with export policies, industrial policies have ramifications into the commodity markets. I think some of the concerns with Europe and gas were a participant, or a producer in the U.K. And so, we're following that market. We have good customers and what their long-term opportunities are or challenges. And then it's geopolitics, or the geopolitical environment that we're currently in with what's going on in the Middle East, what's going on in Ukraine. These have impacts on real people, and real decisions on not just how people eat, but how they live. And then, how do we play in that world. So yes, there are concerns. I think we always have to be mindful of those things in the energy markets, and how we run our business."
},
{
"speaker": "Edlain Rodriguez",
"content": "Okay, thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Dmitry Silversteyn with Water Tower Research. Please go ahead."
},
{
"speaker": "Dmitry Silversteyn",
"content": "Good morning and thanks for taking my questions. Most of them have been answered, but I do want to follow up on the more near-term outlook for pricing - we've seen price comping down year-over-year in the first half of the year and then you reported a price increase here in the third quarter. How do you look at - given the market dynamics and the tightness in the market that you identified, and talk about what do you expect for pricing as you get into the 2025 negotiating season?"
},
{
"speaker": "Bert Frost",
"content": "Well, a lot of the things that drive pricing drive - it's supply and demand, it's energy spreads it's again, some of the issues I just articulated. We did have some weakness going into Q1 and then coming out of Q2 where pricing for urea, for example, fell NOLA to $290 and then recover to $230, $235 -- or excuse me, $330, $335 and we're currently trading around $320. And so the trends in pricing were reflective of the lack of Chinese availability, the lack of North Africans, principally Egypt, and then some other gas constrained areas. And we see that positive environment continuing into Q2 because of those dynamics are not going away. And so we have these episodic moments of movements of pricing, but the trend, we believe, through at least the first half of 2025 is positive."
},
{
"speaker": "Dmitry Silversteyn",
"content": "That's helpful. Thank you. And then one final question. You mentioned the modest hurricane impact from Francine. I'm hoping that nothing else was impacted us as far as your operation is concerned with the - I'm sorry, with the East Coast strike. Anything we should be thinking about in terms of cost deltas going forward as far as logistics cost. The barge traffic in the Mississippi is still kind of slow because of the low water levels after a couple of years of drought. Anything that we should be keeping in mind as we look towards 2025 on your gross margin line?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So what I would say is a lot of those we were able to mitigate those issues that you mentioned with the port strike and then also the hurricane without really much financial costs related to that. I think just in general, with any type of logistics movement, what we're seeing is just the inflationary effects, both from barge prices or whether it be rail. So that, I would say, is the one area we continue to monitor and look at alternatives. The one thing that we have flexibility that differentiates us from other companies is our ability, specifically out of Donaldsonville to move product through five different modes, whether it be vessel, barge, truck, rail or pipe. And that gives us a lot of flexibility to go to alternative transport methods. So I would say it's just Bert's team, and the supply chain doing a little bit more thought provoking, just to keep cost down versus what we're seeing inflation-wise."
},
{
"speaker": "Dmitry Silversteyn",
"content": "Understood. Thank you very much. That's all the questions I had."
},
{
"speaker": "Operator",
"content": "Thank you. Ladies and gentlemen, that is all the time we have for questions for today. I would like to turn the call back to Martin Jarosick for closing remarks."
},
{
"speaker": "Martin Jarosick",
"content": "Thanks, everyone, for joining us. We look forward to seeing you at the upcoming conferences."
},
{
"speaker": "Operator",
"content": "Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cf | 2,024 | 2 | [
{
"speaker": "-",
"content": ""
},
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to the CF Industries First Half and Second Quarter 2024 Earnings Call. All participants will be in a listen-only mode. [Operator Instructions] I would now like to turn the presentation over to the host for today, Mr. Martin Jarosick with CF Investor Relations. Please go ahead."
},
{
"speaker": "Martin Jarosick",
"content": "Good morning, and thanks for joining the CF Industries Earnings Conference Call. With me today are Tony Will, President and CEO; Chris Bohn, Executive Vice President and Chief Operating Officer; Greg Cameron, Executive Vice President and Chief Financial Officer; and Bert Frost, Executive Vice President of Sales, Market Development and Supply Chain. CF Industries reported its results for the first half and second quarter of 2024 yesterday afternoon. On this call, we'll review the results, discuss our outlook and then host a question-and-answer session. Statements made on this call and in the presentation on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statements. More detailed information about factors that may affect our performance may be found in our filings with the SEC, which are available on our website. Also, you'll find reconciliations between GAAP and non-GAAP measures in the press release and presentation posted on our website. Now let me introduce Tony Will."
},
{
"speaker": "Anthony Will",
"content": "Thanks, Martin, and good morning, everyone. I'm going to start with a big welcome to Greg Cameron, who joined the CF Industries team as our Chief Financial Officer in June as being his first earnings call with us. Greg brings a strong background in executive leadership finance and clean energy. He is succeeding Chris Bohn, who was promoted to Chief Operating Officer. So welcome, Greg, and congratulations, Chris. Turning to earnings. Yesterday, we posted financial results for the second quarter of 2024, in which we generated adjusted EBITDA of over $750 million. This brought adjusted EBITDA for the first half of this year to $1.2 billion. We're very pleased with our performance during the quarter, both in terms of how well we operate and also the progress we have made on our decarbonization and clean energy projects. With that, Chris is going to provide more detail on our operating results as well as on our strategic initiatives. Chris?"
},
{
"speaker": "Christopher Bohn",
"content": "Thanks, Tony. The CF Industries team delivered outstanding operational performance during the second quarter. We operated our ammonia plant at 99% utilization rate in the second quarter following a challenging first quarter of production outages. This utilization performance includes the Waggaman ammonia production facility which has been operating approximately 10% above nameplate capacity following its first significant CF led maintenance event. Most importantly, we operated safely. Our 12-month recordable incident rate at the end of the quarter was 0.17 incidents per 200,000 labor hours, significantly better than industry averages and one of the company's lowest incident rates ever. We continue to advance the series of strategic initiatives. These include our industry-leading carbon capture and sequestration projects that will generate low carbon product and significant 45Q tax credits. The Donaldsonville project is on track with sequestration expected to begin in 2025. We also recently announced the carbon capture and sequestration project at our Yazoo City, Mississippi complex. We will invest approximately $100 million in the site to enable ExxonMobil to transport and sequester up to 0.5 million metric tons of carbon dioxide annually. We expect sequestration at Yazoo City to begin in 2028. Additionally, commissioning for our green ammonia project at Donaldsonville is ongoing as we work to integrate safely, the electrolyzer into our ammonia operations. We continue to evaluate construction of a greenfield low-carbon ammonia facility in Louisiana with Global Partners. We have made additional progress on our auto thermal reforming ammonia plant FEED study, which should be complete before the end of the year. We remain focused on a disciplined approach based on the return profile of new capacity, the technologies needed to meet customers' carbon intensity requirements and the global demand outlook. With that, let me turn it over to Bert to discuss the global nitrogen market."
},
{
"speaker": "Bert Frost",
"content": "Thanks, Chris. The North American spring application season saw strong demand for urea and UAN driven by higher-than-expected planted corn acres in the United States. This demand absorbed urea and UAN imports that were significantly higher in 2024 than the prior year. Spring ammonia applications were low this year following a strong fall 2023 application season. However, industrial demand and exports offset the lower spring volumes. As a result, we believe the North American nitrogen channel exited the spring application season with low inventories across all products. This supported our ammonia and UAN fill programs, which achieved prices that were well above last year's programs, but also represent value for farmers despite lower corn prices. Corn prices have been declining due to anticipated high production of corn in the United States and Brazil this year. As a result, the outlook for farm economics is softer compared to recent years. We have begun to see this ripple through different parts of the agricultural value chain. We don't expect to see a major impact for nitrogen given the non-discretionary nature of our products, but we may see changes in buyer behavior. Globally, the nitrogen supply demand balance tightened as the second quarter progressed. Natural gas curtailments in Egypt resulted in widespread nitrogen production outages from late May to early July, reducing global supply. The continued absence of urea exports from China also helps tighten the global market. We expect exports from China to resume at some point in the second half. However, we believe total volumes for the year will be much lower than the 4.3 million metric tons of urea exported in 2023, given the Chinese government's focus on domestic fertilizer availability. Brazil and India will be a key focus of the global nitrogen market in the coming months. We continue to project that urea consumption and imports in Brazil will grow in 2024. Imports of urea to India will be lower than in previous years as domestic production has ramped up. However, India has imported less than 2 million metric tons of urea so far in 2024. As a result, we believe substantial import volumes are required in the coming months to meet urea demand in India. On a longer-term basis, we anticipate growing demand for low-carbon ammonia and low carbon nitrogen fertilizers for traditional applications. We've had a growing number of conversations with customers who want low carbon versions of the products they buy today. This is because the consumers of agricultural and industrial products, including ethanol producers such as POET are increasingly focused on reducing the carbon footprint of their supply chain, which lower carbon fertilizers will do in a quantifiable and certifiable manner. We expect even greater interest as we bring low carbon ammonia and fertilizers to the market. With that, Greg will cover our financial performance."
},
{
"speaker": "Gregory Cameron",
"content": "Thanks, Bert. For the first half of 2024, the company reported net earnings attributable to common stockholders of approximately $614 million or $3.31 per diluted share. EBITDA and adjusted EBITDA were both approximately $1.2 billion. For the second quarter of 2024, the company reported net earnings attributable to common stockholders of approximately $420 million or $2.30 per diluted share. EBITDA and adjusted EBITDA were both $752 million. As you can see on Slide 5, the largest driver of adjusted EBITDA variance between these periods in the same periods in 2023 with lower product prices, partially offset by lower realized natural gas costs in our cost of sales. Our trailing 12-month net cash from operations was $2 billion, and free cash flow was approximately $1.2 billion. We continue to return substantial capital to our shareholders. Over the previous 12 months, we paid $341 million in dividends. We also repurchased 13.1 million shares, approximately 7% of outstanding shares at the start of the period for $1 billion. We have approximately $1.9 billion remaining on our share repurchase authorization, which we intend to complete by its expiration in December of 2025. Share repurchases, coupled with disciplined investments in growth continue to offer strong returns for our shareholders. We believe our enterprise value remains significantly undervalued. This is reinforced by two recent acquisitions in our industry. The first one focused on traditional nitrogen products and the last driven by low carbon ammonia that transacted at valuations consistent with our view of our assets, but significantly above our current enterprise value. With that, Tony will provide some closing remarks before we open the call to Q&A."
},
{
"speaker": "Anthony Will",
"content": "Thanks, Greg. A year ago on our second quarter earnings call, I expressed dissatisfaction with our safety record as we had experienced an unacceptable number of very preventable injuries. I am really proud of the team for their response and focus on this front, and we have achieved fantastic results both on safety as well as our asset utilization and onstream factors. So, really well done to Chris, Ashraf, Sean, Kelvin and the entire manufacturing team. I also want to recognize the rest of the organization. We are operating extremely well, not only in manufacturing but across the whole company. Our price realizations were strong. We ended the quarter in a fantastic position from an inventory perspective and we are doing a great job on the supply chain side of logistics and gas procurement. Before we turn to your questions, I do want to highlight one other thing that Greg touched on during his remarks. We have seen two significant transactions recently by knowledgeable successful companies acquiring production assets in North America. One transaction, as Greg mentioned was by a long-term entrenched industry participant in the agriculture side of the business, the other by an energy company looking to capitalize on clean energy attributes of low carbon ammonia. Both transactions place values on production assets in North America, roughly new build or replacement cost of those assets. So it is clear that knowledgeable companies looking at the space see higher cash generation and more persistence of that cash generation than the general market recognizes. With our operations really hitting on all cylinders and our world-class EBITDA to cash conversion efficiency, we are in a unique position to continue creating significant value for our long-term shareholders. In fact, over the last 15 years, we have leveraged our cash generation to buy back half of the outstanding shares of the company, while increasing our production capacity by over 1/3. This formula of adding capacity in a disciplined way, while reducing the outstanding share count has driven the best total shareholder return results in the industry. As we look forward, we see the opportunity to continue with this winning approach, providing superior returns for our shareholders. With that, operator, we will now open the call to your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Andrew Wong with RBC Capital Markets."
},
{
"speaker": "Andrew Wong",
"content": "It sounds like you're receiving more interest in low carbon ammonia from the agriculture side of things, which I think is a bit of a shift from about a year ago when we were all kind of talking about more interest on the industrial side of things. So can you talk about that shift and what that might mean for pricing of low-carbon ammonia?"
},
{
"speaker": "Bert Frost",
"content": "This is Bert. I think it's -- the question is a focus of where we are driving our business in all different formats. So energy is a focus, industry is a focus and ag is a focus. And because we're netback-driven or value-driven, we're going to pursue each of those vectors with vigor in the context of what it can do for the company to move these products. As Chris mentioned in his remarks, we're leading the industry in bringing these products to market and also discussing that with our customers. And as I said in my remarks, the feedback is, as folks and customers are looking at their scope missions in their process, whether that CPGs or an industry or ag or ethanol low-carbon products will play a valuable part of that solution. And so that's where we're talking about increased activity. Regarding pricing, we believe and we have already been discussing that in the context of those discussions that a valuable part of our component, not only what we received from the tax credits. But as we put these products to market, we're expecting to receive a superior value to conventional."
},
{
"speaker": "Anthony Will",
"content": "And Andrew, I'm just going to tack on one other thing. It's not that we've seen a diminution or reduction on the industrial or energy side for these products. It's just what has happened is on the agricultural side, we've seen demand develop that we hadn't previously recognized. What we're also seeing is a lot of interest from other potential industrial companies and looking at new low-carbon intense ammonia production for a variety of potential industries that they're focused on as well. So we're not only seeing it in terms of demand across the product space, but also demand from companies that are looking to vertically integrate their inputs."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. And I would just one point to that. I think the agricultural side is also seeing how they can benefit through the industrial side. So for example, with some of the incentives related to the 40B and the 45Z, how low corn production or agricultural production could work into fuel standards, whether it be sustainable aviation fuel. So it's seeing the whole value chain and where they participate in that."
},
{
"speaker": "Andrew Wong",
"content": "And then maybe building on top of that then, you talk a lot about the potential for more ammonia supply and the potential for oversupply. But given we're seeing building demand trends around different industrial applications and maybe on the ag side as well. Like is it possible this is an area where maybe the demand for low carbon ammonia could be strong enough to maybe just tighten the overall market just because of how long it takes to build on these plants. And obviously, we know that, that doesn't always go smoothly."
},
{
"speaker": "Anthony Will",
"content": "I think what we're seeing right now is just based on kind of expected nitrogen demand growth even in traditional applications. Looking forward, expected new demand is outpacing the amount of new construction that is already occurring. And so we expect a natural tightening in the S&D balance even before you layer on top new sources of demand for decarbonized products. So we absolutely think there's going to be a tightening in the overall S&D balance on the nitrogen side. And that's one of the reasons we're so optimistic about what the future looks like for us."
},
{
"speaker": "Operator",
"content": "The next question comes from Josh Spector of UBS."
},
{
"speaker": "Josh Spector",
"content": "I actually want to follow-up on a comment Tony, you made towards the end and Greg talked about it with the value of transactions that are out there. And I mean, I guess, to the extent you're willing to kind of opine a little bit here, I mean, the OCI transaction, obviously, there's like hydrogen feed and some other shared economics in that facility, but it was call it, now $2,100 a ton nitrogen, the Koch acquisition that was done was maybe closer to $4,000 a ton. So I wonder if you could talk about those two different dynamics and what view is the right value for your assets given that quite a wide range that's been provided by the market lately."
},
{
"speaker": "Anthony Will",
"content": "Yes, Josh, I think it's a great question that you bring up, but I think you're thinking about this a little wrong. So the way to think about the Woodside OCI transaction as you take a conventional plant and you basically cleave it in half between the front end of the plant and the back end of the plant. And what's essentially happened is I think Linde is putting about $1.8 billion in the ground to create the front end of a plant. And now you've got Woodside that's paying $2.35 billion for the back end of that plan. So you add those together to really look at what an integrated plant looks like, and your north of $4 billion. Now the piece that Linde is building is a bit larger from a capacity standpoint than just the requirements of the back-end ammonia plant but you do get efficiencies of scale when you start getting into a large production volumes. And so that doesn't scale on a linear basis. If you drop that plant down to kind of just what's required on the input basis, you're still probably talking about $1.3 billion to $1.5 billion. So you're looking at an integrated equivalency plant that's probably pushing [3.75 to 4] on that basis. So you really need to think about it in terms of what the total cost of construction of that plant is. And by the way, Linde has got a take-or-pay on the inputs that they're providing to across the fence line to what's now going to be the Woodside plant. And they're expecting a good rate of return on that. So you can't just look at the back end of the plant and try to do the math on it. You really have to look at what they're paying for the hydrogen, the nitrogen, the oxygen and then capitalize that back into the full cost of what a plant is."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. And I think what you'll find when you do that, Josh, is that it's pretty similar to what the Iowa transaction was as well. And that really leads to Tony's comments that you have two sophisticated buyers who are making these investments, one for agricultural, one for energy, but they both see the sustainable free cash flow generation that underlies those assets. And specifically, our assets are similar, if not identical, in some cases to that, but all the way on the low end of the cost curve in the first quartile."
},
{
"speaker": "Josh Spector",
"content": "Definitely a different way to look at it. I want to follow-up and just ask a little bit more longer term on the blue ammonia off-take or really your decision on FID for the greenfield facility. Just I think you've been helpful about thinking about the milestones needed within Japan, Korea, et cetera, to kind of say when they're comfortable knowing what they're willing to pay in terms of contract for difference to maybe enable some of those contracts. So is there any update you can provide on the time line there beyond your FEED study that will be required for decisions to be made?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So Medi published yesterday, I would say the closest thing to the time line that they have right now. So they put out some of the requirements for the carbon intensity and then it's in public comment period right now for the next 30 to 60 days. So if you think about it, it's really -- public comment is this good for Japan in total, bringing in low-carbon ammonia and co-firing with coal. Once that period has gone through and Medi is the Ministry of Economic and Trade for Japan. They're the ones that are going to be making the recommendation to the government for the contract for difference, just to be specific on that. So once they have that time line, applications and submissions will go in. So that will be like the end of October, November for our projects with our partners. Medi then will have probably three months to four months to choose which projects both from a hydrogen side and a low carbon ammonia side that they would give the contract for difference for. So we're looking now at a more, I would say, more clarity on call it, mid-Q1 for that to be determined. But as Tony mentioned, I think the one thing that we're seeing is a little bit more interest around from other industrials globally on this low carbon front, both from an agricultural but also from industrial applications as well. So, a lot of activity that we're feeling pretty good about with our project. But again, all this is based on waiting for the FEED study to be completed by the end of the year."
},
{
"speaker": "Operator",
"content": "Next question comes from Steve Byrne with Bank of America."
},
{
"speaker": "Steve Byrne",
"content": "Bert, you were talking about the strong ammonia applications last fall. Would like to drill into your brain on what your expectations are for this coming fall. You got the outlook for grower margins looks tighter and you got the soybean corn ratio looks like there might be a shift back to soybeans. Do you have a view on whether -- on the strength of the fall season? Or could the uncertainty lead to kind of a shift more towards next spring?"
},
{
"speaker": "Bert Frost",
"content": "So regarding the fall of 2023 was a big season for us. And in the spring this year, as I mentioned was lighter. However, for the fall programs, whether that be urea, UAN or ammonia, there's been very good uptake and it's a good value. The value that we put out for the fall application program was well received from a broad array of customers. And so we're expecting a solid fall application weather permitting. And the outlook -- yes, the grower outlook at $4 corn today were sub-$4 in the cash market, forward market for this 2025 is in the $4.50 range, which is acceptable. And so it's a question of how farmers are managing their economics. But fertilizer in general, that's [NP&K] on a revenue basis is still in that 20% range, which is acceptable, we think that nitrogen is a good value today. And will be well uptake, and we're expecting 90-plus million acres of corn for next year, which will then support, I think, not only ourselves but the imports that come in and so we're positive for 2025 in the fall application of 2024."
},
{
"speaker": "Steve Byrne",
"content": "And Chris, I wanted to just drill into the FEED studies a little bit with you. You have the FEED study for a new SMR plant, which you know that technology well, and you're working on one with an ATR. And you need a carbon capture control technology to add on to the SMR, is it fair to assume that what you're looking for there might have something like a 75% control just so that the overall carbon capture is roughly the same as the ATR approach? And are you looking at a variety of technologies and maybe even something that would be more modest in control, maybe lower CapEx if the Japan authorities don't require 90%, 95% to qualify as flue?"
},
{
"speaker": "Anthony Will",
"content": "Yes Steve, I'm going to start, and then I'll hand the question over to Chris. So we are going through a flue gas capture FEED study right now. And part of that is does it make sense if we were going to do a new build on an SMR, but part of it also is informing us in terms of the path forward of how we're going to long-term approach getting to net zero by 2050. And there's definitely going to have to be a flue gas capture component of ultimately how we get there, in order to make it work. So this is not only good for the current but good for the long-term as well. And as you say, I think you can design these things at different levels of carbon reduction coming out of the flue. The problem is that sort of thing affects the geometries of the vessels. And so, if you were going to go to all of the pain and hassle of an expense of putting in flue gas capture. It's fairly shortsighted, I think to undersize that unit or to make it so that it's not terribly efficient because then ultimately, if your goal over long-term is to get to net zero, you're going to have to mostly replace or rebuild all of that capital you've already put in the ground. But it is certainly something that we're looking at and evaluating. We actually believe that the value of a superior decarbonized product is going to be such in the marketplace from a demand standpoint that extracting as much carbon out of it as you can is going to pay for itself. Not only do you get the 45Q benefit, but also the market demand for -- and premium that would be accompanying a decarbonized product, I think will carry the day."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. Really not much to add from that, but just to agree with Tony, that I think over time, the carbon intensity and the more you can reduce it, the more incentives or the more premium you'll get for that. If you look at the CBAM, that will be going in place really at the end of 2025 here beginning in 2026, with some of the carbon charges to it is going to be based on carbon intensity and how much you get charged based on that. So having the lowest you possibly can -- will be better. Same thing as we look in Asia primarily is for the biggest reduction that we -- the biggest reduction of carbon is going to be the most beneficial for us."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Parkinson with Wolfe Research."
},
{
"speaker": "Chris Parkinson",
"content": "Let's switch it up a little bit. When I'm thinking about the second half of 2024 and into 2025, can you just update us on your current views of both, let's say, your production rates in both India and China as well as import trends in India and export trends or lack thereof in China. Just what is your latest thought process based on the developments over the last few months?"
},
{
"speaker": "Bert Frost",
"content": "When you're looking at India, there has been, as we communicated a growth in domestic production, which has been the Made in India movement by Prime Minister, Modi. And they've been successful in that. However, taking a step back and looking at those investments, with the cost of LNG being 60% of their gas needs, those are expensive operations, not only from a CapEx position but from an operational and a delivered basis. But doing what it is, that's what they've chosen to do. And so exports or imports to India have declined over time, and we're projecting those to be in the 5 million to 6 million ton range for 2024. To date, and that's a January to date, India has imported about 2 million tons, including their NIFCO tons. And so we would expect over the next several months, September, October, November, December, you would probably see approximately 3 million tons. And so India is still a significant importer but has now fall into the second place as Brazil has taken over the lead for the largest importing country at approximately 8 million tons. And that's been a tremendous growth of demand reflected in their exports of corn and other products. So Brazil is the agricultural powerhouse we've been projecting for years, and we'll continue to grow in their imports of nitrogen. When you look at China, just the second part of your question that has been a great moderator to the -- or the supply of urea for the world. China has been in the 3 million to 5 million-ton export range for the last several years. And this year, it's almost insignificant because it's almost zero of their exports to date. We have talked about them being in the 2 million to 3 million-ton range. I don't think that's a questionable volume. And so when you put that in perspective of if the world export vessel traded market is approximately 55 million tons, taking 3 million to 4 million tons out of that supply is a great supporter of the current price structure where we are, that as well as the Egyptian loss of production in May through July, as what has been supporting the price structure that we have today."
},
{
"speaker": "Chris Parkinson",
"content": "Just a quick follow-up. Over time, you've traditionally converted correct me, if I'm wrong, about 70, and if you adjust for a tax in a few years ago, probably close to 80% of EBITDA and free cash flow. Can you just help us, especially given your remarks about some transactions in the space? Can you just give us how the market should be thinking about buyback activity versus potential CapEx outflows in terms of the cadence, not only '24, but also when CapEx could even rise in the future. So just help us think about the balance of capital allocation over the next 18 months or so, just given that conversion rate."
},
{
"speaker": "Christopher Bohn",
"content": "All right. I'll start with the CapEx part, Chris. Our CapEx that we have is right now in the range of $550 million. As you know, having followed our company long enough that Q3 is when we do a lot of our planned maintenance. So we'll see probably a little heavier spend in Q3 here along with some of the production being a little bit lower. But with the full year being at gross ammonia production of the 9.8 million tons we talked about. As we get into an FID and say it's a positive FID to move forward with a new plant, the spending really occurs over five years, and it's almost just like a standard distribution a little bit with the beginning spend being relatively thin and then getting into years back half of the second year, third and fourth year, heavier and then the tail back on the fifth year. So a bit longer of a spend trajectory than the actual construction of plant itself is how we plan that out based on whatever our share component of that will be. I'll let Greg talk about maybe share repurchases."
},
{
"speaker": "Gregory Cameron",
"content": "Yes. So as I said in the remarks, we have about $1.9 billion left in our current authorization, and we plan to complete that opportunistically by the end of December of 2025."
},
{
"speaker": "Anthony Will",
"content": "And I would just add one thing, Chris, which is the good news, you mentioned our best-in-class EBITDA to cash conversion. And I think somewhere fairly traditionally in the 60% to 70% range is pretty normal for us. We were a little lower given kind of some of the operating challenges we had in Q1 with the weather-related outages and then the ripple on in terms of what that meant from some of our industrial ammonia contracts. But I would expect us to kind of get back into that range. That's pretty normal for us. And at that kind of conversion efficiency and cash generation, it's not an either/or question. It's both. And even if illustratively you're talking about a greenfield project if we decided to go forward with it that's in the range of what the Woodside/Linde project is trading at. If we're only doing kind of 50% of the capital on that spread over four or five years, it's not such a heavy capital load on us given our cash generation that we can't continue to do pretty significant share repo at the same time. So our view is it's the formula that we have used in the past of disciplined and addition of capacity while reducing our share count, we think works on a go-forward basis and we expect to continue to generate superior returns."
},
{
"speaker": "Operator",
"content": "The next question comes from Adam Samuelson with Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"content": "Bert, in your prepared remarks, you alluded to potential changes in buyer marketing patterns over the balance of the year. And I just wanted to clarify, is that a lot of the global pieces that you were just answering response to Chris' question? Or was there shifts you're seeing amongst your U.S. domestic customers in the fertilizer space? And if so, could you just elaborate a little bit on what is changing in terms of how people are buying fertilizer for the second half of the year?"
},
{
"speaker": "Bert Frost",
"content": "Yes. There's been a trend with buyer behavior of deferring or delaying purchases over the last couple of years. And I think as a reflection of the ag market cycle and lower corn prices to farmers, and therefore, lack of farmer liquidity or maybe financially stressed, those purchases could be delayed to the retail sector. And so based on that, we've gone into a little more of a defensive mode. We've worked on our -- we've kept our inventories low, and we have moved our programs forward and a successful launch of our fall and fill programs, as I mentioned, and so how we're operating is in the context of if that eventuality of delayed purchases were to happen, we won't be constrained as a company. So we've leveraged the utilization that's at our fingertips. So exports, distribution, modes of distribution, production allocations as well as our communication with our customers to make sure we always position CF Industries in the most opportunistic way."
},
{
"speaker": "Adam Samuelson",
"content": "And if I can just ask a follow-up. I believe you had the supply agreement for ammonia to Mosaic for most of the last decade. I believe that you've exercised your right to terminate that supply agreement beginning in January. Just how do we think about the non-trivial amounts of your own ammonia volumes, how do you think about -- how you're thinking about marketing that next year or you working to renegotiate the terms of that agreement?"
},
{
"speaker": "Bert Frost",
"content": "Mosaic has been a fantastic customer. And that was a partnership that was a result of us selling the assets to phosphate production assets to them in Florida which they were, I think, a more economic owner of as well as then associating the ammonia contract, a long-term very large supply contract which was beneficial to CF when we were starting up our new production assets in Donaldsonville to have an outlet. As we've rolled forward, I think both companies realized that we were the one to execute the contract and to terminate it. But we're in negotiations and conversations with them to continue supply, and we anticipate Mosaic to always be a fairly large customer of CF Industries, and we have a great relationship with them, and they're doing a good job. However, there are additional tons, which we have been working on over the years to market. And we do have additional outlets. We've been active in the export market, both with moving ammonia to different locations as well as augmenting our industrial contracts and customers to have a more balanced portfolio."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. And I think as Europe implements the financial aspects of the CBAM, going forward to there may be more alternatives that provide a higher netback for that low carbon ammonia that will be in production next year for Bert and his team to evaluate as well."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Theurer with Barclays."
},
{
"speaker": "Ben Theurer",
"content": "First of all, congrats on a very strong second quarter. Just wanted to give your thoughts around just the cost piece of it, gas pricing and obviously, would it potentially does in Europe right now from a capacity point of view. You've highlighted in your prepared remarks, it was an offsetting a little bit the price decline clearly during the quarter from an EBITDA perspective and also on a first half basis. So as we see it right now, where do you think the spread is going to trend out just also given the geopolitical tension in the Middle East? And have you done any sort of like contracting, hedging et cetera, just to lock in those lower costs that are prevailing right now in the North American market, my first one."
},
{
"speaker": "Christopher Bohn",
"content": "So Ben, this is Chris. I'll start with the European side. So as you mentioned, we continue to see Europe being challenged by the energy costs even before some of the geopolitical events that have happened over the last few days in Ukraine and also in the Middle East. So that's something that we see continuing. And then on top of that, we've done a pretty in-depth analysis of the European assets and we're seeing pretty large maintenance events that are going to be coming forward for some of the plants, and they have to make the decision whether you make those significant capital investments or whether you curtail or shut down completely. I mean, as we've talked about before, the best example of that is what we've done in the U.K., where some of those capital expenditures were going to be so large. We are better off importing ammonia and then just upgrading it from there. So our expectation is between now and 2030 that we see even more tightening in the supply market in Europe related to those two factors, both the energy and then just the additional capital costs coming. And that really is what we see as an opportunity for us out of Donaldsonville, where we have the export capability, and we'll be the first to have low-carbon ammonia and low-carbon products. So we almost see it as a carbon arbitrage opportunity given that we'll be the first mover on low carbon to Europe. But I'll let Bert talk about our hedging strategy."
},
{
"speaker": "Bert Frost",
"content": "Where we are on gas and you see it reflected in our Q2 exceptional performance and great job to the gas team is we're wide open in the cash market, and we're believers in the future of North American production. Today, we're running at a rate of about 102 Bcf and with exports still in the 12 Bcf to 13 Bcf per day and the spreads, you're still injecting and building inventory and that's what's driving and keeping the Henry Hub price lower. And so the spread against the international market, TTF or JKM, Europe and Asia is over $10, and that's an exceptional place for us to be as operators of these assets. But when you look at the trends, you've seen what happened in Egypt when it turns to summer and they want the gas for electricity or other purposes. They're now a large importer of LNG or Trinidad on the gas constraints that we're experiencing with our own assets. And so what will happen when you combine the EU and North Africa and Trinidad combined with their production assets and the global S&D for the products that those plants produce, it places, again, like Chris said, an exporter or a producer like CF Industries in a fantastic place outside of what could happen in the Middle East with all the disruption in Gaza and the Red Sea. So I think we're well positioned."
},
{
"speaker": "Anthony Will",
"content": "I'd also add that what we're seeing and some of this is being driven by machine learning and AI applications and the proliferation of that is the number of data centers that are going up globally is significant and the expected energy draw against those per data center installation is really large. And I think some of the estimates that we've seen is by the end of this decade, there's going to be about 4 Bcf of incremental gas conversion into electricity just for data centers in the U.S. alone. And so the energy is not -- or the world is not reducing the electricity demand to the contrary, it's going up quite heavily. And so to be in a place in that environment where energy is short and tight where we have the kind of resource base that we do have in the U.S., you really couldn't be in a better place. And I think that's one of the reasons why assets over here are trading the way they are."
},
{
"speaker": "Ben Theurer",
"content": "And then just following up, you've talked a little bit about the Waggaman integration, but just wanted to understand where you're at in terms of like efficiency at Waggaman versus your own legacy assets? Where is still the potential? And just like from an operating run rate perspective. Where are you at right now? And where do you want to be maybe by year-end or in the first half of '25?"
},
{
"speaker": "Christopher Bohn",
"content": "So what I would say, Ben is right now, the plant is currently operating at about 10% above its nameplate capacity. And that's pretty much in lockstep with a lot of our legacy plants that we have in the CF network. We haven't really evaluated doing any debottlenecks there at this particular time. I think our goal is just to have upstream on time to be the plant operating more consistently, which it has been since we took it down. If you recall, in the first quarter, it was one of the sites where we had an outage. Our team pulled-forward some of the work and got in there and accomplished a significant amount of maintenance work during that particular time frame. And since then, the plant has been operating fantastic. So from that integration standpoint, we feel very comfortable that where we're running now is where we'll run for the remaining part of the year. As time goes on, we'll look at other projects that may involve with debottleneck and definitely will involve carbon sequestration."
},
{
"speaker": "Anthony Will",
"content": "The other thing I'd just add is from an efficiency standpoint, I think I'm right in saying that is the most efficient plant we have in the entire network. And we're running at, I think, under 30 MMBtu per ton of ammonia, where the legacy systems, not including the recent expansion plans, but the legacy systems are more like 33, 32, and even the expansions are in the 30 range. So not only is it a fantastic plant from being able to operate above nameplate, but it's the most efficient plant in the system. And we've got a really engaged workforce down there. We could not be happier with that acquisition."
},
{
"speaker": "Operator",
"content": "The next question comes from Richard Garchitorena with Wells Fargo."
},
{
"speaker": "Richard Garchitorena",
"content": "So I was wondering if you could maybe give us an update in terms of how you're thinking about the market environment for clean ammonia today versus when you started your process to build out the strategy. Obviously, the recent OCI transaction would confirm, I guess, value that's out there. And then also, we had conflicting views out there in terms of the viability more green ammonia than blue ammonia, but maybe just some updated thoughts would be great."
},
{
"speaker": "Christopher Bohn",
"content": "Well, I'll start. One, we're extremely positive. We think the transaction, I should say, is positive for the industry with Woodside because it’s pretty much validates not only our clean energy strategy but the conversations they're having globally, they're seeing the sort of the same type of demand shoots and new centers starting to evolve, whether it be in power generation or in just marine fuel or just in really placing or supplanting higher carbon nitrogen today. So very positive on that. I think what we've seen change over the time is what Bert talked about in the beginning is that we are largely industrial focused. And we are seeing the pull happen more from power gen and marine side and even sustainable aviation fuel. Now what we're seeing is the agricultural side is probably seeing where they fit into that. And then there's also the demand pull side that's coming more from the CPGs who want a lower carbon product as they're moving forward."
},
{
"speaker": "Bert Frost",
"content": "I agree with Chris. In terms of where we are in our evolution in this process, we're focused on the business and where we can generate higher revenues and higher profitability and clean products are going to be a part of that. And it's amazing the receptivity from the processors. Again, when you look at the corn value chain in and of itself of what low-carbon product low-carbon ammonia or ammonia to upgrade it as UAN or as ammonium nitrate. What that can do in that value chain for corn or wheat as you take it through to the farmer and the farmer does beneficial practices that are being focused on today through the processor and as we sequester that CO2 from, let's say, the ethanol producer, you have a very -- a very low carbon finished product that can go into sustainable aviation fuel or ethanol. And those -- that's where we're focusing our attention on the ag cycle."
},
{
"speaker": "Christopher Bohn",
"content": "And I would say the discussion about blue and green, I would just call it, it's all going to be, as I mentioned earlier, on a carbon intensity. I think to get to zero carbon even as we start to commission our particular plant down there, which is about only 20,000 tons a year. The cost of green is just very significant. And the energy pull on that, but not -- without having the renewable energy sources in place, it's going to be very difficult to leapfrog low carbon and get right to zero. I think as time goes on and by time meaning decades, you'll start to see it evolve to that. But today, when you can get to 65% to 95% carbon reduction that's what's going to lead the day today."
},
{
"speaker": "Bert Frost",
"content": "And I think that's where you see the stalling globally of the green projects where you see CF and others leaping ahead with low carbon products."
},
{
"speaker": "Richard Garchitorena",
"content": "And then during the quarter, you also moved forward Yazoo City with CCS. Given how well Waggaman is running, can you maybe talk about potential moving forward with other projects on CCS maybe in that regard?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. As we've talked about all along, we have a hierarchy of plants that we were hitting that were the most attractive and the soonest to execute so we could move on those. The first being Donaldsonville, the second being Medicine Hat, Yazoo City, so we've executed with Yazoo City, so we're working on Medicine Hat. Waggaman, our initial goal there was just the utilization rate and getting that stable and moving forward with the projects we have in place from a maintenance standpoint. But that definitely is probably the next on the list after Medicine Hat that we begin to look at CCS in that particular region."
},
{
"speaker": "Operator",
"content": "Next question comes from Edlain Rodriguez with Mizuho Securities."
},
{
"speaker": "Edlain Rodriguez",
"content": "Tony, a quick question for you. Like you talked about like the stock being undervalued and those two transactions clearly prove you right. The question is, how do you unlock the value? Like what do you need to do? Or what can you do to make investors see the light?"
},
{
"speaker": "Anthony Will",
"content": "Yes. I mean I think from our perspective, Edlain that we're going to continue to do what we have done, which is just continue to buy the shares out of the marketplace. We've taken 50% of the company's outstanding share count out already, and that has benefited significantly the long-term shareholders that have been with us on that journey, and we're going to continue to do that. And eventually, those that are left will be able to recognize and see the amazing amount of aggregate cash flow and the few number of shares out and that will by definition have to translate into a share price that is, I would say, more reflective of the value of the asset base. But until that time, we're happy to be patient and continue to buy shares out and for the benefit of our long-term believers."
},
{
"speaker": "Operator",
"content": "The next question comes from Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"content": "Can I just start off by -- I just want to clarify a few things that have come up on the blue project, one would be that is FID still intended for later this year? Or did the Medi thing push it into 1Q? And I guess, on top of that, it sounds like you're seeing a lot more demand from multiple actions versus previously. So is there any scenario where the scope of the plant increases? Or is there a second plant? Or does that incremental interest make you willing to move forward maybe with -- maybe ahead of Medi or without take-or-pay contracts or has anything changed in sort of the way that you want to have everything postured before making FID."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So I think the Medi decision time frame is one aspect that's in our partnership with JERA, where they would feel comfortable moving forward once they know what the contract for difference is. However, in saying that what is really the gating item initially right now is completion of the FEED study and our understanding that's going to inform what is the CapEx, what is the volume we can get off of that. And then out of that, what is the return profile. And if that's significantly above our capital -- our cost of capital, there's other partners that we're also in discussion with that could accelerate that. So I wouldn't say it's 100% pinned to Medi just given some of the other activity that we've seen around that. I think given the size of the project, there's two ways we look at partnership. One would be in an equity investment and one would be a long-term off-take no differently than we've done in the past with CHS and as Bert talked about earlier with Mosaic. To move to a second plant right away, I think we would need probably really to be ensured that we had partnerships and the cash flow. As Tony said, we're looking at this in a very disciplined way while continuing to do capital allocation back to the shareholders, but also grow and we think right now, our focus is on that first plant at the blue point side."
},
{
"speaker": "Anthony Will",
"content": "Yes. And I would just echo that, which is having partners that are in there with us not only on to kind of share the capital commitment, but also take the product off-take is an important aspect of this from our standpoint, just in terms of risk mitigation. And so the Medi thing relative to JERA being a potential partner does elongate that time horizon. But as Chris mentioned, there's a lot of other interest from other parties that we feel like if the project holds water from a return profile perspective. There won't be an issue with respect to us having others join us."
},
{
"speaker": "Operator",
"content": "The next question comes from Jeff Zekauskas with JPMorgan."
},
{
"speaker": "Jeffrey Zekauskas",
"content": "I think you sold $47 million of emissions credits -- is that $47 million that net benefited EBITDA in the quarter? Or is the number larger or smaller?"
},
{
"speaker": "Anthony Will",
"content": "No, that does. And it's actually fairly comparable to what we did a year ago. Those were credits that were -- that were provided by the U.K. government as part of the overall ETF submissions scheme in the UK. And we are, at this point, given the fact that our ammonia production is offline kind of largely through that bank of credits. But on an account basis quarter-over-quarter from last year versus this that number didn't change dramatically."
},
{
"speaker": "Jeffrey Zekauskas",
"content": "And looking at the language that you described Donaldsonville and the Mississippi plant, it looks like the Deville carbon dioxide will go into enhanced oil recovery, whereas the Mississippi plant will have carbon dioxide that's sequestered. In the new plant that you want to build the new greenfield plant, does it make a difference to the carbon footprint if you have to go an enhanced oil recovery route versus a sequestration route? Or how much of a difference does it makes?"
},
{
"speaker": "Anthony Will",
"content": "Yes. It matters a little bit in terms of the value of the 45Q tax credit. The payments higher, if you go into a Class 6 well than EOR. The agreement that we have with ExxonMobil was contemplated on a Class 6 well, and so that is still for both plants, both Deville and Yazoo City. So that is still the expectation of where we're going to end up longer term. There is a question in terms of whether Class 6 permitting will be completed by the time that we're ready to begin injection from our side. And so there may be some transition period that we are talking about whether that makes sense to accelerate and go into EOR for a period of time before Class 6. But more to come on that front. Our perspective is the world is going to continue to need that oil. And whether it's our CO2 or whether it's CO2 that comes out of naturally occurring sources like Jackson Dome in Mississippi or other places, that oil is going to get produced. This is a net reduction in the amount of emissions that we're providing that's going into the ground and staying there and the oil is coming out anyway. And so our perspective is this is nothing but good for the environment. I think different potential customers may have different perspectives on that. And we've got to align with customer requirements. But in the near-term, the difference really is about the value of the 45Q tax credit. But longer term, the intent of all of our agreements is Class 6 permitting."
},
{
"speaker": "Jeffrey Zekauskas",
"content": "No, I get it that there's a different remuneration if it's sequestered versus EOR. But what I was wondering is in terms of the way the carbon footprint is thought of by, say, the Japanese are they going to make a different calculation or you make a different calculation."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. I think that's what Tony was trying to explain that certain customer bases are going to view EOR differently than a permanent sequestration. So as you look to Asia, it's more permanent sequestration is a requirement. I think as you look here in the U.S. and some of the other regions around the world, EOR given his point that he made, it's still sequestering CO2 will be acceptable. We look at it both on a strategic basis from that, but also on the economic as he explained as well."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that is all the time we have for questions today. I would like to turn the call back to Martin Jarosick for closing remarks."
},
{
"speaker": "Martin Jarosick",
"content": "Thanks, everyone, for joining us today. We look forward to seeing you at upcoming conferences."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cf | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to CF Industries' First Quarter of 2024. [Operator Instructions] I would now like to turn the presentation over to the host for today, Mr. Martin Jarosick, with CF Investor Relations. Sir, please proceed."
},
{
"speaker": "Martin Jarosick",
"content": "Good morning, and thanks for joining the CF Industries Earnings Conference Call. With me today are Tony Will, CEO; Chris Bohn, Executive Vice President and Chief Operating Officer; and Bert Frost, Executive Vice President of Sales, Market Development and Supply Chain. CF Industries reported its results for the first quarter of 2024 yesterday afternoon."
},
{
"speaker": "",
"content": "On this call, we'll review the results, discuss our outlook and then host a question-and-answer session. Statements made on this call and in the presentation on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statements."
},
{
"speaker": "",
"content": "More detailed information about factors that may affect our performance may be found in our filings with the SEC, which are available on our website. Also, you will find reconciliations between GAAP and non-GAAP measures in the press release and presentation posted on our website."
},
{
"speaker": "",
"content": "Now let me introduce Tony Will, our President and CEO."
},
{
"speaker": "W. Will",
"content": "Thanks, Martin, and good morning, everyone. Yesterday afternoon, we posted results for the first quarter of 2024 in which we generated adjusted EBITDA of $460 million. Our performance reflects a challenging quarter for our production network. Plant outages caused by severe cold in January as well as other unplanned downtime resulted in a significant loss of production and maintenance activity."
},
{
"speaker": "",
"content": "Even with the production outages and associated expenses, our business generated strong cash flow for the quarter. Net cash from operations from the first quarter was $445 million, and free cash flow was approximately $200 million. Longer term, we expect the global energy cost structure to continue to provide a significant margin opportunities for our North American production network and for clean energy to provide a growth platform for the company."
},
{
"speaker": "",
"content": "As a result, we expect to have significant free cash flow available to both invest in growth and return capital to shareholders. We remain focused on disciplined investments in clean energy that offer returns well above our cost of capital."
},
{
"speaker": "",
"content": "These include decarbonization projects within our existing network and potential new low-carbon ammonia capacity. We also remain committed to returning capital to shareholders through our dividend and share repurchases. In the first quarter, we returned $445 million, including repurchasing 4.3 million cars. We have approximately $2.2 billion remaining on our current share repurchase authorization, which we intend to complete by the end of next year."
},
{
"speaker": "",
"content": "With that, let me turn it over to Bert, who will discuss the global nitrogen market conditions in more detail. Bert?"
},
{
"speaker": "Bert Frost",
"content": "Thanks, Tony. The global nitrogen market has experienced rapidly changing dynamics throughout 2024, including in North America. The spring application season began earlier than normal in late February with demand for ammonia applications brought forward from the second quarter into the first or weather at the end of March, subsequently stalled field work and fertilizer purchases with the region now on a normal application and planting pace."
},
{
"speaker": "",
"content": "Overall, we expect nitrogen demand in North America to be positive with approximately 91 million acres of corn planted. Good soil moisture supports higher application rates than in previous years, and farm economics remain constructive, though weaker than the record highs from previous and recent years."
},
{
"speaker": "",
"content": "We believe the spring ammonia season will see fewer tons of ammonia applied this year. However, total ammonia application volumes for the fertilizer year, which runs from July 2023 through June 2024, should be comparable to previous years, given the strong fall ammonia season. As the pace of spring application season has normalized, the lineup for urea and UAN imports for the region has grown."
},
{
"speaker": "",
"content": "These tons will be necessary to meet expected demand, given low inventories in the region to start the year and production disruptions in January. Even with the imports, we expect that inventory in the North American nitrogen channel across all products will be low at the end of the season. This activity is occurring as the global nitrogen market supply position has loosened, leading to lower global prices than we saw earlier this year."
},
{
"speaker": "",
"content": "Lower imports of urea to India, including the impacts of lower volumes taken in the recent tender, lower-than-expected to deferred demand in Europe and other countries and good production from the [ Europe, ] Gulf and North Africa, all played a role. We did not believe demand during the spring season in North America will resolve the length in the global nitrogen market by itself."
},
{
"speaker": "",
"content": "As North America hits its traditional pricing reset in the summer, Brazil, India and China will provide the most important signals regarding the state of the market. We project that urea consumption and imports in Brazil will grow in 2024, maintaining that company's status as the world's largest importer of urea. India will remain a major importer of urea, though they have lower requirements today, reflecting their commitment to increase domestically produced urea."
},
{
"speaker": "",
"content": "China continues to prioritize lower fertilizer prices for their farmers with export restrictions playing a significant role in that effort. We expect China to export approximately 4 million metric tons of urea this year, but actual volumes will depend on the timing and duration of when exports are allowed."
},
{
"speaker": "",
"content": "Even with these sources of near-term uncertainty, North American producers remain firmly positioned on the low end of the global cost curve. Forward energy curves continue to show spread between North America and Europe, which is home to the industry's marginal high-cost production remaining wider than historical averages. As a result, we expect attractive margin opportunities for our network in the near and longer term."
},
{
"speaker": "",
"content": "With that, let me turn the call over to Chris."
},
{
"speaker": "Christopher Bohn",
"content": "Thanks, Bert. For the first quarter of 2024, the company reported net earnings attributable to common stockholders of approximately $194 million or $1.03 per diluted share. EBITDA was $488 million, and adjusted EBITDA was approximately $460 million. The production outages that we experienced earlier this year affected our results in 2 significant ways."
},
{
"speaker": "",
"content": "Maintenance expenses were approximately $75 million higher in the first quarter of 2024 compared to the first quarter of 2023. Additionally, we had approximately 160,000 fewer tons of ammonia available to upgrade in the quarter compared to the same quarter last year."
},
{
"speaker": "",
"content": "This equates to approximately 275,000 tons of urea that we would otherwise have been able to produce and sell at higher margins. The production issues were continued through the first quarter, and our network is operating at our typical high utilization rates today. We believe we currently project that growth ammonia production for 2024 will be approximately 9.8 million tons, which reflects normal asset utilization rates moving forward."
},
{
"speaker": "",
"content": "Our forecast for 2024 capital expenditures remains approximately $550 million. Capital expenditures were higher in the first quarter of 2024 compared to the first quarter of 2023, primarily due to a large planned turnaround event. We are making continued progress on our clean energy initiatives."
},
{
"speaker": "",
"content": "Commissioning activities for our green ammonia projects are nearing completion. We intend to purchase 45V compliant renewable energy certificates to pair with the startup of the electrolyzer to enable green ammonia production and maximize the value of the hydrogen production tax credit."
},
{
"speaker": "",
"content": "Additionally, construction of the carbon dioxide dehydration and compression unit at Donaldsonville is progressing well. We believe it will be ready for start-up in 2025, at which point our partner, Exxon Mobil will begin to -- will be able to begin transportation and permanent sequestration of up to 2 million tons of CO2 from the facility per year."
},
{
"speaker": "",
"content": "This will not only significantly reduce our carbon emissions, but also enable low carbon ammonia production and generate substantial 45Q tax credits. Our evaluation of low-carbon ammonia capacity growth continues with potential partners and offtakers. We have made additional progress on our auto thermal reforming ammonia plant and flue gas capture FEED studies."
},
{
"speaker": "",
"content": "These should be complete before the end of the year and will be an important component of our final investment decision. We continue to emphasize a disciplined approach based on the return profile of new capacity, the technologies needed to meet customers' carbon intensity requirements and the global demand outlook."
},
{
"speaker": "",
"content": "With that, Tony will provide some closing remarks before we open the call to Q&A."
},
{
"speaker": "W. Will",
"content": "Thanks, Chris. Before we move on to your questions, I want to thank everyone at CF Industries for their hard work during the difficult first quarter of 2024. In particular, the team did an outstanding job restoring our network to full utilization rates and most importantly, doing so safely."
},
{
"speaker": "",
"content": "Our 12-month recordable incident rate at the end of the quarter was 0.36 incidents per 200,000 labor hours, significantly better than industry averages. Despite the challenges we faced earlier this year, we believe CF Industries is well positioned for the years ahead. In the near term, the global energy cost structure remains favorable to our North American production network. Longer-term disciplined investments in low-carbon ammonia production provide a robust growth platform for the company. Taken together, we expect to drive strong cash generation and continue to create substantial value for long-term shareholders."
},
{
"speaker": "",
"content": "With that, operator, we will now open the call to your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question comes from Chris Parkinson with Wolfe Research."
},
{
"speaker": "Christopher Parkinson",
"content": "Tony, it's been a while since I think anybody has asked you this, but what are your latest thoughts across the organization on the global cost curve? I mean, obviously, it seems things have very much normalized in Europe. It seems -- obviously, you have this back and forth debate in terms of timing on Chinese markets. And then obviously, there's been a lot going on in India as well. So when you put all these things together, once again, I don't think anybody is really focused on this for years and years, what's yes, latest and greatest on how we should be thinking about this over the next year or 2?"
},
{
"speaker": "W. Will",
"content": "Yes, Chris, I think that we believe, going forward, there are some significant challenges for a number of the production facilities in Europe. And our expectation is that utilization rates there will continue to be challenging. And we would expect some of those assets to permanently close. So I think that the combination of some challenges in Europe and other places in the world -- Trinidad is both running out of gas and with gas cost climbing as each of the existing contracts roll off, you've got challenges in parts of Asia and Latin America as well."
},
{
"speaker": "",
"content": "You look at all of that and you see somewhat of a tightening out of the existing production network, you combine that with the fact that there is not enough new production under construction at the moment to meet the traditional growth in normal applications. And we see a tightening of the S&D balance going forward with Europe and Asia being at fairly high end of the cost curve."
},
{
"speaker": "",
"content": "And so there will be periods of time where we need to bid some of that production in just to meet global demand. So I think it provides a very constructive backdrop for our North American focused production network. And we remain excited about what the long term holds for us and even the near term, for that matter."
},
{
"speaker": "Christopher Parkinson",
"content": "Got it. And just a real quick follow-up, and I apologize for the ultra short-term question, but obviously, your organization has gone through a lot during the first quarter. Can you just give us kind of a -- just one additional update on just how we should be thinking about where you stand operationally. I assume Bert's team had to move a lot of products suboptimally towards the end of the quarter."
},
{
"speaker": "",
"content": "When we think about the process back normality, are we basically already there yet, and we can -- you can instill the confidence that we should just be focusing on market pricing right now? Or how should we be ultimately thinking about your pathway forward for the remainder of 2024?"
},
{
"speaker": "W. Will",
"content": "Yes. I think as you look at the first quarter, as Chris said, there was kind of 2 primary factors that impacted us. One was because we had significant outages both weather-related and other downtime. We ended up with less production of ammonia, and we have existing industrial ammonia contracts that obligate us to kind of meet those needs first."
},
{
"speaker": "",
"content": "And Waggaman was one of the facilities that experienced some downtime in the quarter. And so we had to make sure that we were meeting the customer commitments out of that facility and other industrial customers as well. And so what that math was, as Chris mentioned, there was ammonia that we were producing that normally we would have upgraded to urea and/or UAN that we needed to ship out as industrial ammonia, which generally is at a bit of a lower margin than agricultural ammonia or ag-based urea/UAN."
},
{
"speaker": "",
"content": "So the loss of production was both the opportunity cost of loss of absolute tons, but also the opportunity costs associated with being -- not being able to upgrade product for higher-margin urea than we normally would. As Chris mentioned, we were able to go ahead and get the plants back up and running and have been running sort of that normal operating utilization rates since the beginning of the quarter."
},
{
"speaker": "",
"content": "And so we're back to kind of normal operations, and therefore, I think what's been transpiring in the way of spot pricing is appropriate for -- and our volumes as appropriate for the second quarter."
},
{
"speaker": "Christopher Bohn",
"content": "Chris, the only additional thing I would add to what Tony said is not only that it was discrete production issues contained in Q1 but also where the product mix was and being produced. We had incremental distribution costs that went over and above the margin loss that Tony spoke about and also the $75 million approximate higher maintenance expense. So it was a pretty tough quarter from that, but all of that, as you said, is sort of in the rearview mirror and our distribution and production assets are back to their historical levels."
},
{
"speaker": "Operator",
"content": "The next question comes from Joel Jackson with BMO Capital Markets."
},
{
"speaker": "Joel Jackson",
"content": "Just a couple of things you can maybe ask -- sorry."
},
{
"speaker": "",
"content": "Are you really open for Q2 here for gas? Maybe talk about -- we've seen obviously, prices come down well below to where you're standing at Q2 into Q3? And then you talked about 9.8 million tons of gross ammonia production '24. What is your view that what you can do in 2025 for gross ammonia production with hopefully some improvements at Waggaman and these issues from Q1 behind you?"
},
{
"speaker": "Bert Frost",
"content": "Joel, this is Bert. And on gas, yes, we are wide open, and we do have fixed contracts that are gas-based that will fix in the beginning of the month. And we do have [ bases ] that we've covered in places more of a winter item. We'll have some Q1 gas purchases trail into Q2. But in effect, the gas values that you're seeing and through the various hubs, you can bleed into your model, and that's what we're doing."
},
{
"speaker": "Christopher Bohn",
"content": "Yes. From a production standpoint, Joel, I think you can look at 2025 and going forward similar to what we had announced earlier this year at sort of the circa 10 million tons of ammonia -- gross ammonia production. And then based on where the margin potentials are that's going to change the product mix related to the total product that we do. But give or take, 100,000 tons on either side of that is generally where we look to produce."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Wong with RBC Capital Markets."
},
{
"speaker": "Andrew Wong",
"content": "So my first one is really on Blue Point. I understand the plan is to go with mostly sales that are based on like a fixed margin type offtake. Just curious, how does the ammonia market pricing effect you're thinking on the investment decision there?"
},
{
"speaker": "W. Will",
"content": "Well, Andrew, as you know, once we make an investment decision, if we decide to move forward with it, it's going to be approximately 4 years between when that decision is made and when production commences. So what's happening in the very near term ammonia market from a pricing perspective, it is an important starting point."
},
{
"speaker": "",
"content": "But what you really need to do is project where we are 4 years going forward and take a look at where we think the S&D balance will be at that time. We do expect the S&D balance to tighten as I talked about earlier, both in terms of existing production capacity that will not be running at historic utilization rates, principally in Europe and some in Asia and Latin America."
},
{
"speaker": "",
"content": "But also because the new capacity that is currently under construction doesn't meet traditional growth of, call it, 1.5% to 2% within the nitrogen markets, let alone any new applications for clean ammonia going into either electricity generation or into marine fuels or some of the other applications that are beginning to develop."
},
{
"speaker": "",
"content": "So as we look forward, the development of those new markets is an important input as well as just our assessment of where the S&D balance is going to be on a global basis. And so again, where we are today is a starting point, but it's not really that useful in determining what the future is going to look like 4 to 5 years out."
},
{
"speaker": "Andrew Wong",
"content": "Okay. That's fair. And maybe just going on to clean ammonia market and demand, it's been a few years here now since you started talking about it and feels like things have started to develop over the past couple of years."
},
{
"speaker": "",
"content": "So as we get closer and closer to some of these use cases that are maybe later 2020 into 2030, do you have a sense on like how to quantify that demand, let's say, by the time we get to 2030. And what would be the primary use cases by then? Would that still be co-firing in power generation, maybe marine is coming up a little bit faster? Just curious."
},
{
"speaker": "W. Will",
"content": "Yes. So there have been -- I believe it's 5 power stations in Japan that have been kind of approved for conversion to be co-firing ammonia. Those include 2 from JERA and 3 others. And so the assessment of the volume of ammonia that would go into those applications, assuming only a 20% dosage rate is about 2 million tons a year."
},
{
"speaker": "",
"content": "So that's a pretty sizable increase in terms of demand, and that would be expected to be online by, call it, 2030, if not before. Additionally, we see demand beginning to develop, both in terms of marine, but also Bert can talk about some of the things that we're seeing in the way of using a decarbonized fertilizer product for certain applications in ag, not only for CPG companies but also to develop a traceable sustainable aviation fuel as well as ethanol that will meet the California low carbon fuel standard."
},
{
"speaker": "Bert Frost",
"content": "That's exactly that, Tony. In terms of the low carbon value chain, we see developing 4 ag and the pull-through that will take place from the CPGs and consumers. But when you look at whether that be corn or wheat, the principal consuming crops for nitrogen, as a low or no carbon ammonia is passed through corn to the ethanol plant, which is decarbonized, you have a very good upside for a decarbonized product coming from that corn value chain of starch, ethanol, fructose and the same thing with the wheat value chain. So we're working on that with several players and more to come."
},
{
"speaker": "Operator",
"content": "We have the next question from Adam Samuel -- sorry, that's Adam Samuelson with Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"content": "Maybe picking up on that last topic, Bert, there was earlier this week that the treasury department issued kind of the rules for the new 40B tax credit for sustainable aviation fuel that tax rate will change next year, but the rules that would presumably be somewhat applicable. And one of those requirements for ethanol to jet was the requirement to use climate smart agriculture, of which one of the requirements was the use of enhanced efficiency nitrogen fertilizer by corn growers."
},
{
"speaker": "",
"content": "And I would just love to hear your perspective on kind of how kind of disruptive that could be to the existing domestic nitrogen market and how available enhanced efficiency nitrogen fertilizer. I know there's a bunch of things that fall under that. But how -- what is that -- what could that do to domestic demand by product or form both opportunity and risk as you think about the CF network?"
},
{
"speaker": "Bert Frost",
"content": "I don't view it as a threat. I view it as an opportunity because of the first mover with low-carbon ammonia as the largest ammonia supplier to corn production in North America, that's just right up our wheelhouse. And so working with the co-ops, CHS and Land O'Lakes and others as well as the ethanol producers, POET, ADM, CHS. Those are the people that will drive through their management area in our area, the responsibility is as we started with decarbonized product."
},
{
"speaker": "",
"content": "But we have the pipeline through a terminal, it's traceable, it's producible, it's manageable. And so each of these steps were getting tighter and better and that time frame that I would have thought was longer dated is, I would think being pulled closer. And so there is some more development. We'll be communicating this over the next quarters and years."
},
{
"speaker": "",
"content": "But that's where I see this going. And climate smart agriculture, regenerative agriculture, precision agriculture, there's a lot of names for this. A lot of this is already being utilized. Some of it incorporating obviously, the seed companies and the crop protection. So our whole industry is working towards this future that's coming, and we're going to play a vital part of it."
},
{
"speaker": "Adam Samuelson",
"content": "That's helpful. And if I could just ask a follow-up on the spring demand here. Obviously, the ammonia side of things is more complete. Can you talk about kind of where we are on UAN from a side dress and topdress perspective and kind of when you start to think that in-season pull will really start to materialize?"
},
{
"speaker": "Bert Frost",
"content": "So we're just getting started as we talked about planting and product movement and field work did start early. It was a surprise in February and early March, and then the rainy cold weather came through in March, delaying again field work and applications and planting. And now I would say we are on a normal -- a good pace with very good soil moisture from the Texas panhandle up through into Canada."
},
{
"speaker": "",
"content": "So the UAN season really hasn't started and where we've been positioning product, utilizing our logistics team with additional toes of UAN through our terminals and our customers' terminals, and we expect that, and I would say, now going forward -- and it should be fairly heavy because the opportunity, the upside, the pricing structure of where UAN is today compared against the price of corn on the forward for December, let's say, [ $4.60 ], [ $4.70 ]. It's attractive. And we would expect with the lower volume of spring ammonia applied, that will then move to UAN."
},
{
"speaker": "Operator",
"content": "The next question comes from Steve Byrne with Bank of America."
},
{
"speaker": "Steve Byrne",
"content": "Yes. Thank you. I'd like to continue that discussion there, Bert. You had production issues this year. You had less imports into the U.S. China's exports of urea first couple of months were almost 0. We were thinking that there was going to be some strength going into the application season, but yet over the last month, pricing has fallen."
},
{
"speaker": "",
"content": "Just curious what you think of that? Has there been less application rates of nitrogen than maybe you expected? Or was there significant ammonia application in the fall that may have reduced some of the near-term demand? Or is this a shift towards UAN? Curious of your view of where that price trajectory on Slide 8 goes."
},
{
"speaker": "Bert Frost",
"content": "Yes. Welcome to my confusing world because that is exactly that you've listed the dynamics that we deal with every day that really were confusing. And then just pointing to the CF system of what Tony and Chris articulated with the difficulties with the weather and the production and the maintenance issues that created on the sales side or at least the commercial side, different product allocation and movements, and I give a lot of credit to our logistics team for moving that product around."
},
{
"speaker": "",
"content": "But yes, the -- when you look at the overall market, and I would have expected what you thought coming in a strengthening market or at least a firm market, but a lot of work has gone into detail this. And you've really had some pullback in demand in some areas."
},
{
"speaker": "",
"content": "I would say the EU when you look at Italy, Germany, Belgium, France on this year basis and on a fertilizer both a fall in demand along with Mexico, Philippines and then there's India tender that took place where they had a tender, had 3 million tons put into the tender, announced 750,000 tons of purchases with LOIs issued and then canceled that, would not cancel, but cut it to 350,000 tons, the traders and producers that had positions allocated towards that, then had to move that into the market and got aggressive."
},
{
"speaker": "",
"content": "And that, coupled with some additional production coming on in different places, but also India, Russia, Iran and Nigeria coming back on production because several places were limited on gas, probably overwhelmed a little bit the second quarter market. And so what we would have thought was tight inventory is probably looser inventory and the U.S. won't resolve that long, but lower prices tend to incent additional demand. So as we work through Q2, I think we'll still be in the state of where we are today with pricing probably a line plus or minus where we are today and work towards the back half of the year."
},
{
"speaker": "Steve Byrne",
"content": "Okay. And just a question on the green ammonia plant that you're commissioning. Just curious if you've signed any contracts for that product and any of your partners in Japan or South Korea interested in bringing green ammonia into their facilities? Or do they really prefer the blue?"
},
{
"speaker": "W. Will",
"content": "Well, the volume is not really sufficient to be able to meet the application for co-firing. We're only going to be able to make about 20,000 tons a year. And even the smallest of the power stations is going to require somewhere in the neighborhood of 350,000. And because that is a part of a broader program with some incentives provided by the government, they are going to be, I think, focused on the most economically available decarbonized product. And so that's going to be a blue product as opposed to green."
},
{
"speaker": "",
"content": "But we are in conversations with a number of companies, particularly some companies in Europe that are focused on the extremely low carbon attributes of the green product. And we need to begin making it and very likely building some level of inventory for probably half a year before we've got sufficient volume to be able to ship. So more to come on that, Steve, but we're excited about being able to both start that plant up as well as what the future holds for us."
},
{
"speaker": "Bert Frost",
"content": "And we're looking at 2 options. Like Tony said, as we build inventory, that could be for a vessel to a customer that wants only 0 carbon product or it could go up to one of our terminals, which our terminals are about that size, where we can isolate an area with 0 carbon ammonia, again, back to the corn value chain. So working on several different fronts at this time."
},
{
"speaker": "Operator",
"content": "The next question comes from Josh Spector with UBS."
},
{
"speaker": "Joshua Spector",
"content": "So I wanted to ask on all the projects you guys are evaluating. So particularly, I guess, with JERA, converting to a JDA, how many separate plants are you now considering at this point? And I guess, as you look at all these separate agreements, could that combine together to be more offtakes from a smaller number of plants? And would CF be interested in a very small stake and maybe more of an operator role? Or do you see yourself as requiring majority control over the facilities you built?"
},
{
"speaker": "W. Will",
"content": "Yes, Josh. While we're evaluating a couple of different projects, principally, what we're looking at is different technology pathways to get us to a very low carbon intensity solution. And realistically, at least at this time, we're focused on one plant as opposed to multiple plants and doing the evaluation, as I said, should that be just a straight SMR, should it be an SMR with flue gas capture?"
},
{
"speaker": "",
"content": "Should it be an ATR? Kind of what's the right technology to deliver on both an OpEx and CapEx basis the most competitive returns for us and our partners? And on the second question about the role that we would play, I think we're -- we are open to a variety of different structures, some of which would have us with a majority control and other structures might have us on equal footing or even, as you say, more of an operator of the asset, but with a smaller equity participation."
},
{
"speaker": "",
"content": "So we're pretty open to different ways of structuring the agreements. And we're in those discussions at the same time as doing the technology evaluation, but we're really only looking at building one plant initially and seeing how the market develops, then we'll make some decisions as that continues moving forward."
},
{
"speaker": "Joshua Spector",
"content": "That's helpful. I guess just to clarify on my part. I guess I'm thinking about the Mitsui JV announced earlier, now JERA, JDA. Are those just different tranches of the same plant, those aren't 2 separate plants you're looking at then?"
},
{
"speaker": "W. Will",
"content": "Initially, they were different based on the type of technology but certainly, it's our hope that we can find a way to have all of our partners participate in the same project, and that would be something that we can combine together and aggregate demand so that we're -- have a home for more rather than fewer of the tons coming off of that project."
},
{
"speaker": "Christopher Bohn",
"content": "I would also say, Josh, that all 3 of the FEED studies that we have ongoing, the SMR, the HR and then the flue gas, all the partners that Tony just spoke of are all participants in that even though the JDAs and the MOUs may look different. So all the partners are working collaboratively to determine what we need to do from a carbon intensity standpoint, how does that influence the technology we choose, and as Tony said, and then really the contract for difference and the economics not that come out of that in the end."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Isaacson with Scotia Bank."
},
{
"speaker": "Ben Isaacson",
"content": "Just one question from me. Tony or Bert, can you talk about the situation in Russia when it comes to nitrogen supply? If we break down ammonia, urea and nitrates, where are we right now in terms of supply? Where have we come from and where are we going? And I'm also referring to the pipeline that's being built right now."
},
{
"speaker": "Bert Frost",
"content": "Yes, Ben, this is Bert. And the situation in Russia is as cloudy and clear as it's ever been. So that's a little bit of a dichotomy. But it's difficult because there are some places in the world that will not accept Russian product. And so there are places that are. And the largest happens to be the United States, which is surprising with where we are geopolitically, but the other is the EU."
},
{
"speaker": "",
"content": "And so what has happened over the last year since the invasion has been just a reorganization of the distribution channel for Russian product. So a lot goes to Brazil, a lot goes to North America or not even Canada, actually just the United States and then to Europe. And so with the recent restrictions on ammonium nitrate, a lot of that was stored in St. Petersburg and are probably a decision as a reflection of some of the capabilities of the Ukraine to cause disruptions."
},
{
"speaker": "",
"content": "They have canceled some of that movement or all of that movement out of those ports and are reorganizing how they'll be able to export. That has created a little bit of a shortage of ammonium nitrate in some markets. And with ammonia, you're right, the -- but the pipeline that used to go through Ukraine was stopped during the war and has been stopped and probably is not operable today, that was there usually. And so they have developed a new export corridor through the port of Taman, and they're working to get the Togliatti tons out through that. That's a black seaport and that we expect to happen probably in Q3."
},
{
"speaker": "",
"content": "And so going from, let's say, 0.5 million tons of exports out of the Baltics will probably convert to a couple of million tons -- 1.5 million to 2 million tons probably over the next year and probably positioning that product in the Mediterranean, Morocco and different places."
},
{
"speaker": "",
"content": "Urea and UAN, a lot of that UAN they produce comes to NOLA and the East Coast as well as Europe. And that's probably on a -- looking at the statistics for United States, UAN imports from Russia are up; from Trinidad, they're down. But that balance of UAN is probably okay."
},
{
"speaker": "",
"content": "And that's about it. I think what we're going to see out of Russia is trying to get those tons out. They put out some export restrictions, but I think those are manageable, and we'll see what happens going forward."
},
{
"speaker": "W. Will",
"content": "Yes. I mean to tag along on that one just for a second. It's kind of shocking and I think actually, [ Yara may ] mention this as well in their call. But what's kind of shocking is that there's been all of this focus on not funding the Russian war machine and not buying Russian gas and yet the U.S. is arms wide open to take urea and UAN coming out of Russia, which is effectively just natural gas that's been converted and so it's -- the U.S. is funding the very war effort over there that on the one hand, it's condemning. So it's absolutely shocking, but I think that's not surprising given the political climate over here and the fact that we're in an election year."
},
{
"speaker": "",
"content": "But you see some of that going on, I'd say, in Europe as well where there's a lot of Russian nitrogen that's planning its way into Europe, and it's just supplanting what used to be gas."
},
{
"speaker": "Ben Isaacson",
"content": "And maybe just a quick follow-up on that. Can you talk about Ukraine? I mean before the invasion, I think, in 2014, Ukraine was a major exporter. And where do they stand right now? Are they self-sufficient for the net importer?"
},
{
"speaker": "Bert Frost",
"content": "So it's actually when you take into account the acres that are planted and applied and harvested against probably the previous -- let's go back, maybe not 2014 as far back, but before the war, you've got a loss of acres, obviously, in the contested area, especially, which is good agricultural land. But you have several plants that are off-line and OPZ plant in Odessa that has been -- they're trying to -- I just read they're trying to bring that back up."
},
{
"speaker": "W. Will",
"content": "Although that one was struggling economically even well prior to the war. So that one has always been sort of up and down again."
},
{
"speaker": "Bert Frost",
"content": "So there are gas questions on gas supply. And yes, they have imported product. And so it's a question of why I think getting through the current crisis to see where we are coming out of it."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Theurer with Barclays."
},
{
"speaker": "Benjamin Theurer",
"content": "Just wanted to follow up a little bit on the global dynamics and thanks for all the comments on Russia, but coming back to China and India to a degree. So in your press release, you kind of alluded to China probably going to be back exporting some 4 million tons, also India being a little more aggressive on the internal supply, and you've talked about the tender and the implications."
},
{
"speaker": "",
"content": "So if you think about it those 2 markets, coupled with what you just said on Russia, how does that kind of level set the pricing? How do you think about pricing going forward in the medium term when -- if cost curves stick where they are right now, just given that potential supply out of China and India on top of the Russian you just mentioned?"
},
{
"speaker": "Bert Frost",
"content": "Well, the good thing is it's a global market. And you have, in a global market today, a lot of production in dispersed countries and also a lot of consumption in dispersed countries. And in a growing population, a growing need to feed the world and the benefits of nitrogen for pollution control, which are growing, not only in DEF but in power generation and with clean energy, you have demand."
},
{
"speaker": "",
"content": "So today, let's just take urea. Today's urea market is about 55 million tons of globally traded on a vessel out of about 190 million tons of production. And so when you look at China and our number of 4 million metric tons of possible exports, that's less than 10%."
},
{
"speaker": "",
"content": "If you look at India, and India has been a major player in the importation of urea and the support of the global urea price, but they're falling from imports of 7 million to 9 million tons, and we're projecting 5.5 million to 6.5 million. So that is being taken out of that global trade. But the countries that are growing, and Brazil is growing significantly, we project them to be 8 million tons."
},
{
"speaker": "",
"content": "Just 15 years ago, that was around 3 million tons. So the countries that are increasing, Argentina, Australia, Brazil, Ethiopia, South Africa, Turkey, Thailand. Those countries have grown this year in their urea consumption. The price of urea today at around $300 is highly attractive for agricultural and production control."
},
{
"speaker": "",
"content": "The challenge, I think, for India -- or excuse me, for China going forward is the export controls that are in place. And the new controls are such that you have to have prepayment, a shipment date, a destination, a product price and all that set up in a contract before applying for the CIQ application."
},
{
"speaker": "",
"content": "And then prepayment has to take place before the cargo moves to port. So that's a very difficult transactional structure to have China, I think, even hit the 4 million tons. And so I think we're a little vague in our comments because it's a little opaque right now in the market on how it's going to develop. But China, I think, will play in the international market once the spring season is over. And then we'll see how the pricing develops from there."
},
{
"speaker": "Benjamin Theurer",
"content": "Okay. And then just a quick follow-up on that industrial versus agriculture use, the impact you had in the first quarter that shift towards the lower profitability on the industrial use just because of fulfilling those contracts. Has that already normalized now that we're like early May, so that was really just like kind of a onetime? Should we think about that volume balance to be more normal and not as skewed towards the raw ammonia because of the industrial needs?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. As we talked about, a lot of the issues that occurred in Q1 were discrete to Q1 and that those are passed us both from a production and also a sales perspective. But as you mentioned, we did take 167,000 tons of what would normally have been upgraded to urea, which, as I said in my remarks, would be about 275,000 tons of urea. So you see the urea decrease in sales and the increase we had in ammonia."
},
{
"speaker": "",
"content": "But when you put that on a nutrient margin basis of what the quarter was for the industrial ammonia versus the ag urea, you're looking at something that was almost about a $30 million margin impact. And that, combined with that $75 million of approximate maintenance expense really is what set the quarter back. But again, can emphasize enough that those are discrete items to Q1."
},
{
"speaker": "Operator",
"content": "The next question comes from Richard Garchitorena with Wells Fargo."
},
{
"speaker": "Richard Garchitorena",
"content": "I just wanted to ask about Waggaman. You mentioned that the facility had some downtime from weather in January. I was wondering if you can give us an update in terms of how the ramp-up has been since you'd closed the acquisition, integration of that asset into your facilities? And have you been able to get utilization rates up to sort of typical CF average levels as it was maybe lower than that prior to your ownership?"
},
{
"speaker": "W. Will",
"content": "Yes, you bet. So we had an outage and we took that opportunity to conduct the turnaround that was kind of scheduled for later in the year. And so we were able to take advantage of that downtime. But prior to that and in fact, post turnaround we're operating at rates that reflect north of what nameplate capacity has been on that or is on that unit."
},
{
"speaker": "",
"content": "And so that reflects kind of more traditional operating rates for CF across our network. And I'd say the integration has gone remarkably well. The team at Waggaman has worked extremely well with the rest of the CF network."
},
{
"speaker": "",
"content": "And I think it's that kind of partnership and coordination that has led to some of the improvements we've made in terms of onstream factor and operating rate at the location. So we couldn't be more happy about the acquisition and in fact, particularly at the value of it, given where new assets look like they're trading and what the cost of new construction is. So we're really pleased with adding Waggaman into the portfolio."
},
{
"speaker": "Richard Garchitorena",
"content": "Okay. Great. And then just on the press release on the JDA with JERA. I'm just curious in terms of -- so if capacity ends up being 1.4 million tons, JERA procurement of 500,000 tons. So how should we think about that available 900,000 tons? Is that -- given JERA is going to be taking potentially a 48% stake, did they get sort of percentage of that amount as well?"
},
{
"speaker": "",
"content": "Are you looking at as potentially merchant sales or are you looking to lock that up? I know you had said earlier that you basically have 4 years from decision to production. So maybe how you think about how much you want to get locked up before you get into that sort of development of that project?"
},
{
"speaker": "Christopher Bohn",
"content": "Yes. So I think just starting the encouraging thing is that about 0.5 million tons as a home already for it. And as you mentioned, with the next 4 years, and that provides a lot of opportunity to find basically sales for the remaining amount, along with keeping a little bit for merchant."
},
{
"speaker": "",
"content": "But the one thing with JERA is that 500,000 is just for one particular unit at their coal plant facility. And they have multiple units they're looking at in addition to that, as you look at what's going on with the JERA test right now, which is a commercial test going on, which is performing to expectations."
},
{
"speaker": "",
"content": "You could see other areas that JERA has within Asia, also converting to a 20% ammonia injection into the coal along with some other additional players that are looking at it that Tony mentioned within Japan as well."
},
{
"speaker": "",
"content": "So I think we're just on the first few innings of where that demand side goes. But I would say that we're very encouraged that we have a large portion of it already taken. Additionally, as Bert mentioned, you're just seeing more and more activity come along, whether it's through the power gen, the marine or the sustainable aviation fuel or even just on the legacy agricultural business, where decarbonized product is going to have a home from a supply standpoint. So we're pretty encouraged by what we have and what we're seeing going forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Aron Ceccarelli with Berenberg."
},
{
"speaker": "Aron Ceccarelli",
"content": "I wanted to ask you, in the scenario where you go ahead with both the Mitsui plant and the JERA one or, say, a combined one, how should we be thinking about your capital expenditure phasing for the next 3 to 5 years?"
},
{
"speaker": "W. Will",
"content": "Yes. So I think as Chris mentioned in our last earnings call, the FEED study for an SMR steam methane reformer, kind of a copy of Ammonia 6 at\t Donaldsonville was about $2.5 billion, and then there would be roughly another $500 million for scalable infrastructure that could be leveraged against additional plants on site."
},
{
"speaker": "",
"content": "So all in for the first one, it would be circa $3 billion. Now that does not include if it was required flue gas capture. And we are still in the middle of a FEED study to evaluate what it would look like to do an auto thermal reformer or an ATR. And so more to come in terms of what the cost of a different approach or different technologies are."
},
{
"speaker": "",
"content": "But if we had both, let's say, JERA and Mitsui and CF kind of all aligned on one particular project, and it was 1/3, 1/3, 1/3, that would be kind of $1 billion per company to do the SMR spent over, call it, 4-ish type of years."
},
{
"speaker": "",
"content": "Now if it's 50% for us and 50% for somebody else, then that increases to $1.5 billion. It just kind of scales appropriately. But it's in that order of magnitude, and it's spread over 4 to 5 years of cash outflow."
},
{
"speaker": "",
"content": "So while it's a meaningful amount of cash compared to the amount of free cash that we're generating, we still have plenty of free cash available to be able to return cash to shareholders in the form of dividend and share repurchases. So it's not going to impede us from being able to execute our return of capital program and other incremental growth opportunities that we have."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that is all the time we have for questions for today. I would like to turn the call back to Martin Jarosick for closing remarks."
},
{
"speaker": "Martin Jarosick",
"content": "Thanks, everyone, for joining us today. We look forward to seeing you at upcoming conferences."
},
{
"speaker": "Operator",
"content": "Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cfg | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, everyone and welcome to the Citizens Financial Group Fourth Quarter and Full-Year Earnings Conference Call. My name is Ivy, and I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. I'll now turn the call over to Lovin Thomas, Senior Vice President, Investor Relations. Lovin, you may begin."
},
{
"speaker": "Lovin Thomas",
"content": "Thank you, Ivy. Good morning, everyone, and thank you for joining us. I'm stepping in today for Kristin, who is out sick. First this morning, our Chairman and CEO, Bruce Van Saun and CFO, John Woods, will provide an overview of our fourth quarter and full-year results. Brendan Coughlin, Head of Consumer Banking and Don McCree, Head of Commercial Banking are also here to provide additional color. We will be referencing our fourth quarter and full-year earnings presentation located on our investor relations website. After the presentation, we will be happy to take questions. Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on page two of the presentation. We also reference non-GAAP financial measures, so it's important to review our GAAP results on page three of the presentation and the reconciliations in the appendix. And with that, I will hand it over to Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay, thanks, Thomas. Good morning, everyone, and thanks for joining our call today. We were pleased to finish the year with a strong quarter as our financial results reflect good sequential revenue growth led by NIM expansion and capital markets fees, positive operating leverage, favorable credit trends, and a robust balance sheet across capital, liquidity and LDR. We are still seeing subdued loan demand, but we've more than compensated for that with 10 basis points of NIM expansion that drove sequential NII growth of 3%. Fees grew sequentially by 6%, paced by capital markets and mortgage. While expense growth was 3.5%, paced by hiring in private bank, private wealth, and commercial middle market, we still delivered positive operating leverage of around 50 basis points. Our credit trends are looking favorable with NPAs down sequentially, criticized assets trending down, and no surprises in charge-offs as we work through our CRE office portfolio. Given these trends and the contraction in loan balances, we added $162 million to our provision against $189 million in charge-offs, and our ACL-to-loan ratio increased slightly to 1.62%. We currently expect that the credit trends should continue and that we should be able to see credit costs come down in 2025. We continue to repurchase shares in the quarter $225 million, bringing the full-year total to $1.05 billion. We repurchased 28 million shares in 2024, or 6% of the beginning of year balance. With respect to execution of our key initiatives, we made further progress across the private bank, our New York City metro strategy, serving private capital, and growing our payments business. BSO efforts saw a reduction in non-core loans of $4.2 billion in 2024 with a remaining balance of $6.9 billion. We are looking for opportunities to accelerate the rundown, so stay tuned on that. In addition, we made further progress in exiting low-returning relationships in C&I and in reducing overall CRE loans. Our TOP 9 program was executed well, delivering $150 million in annualized Q4 run rate benefits, and we've launched TOP 10 with a target benefit of $100 million. The private bank, private wealth progress is worth spotlighting. The business continues to ramp up nicely, growing the customer base and hitting all financial targets. We reached $7 billion in deposits, $3.1 billion in loans, and $4.7 billion in AUM, and we were profitable in the quarter. We are confident in our ability to meet or exceed our goal of having this business be 5% accretive to our bottom line in 2025. And we added a banking team to Southern California in Q4 and this morning we announced an additional wealth team in South Florida. For the full-year 2024, we hit most line items in our beginning of year guide, that's shown on slide 34 with the exception of balance sheet volume. That said, we were able to repurchase more shares given the lack of loan demand. Turning to our 2025 outlook, we expect solid growth in NII given further NIM expansion and a resumption of modest net loan growth. Fees should grow nicely, paced by capital markets and wealth. We have confidence in this revenue outlook, so we'll step up investments in OpEx and CapEx to support key growth initiatives. We anticipate attractive positive operating leverage for the full-year of around 1.5%. Credit costs are projected to improve year-on-year, and we expect to see reserve releases continue throughout the year. We will manage our CET 1 ratio above the high end of our 10% to 10.5% range, given ongoing uncertainty, but we expect to continue with regular share repurchases. We've included some slides on our medium-term outlook and how the drag from our legacy swap portfolio will dissipate with time. We remain confident in our ability to achieve our medium-term 16% to 18% ROTCE target. Exciting time for Citizens. Our strategy rests on a transformed consumer bank, the best positioned super regional commercial bank, and the aspiration to have the premier bank-owned private bank. We've made steady progress and will continue to execute with the financial and operating discipline you've come to expect from us. I'd like to end my remarks by thanking our colleagues for rising to the occasion and delivering a great effort in 2024. We know we can count on you again this year. So with that, let me turn it over to John."
},
{
"speaker": "John Woods",
"content": "Thanks, Bruce. Good morning, everyone. As Bruce indicated, we delivered results in 2024 that were broadly in line with our expectations at the beginning of the year. 3Q was our trough quarter, 4Q was a nice bounce back, and we are well positioned for growth in 2025. On slide six, you can see that we delivered underlying EPS of $3.24 for 2024, which includes a $0.45 drag from non-core and a net $0.05 investment in the private bank. Full-year ROTCE was 10.5%, which was 12% excluding these items. Despite loan volumes being lower than expected given market dynamics, net interest income came in broadly in line with our expectations for the year, down 9.7% as we delivered a full-year margin of 2.85%. Fees were up a strong 9%, led by a pick-up in capital markets, card and wealth fees, while expenses were managed tightly, up only 1.5%, notwithstanding meaningful investments to support the build out of the private bank and private wealth. We also manage to alter an uncertain credit environment, maintaining strong reserve coverage levels with credit losses coming right in line with our expectations at the start of the year. The transformation of our deposit franchise since our IPO became clear in 2024, as we managed through a very competitive environment against a backdrop of rapidly rising rates. Our deposit cost performance is better than the peer average, a meaningful improvement compared with prior rate cycles. And with the latest Fed rate cuts, we have aggressively lowered deposit costs in 4Q. Importantly, our financial strength has allowed us to execute well against our strategic initiatives, providing momentum as we head into 2025. We've opportunistically built out the private bank, which has raised $7 billion of deposits through the end of the year and as expected became profitable in the fourth quarter. We also continue to make solid progress building out our New York City metro franchise. We are investing in our payments platform and we are solidifying our commercial middle market coverage with investments in key expansion markets that complement our private bank success. I'll start with some of the highlights of the fourth quarter financial results referencing slides five and seven before we get into the details. We generated underlying net income of $412 million, EPS of $0.85, and ROTCE of 10.7%. This includes a negative $0.10 impact from the non-core portfolio, which will continue to steadily run off, creating a tailwind for overall performance going forward. As I mentioned, the private bank contributed to earnings in the fourth quarter, adding about a $0.01 to EPS. Importantly, we've returned to positive sequential operating leverage in the fourth quarter with a nice lift in NII and fees, even as we made important investments in the private bank and private wealth and added commercial middle market bankers in key expansion markets. We ended the year in a very strong balance sheet position with CET1 at 10.8% or 9.1% adjusted for the AOCI opt-out removal, a pro forma Category 1 LCR of 119%, and an ACL coverage ratio of 1.62%, up from 1.61% in the prior quarter. This includes a robust 12.4% coverage for general office, up from 12.1% in the prior quarter. We also executed $225 million in stock buybacks during the quarter. Next, I'll talk through the fourth quarter results in more detail, starting with net interest income on slide eight. NII was up 3.1% linked quarter, reflecting a higher net interest margin and slightly lower interest earning assets. As you can see from the NIM walk at the bottom of the slide, our margin was up 10 basis points to 2.87%, reflecting the benefit of non-core runoff, fixed rate asset repricing, and better deposit and loan betas, partially offset by our net asset-sensitive position as rates declined. With the Fed cutting rates to the end of the year, we executed our down rate playbook, reducing rates ahead of the cuts and bringing down higher cost deposit balances. Our cumulative interest bearing deposit down beta was about 50% better than our initial expectation. Moving to slide nine, fees were up 5.6% linked quarter, primarily driven by an improvement in capital markets. Capital markets saw strong loan syndication activity and a pickup in M&A, which benefited from seasonality and a general improvement in the environment. Debt underwriting was lower coming off a strong third quarter. Mortgage banking fees reflect higher MSR valuation with overall operating results remaining stable. The wealth business delivered a solid quarter with good momentum and AUM growth from the private bank, but that was offset by lower transactional sales activity. On slide 10, expenses were up 3.5% linked-quarter, primarily reflecting hiring for the private bank and private wealth build out and commercial middle market bankers to complement our private bank footprint in Southern California and Florida. Our TOP 9 program achieved a $150 million pre-tax run rate benefit exiting the year, which is above our original target of $135 million. And we have launched our TOP 10 program, which is targeting $100 million in run rate efficiencies by the end of 2025. On slide 11, average loans were down slightly and period-end loans were down 1.7% linked-quarter. This reflects the non-core portfolio runoff of approximately $900 million, a decline in commercial loans given paydowns in C&I and CRE against a backdrop of low client demand and lower line utilization. The private bank continues to make nice progress with period end loans up about $1.1 billion to $3.1 billion at the end of the year. Next, on slides 12 and 13, we continue to do a good job on deposits in a very competitive and dynamic environment. Period-end deposits were broadly stable linked-quarter with attractive growth in retail in the private bank offset by the continued pay down of higher cost treasury and commercial deposits. This was primarily tied to non-core loan run down and a proactive effort to optimize the liquidity value of deposits. The private bank continues to add customers and grow nicely with period end deposits up about $1.4 billion to $7 billion at the end of the year. Our retail franchise did a nice job raising deposits this quarter in low-cost categories, and importantly, we've seen strong retention as the CD portfolio turns over at lower rates. We also grew non-interest-bearing deposits by about $940 million linked-quarter driven by the private bank and seasonal flows in commercial. Combined our non-interest-bearing and low-cost deposits increased to 42% of total deposits in the fourth quarter. Overall, our deposit franchise continues to perform well in a very competitive environment. Our interest-bearing deposit costs are down 31 basis points linked-quarter, which translates to a 50% cumulative down beta. Moving to credit on slide 14, as expected, net charge-offs were broadly stable at 53 basis points, compared with 54 basis points in the prior quarter. A decline in C&I charge-offs was offset by an increase in commercial real estate primarily coming from the general office portfolio. Retail charge-offs were stable. Of note, non-accrual loans were down slightly, reflecting a decline in commercial given the resolution of a number of general office loans. Criticized loans were meaningfully lower in the fourth quarter, following relative stability over the past few quarters. We continue to make consistent progress in working out the general office portfolio with limited new inflows and to work out. Turning to the allowance for credit losses on slide 15. Our overall coverage ratio increased slightly linked-quarter to 1.62%, primarily reflecting the denominator effect of lower portfolio balances. While we maintain strong reserve coverage for certain portfolios such as general office, our overall reserve declined slightly in light of a broadly stable macroeconomic outlook and improving loan mix giving the runoff of non-core auto portfolio and originations in retail, real estate secured and commercial categories that have a lower loss content profile. The reserve for the $2.9 billion general office portfolio is $364 million, which represents a coverage of 12.4%, up from 12.1% in the third quarter as the portfolio continues to reduce. Note that the cumulative charge-offs plus the current reserve translates to an expected loss rate of about 20% against the March 2023 loan balance when industry losses commenced. Moving to slide 16, we have maintained excellent balance sheet strength. Our CET1 ratio strengthened to 10.8%, which compares with 10.6% in the prior quarter. Adjusting for the AOCI opt-out removal, our CET1 ratio was relatively steady at 9.1%, despite the impact of higher long-term interest rates on AOCI in the quarter. Given our strong capital position, we repurchased $225 million in common shares and including dividends we returned a total of $413 million to shareholders in the fourth quarter. Over the full-year, we repurchased $1.05 billion in common shares, representing $28.1 million or about 6% of our beginning of year outstanding shares at an average price of $37.35 per share. Turning to slide 17, we view our overall strategy in three parts, a transformed consumer bank; the best positioned commercial bank amongst our regional peers; and our aspiration to build the premier bank-owned private bank and private wealth franchise. Slides 18 to 20 provide some updates on our positioning and progress, which you can read at your convenience. Note on slide 20, we've updated our private bank targets for 2025, given the success we've had to-date. We bumped deposits from $11 billion to $12 billion, and AUM from $10 billion to $11 billion. We adjusted loans to $7 billion, given the impact of higher rates on borrowing demand. We are tracking well to meet or exceed our 5% accretion estimate to Citizens bottom line in 2025. On slide 21, we provide an update on some of the tremendous progress in New York, since we made a play there about three years ago with HSBC's East Coast branches and Investors Bank. Moving [Technical Difficulty] Fed Funds rate of 4% and a 10-year treasury rate of 4.5% to 4.75%. We expect NII to be up 3% to 5%, driven primarily by an increase in NIM to about 3% for the year. We project spot loan growth in the low-single-digits overall and mid-single-digits excluding non-core. Loan growth will be impacted by non-core runoff, paydowns, and more selective originations in CRE and muted commercial loan demand early in 2025. We expect C&I to pick up in the second-half of the year as new money gets put to work. Private banks should see consistent loan growth throughout the year. We expect average loans will be down roughly 2% to 3% and overall earning assets to be down about 1%, which reflects the extent of the 2H ‘24 drop and continuing non-core runoff. Non-interest income is expected to be up in the 8% to 10% range, led by capital markets and wealth. We are projecting expenses to be up about 4% as we are confident in our revenue outlook and want to step up our investments and growth initiatives after a constrained 2024. Excluding the private bank and private wealth, the increase in expenses would be about 2.6%. We have provided a walk showing the key components of our 2025 expense outlook on slide 23. When you put the revenue and expense outlook together, we expect to deliver positive operating leverage for 2025 of roughly 150 basis points. Our outlook for net charge-offs is to trend down to approximately $650 million to $700 million or high-40s in basis point terms. We will continue to work through the general office portfolio and given macro trends, the remixing of the balance sheet, and expectations for modest spot portfolio growth, we will likely see ACL releases over the course of the year. And finally, we expect to end the year with a strong CET1 ratio in the 10.5% to 10.75% range, which is above our medium term operating range of 10% to 10.5%, given the continued uncertainty in the macro environment. As we monitor the market environment and loan growth levels, we will opportunistically engage in share repurchases. It's worth noting that loan growth was below expectations in 2024 and we were able to offset the impact of share repurchases and less pressure on deposit costs. We would use the same playbook in 2025 if needed. On slide 25, we provide the guide for the first quarter. Note that the first quarter has seasonal impacts on revenue, namely capital markets fees, lower day count, reducing net interest income, and taxes on FICA reset and compensation payouts impacting expenses. Credit trends are expected to improve and we should end the first quarter with CET1 in the range of 10.5% to 10.75% with a good amount of share repurchases. Moving to slides 27 to 28, as we look out over the medium term, we have a clear path to achieving our 16% to 18% ROTCE target. Expanding our net interest margin is an important part of improving our ROTCE, which we project to be in the 3.25% to 3.5% range in 2027. However, given our balance sheet positioning and our asset sensitivity, if the Fed maintains an elevated Fed funds rate at or above 4%, this will help to deliver a NIM level at the upper end of our range or higher. On slide 28, we provide a walk to our target 16% to 18% ROTCE. We have significant NII tailwind driven by non-rate dependent terminated swaps amortization and non-core runoff, which will generate about 300 to 400 basis points of ROTCE through 2027. We add roughly another 100 basis points with the net impact of other dynamics such as positive fixed asset repricing, the runoff of legacy active swaps, and the offsetting impact of our naturally asset sensitive balance sheet. That puts you into the 15% to 16% range. We expect to generate solid returns from our legacy core business plus the successful execution of the private bank and other key initiatives I talked about earlier, which should drive meaningful revenue growth, generate positive annual operating leverage, and improving our efficiency ratio, which will add another 200 to 300 basis points to ROTCE. We should see some benefit from credit where we have been over-providing today versus a more normal environment, with charge-offs improving to the low to mid-30s basis points, reflective of the improved mix of the portfolio with less auto-increase and more private bank loans and C&I. AOCI impacts are providing a ROTCE benefit today, which should normalize with time. This impact will partially offset with share repurchases. In short, we feel very confident in our ability to achieve the 16% to 18% medium-term target. To wrap up, we delivered a solid performance in 2024, broadly in line with expectations. Importantly, we turned the quarter on net interest margin, delivered improving capital markets results, and remained disciplined on expenses, returning to positive operating leverage in the fourth quarter. We ended the year with a strong capital liquidity and credit position that puts us in an excellent position to drive forward with our strategic priorities. We are well positioned for 2025, and we remain confident in our ability to deliver our medium term 16% to 18% return targets. With that, I'll hand it over to Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay, thank you, John. Ivy, let's open it up for some Q&A."
},
{
"speaker": "Operator",
"content": "Thank you, Mr. Van Saun. We are now ready for the question-and-answer portion of the call. [Operator Instructions] Our first question will come from Scott Siefers from Piper Sandler. Please go ahead."
},
{
"speaker": "Scott Siefers",
"content": "Good morning, guys. Thank you for taking the question. Let's see, John, maybe wanted to start on sort of that medium-term margin outlook? Can you just sort of add some additional context on what gave you the confidence to bump up the top end of that medium-term range to basically the extra error between the 3.40% and the 3.50% at the top end of the range, please?"
},
{
"speaker": "John Woods",
"content": "Yes, sure. I think the main reason for that is just the outlook on rates. I'd say that when you think about where we were last quarter and in prior quarters, you know, the Fed was landing in a terminal, you know, rate that was well below 4% when we put this together previously. Now, when you see the Fed, you see the bond market discounting something closer to 4%, we've basically widened the expectation of range that you could see at the upper end. So 3% would be sort of consistent with our floor of 3.25%. But 4%, given our asset sensitive balance sheet, would be more consistent with a higher number than the 3.40%, we showed last quarter. And you may recall last quarter we said that, hey, a 3.50%-ish or a 3.75% Fed would be consistent with 3.40%. But now the Fed, you know, could land somewhere near 4%, and so that's the main reason why we, you know, we raised that. I think there are other reasons too. I mean, just getting, you see the confidence. We have a growing confidence based on our performance in the fourth quarter with a very solid 10 basis point increase in NIM. We've continued to opportunistically hedge to reduce the impact of rates falling into the future. So just a number of positive benefits that we were able to see that gave us the confidence to increase the upper end to 3.50%."
},
{
"speaker": "Scott Siefers",
"content": "Got it. Perfect. Thank you for that. And then separately, I was hoping you could help to put in a little bit more context, sort of the higher fourth quarter costs and investments. I mean, I certainly understand them in light of what you're building with the private bank, but just maybe curious about where you stand such that you're confident that costs can hold more firm after that small additional lift that we would expect in the first quarter?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean, I would say we did -- we put something in the slide deck there on slide 23 that you can take a look at. I mean, I think in 4Q for the full-year, but in 4Q, you know, we've been investing in the private bank all along and just given how well that's performed, that gave us the confidence to continue to invest and maybe accelerate some investments in the private bank through team advisor lift outs and also in the commercial bank where we're investing in our capabilities in Southern California and Florida. So a combination of those two things is what caused our expense number to be up a bit in 4Q. And maybe, Bruce, you want to add to that?"
},
{
"speaker": "Bruce Van Saun",
"content": "I'd also just add to that, Scott. For the full-year, we were still on our guide range of 1% to 1.5%. And so what I would say is that 2024, given some of the built-in revenue trajectory was a year where I think all banks, including ourselves, had to be very, very disciplined on expenses. When you start to see that revenue is improving, the revenue outlook is improving, which we saw that occurring in Q4, and we can see more visibility into revenue strength into next year than some of the things that you may be deferred that are really attractive investment cases, you start to lean in again a bit. So we started that process a bit in Q4. When you look at next year, we'll be guiding to about a 4%. But again, if you strip out the impact of private bank and private wealth, which we want to continue to, there's a great opportunity there to fill that void in the market. We want to keep disciplined investing into that, the rest of bank is down at roughly 2.5%. And so the top program usually provides about a 1% benefit. So we're leaning in a little bit across some attractive investment opportunities across the rest of bank, but still the overall numbers are kind of in a position where we should have quite a bit of confidence we can deliver positive operating leverage in 2025."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. All right. Thank you very much."
},
{
"speaker": "Bruce Van Saun",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Erika Najarian from UBS. Please go ahead."
},
{
"speaker": "Erika Najarian",
"content": "Yes. Hi, good morning. I just wanted to think about some of the dynamics that are more strategic than mechanical on the margin improvement, John. Give us a sense in terms of how you're thinking about deposit growth and the mix of that deposit growth and also sort of what the repricing cadence looks like? And given that the neutral rate seems to be settling around 4%, does the pacing change? Is the beta fast first and then slow down as loan growth comes back?"
},
{
"speaker": "John Woods",
"content": "Yes, a couple of comments related to that. I mean, I think strategic opportunities to grow deposits, you know, you see what we've been able to do with the private bank and we've raised our target there. You know, our performance in the last rate tightening cycle has been better than average and we've seen our opportunities to grow low cost actually be better than what we're seeing in a lot of our industry peers. So the core retail franchise is performing extremely well. The idiosyncratic opportunities in New York Metro and private bank are adding on top of that. And our commercial business is driving DDA growth as well. So from a strategic standpoint, the deposit franchise is an incredibly solid foundation as we head into this potential easing cycle. I mean, I think when you look at betas, we did outperform our own expectations in the fourth quarter with betas around 50%. When we were originally thinking around 40%, based on the rate outlook, we expect that betas can continue to increase. So we went with the earlier beta is we did get out of the gate pretty quickly and I think later, our opportunity to grow beta from here, we're going to end up seeing our betas get to low to mid-50%s, maybe by the time you get to a terminal 4%, so that you can do the math there on what the sequential betas look like, but feeling incredibly confident in the underpinning of the NIM trajectory given the deposit franchise."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, maybe ask Brendan to comment a little bit about deposits."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes, thanks for the question, Erica. Maybe a quick point on private, and I'll talk for a minute about core retail deposits. On private, our low cost deposits remain around 40%, so DDA [Indiscernible], despite the pretty, pretty healthy growth, the quality of the deposit book has been very consistent and very accretive to the overall mix to Citizens. And we expect that, while that could pull back a little bit, we expect the accretion mix to still be very strong throughout 2025. So that growth will both be in quantity and quality for the overall franchise, which is great. On the retail book, I've mentioned this on most every call, but the full-year performance for the retail portfolio was very, very strong against peers with benchmarks that we look at. We think we're somewhere in the range of 150 basis points better than peer average on low cost deposits, which is again largely DDA and [Indiscernible]. Our DDA book, the outflows sort of stopped around August, September, and we've been flattening out. We saw some very modest growth at the back half of Q4, including a pretty sizable tick up in [Indiscernible] in the back half of Q4. So the strength there is still very good. We believe we were indexed probably number one in the regional bank peer set, and retail banking core DDA growth for the full-year 2024. And there's nothing that I see that suggests that we won't continue to outperform peers on our relative low cost deposit performance. The other thing I would say is we've been very, very successful in our CD book turning over at lower yields with high retention. So in Q4 we had about $5.5 billion in CDs in the retail book turnover with over a 90% retention rate. And those CDs are coming in at about 100 basis points better in yield. And so when I look at the first-half of the year, we've got a little bit more at the $14 billion in CDs on the retail book that will also turn over. So that should give us some dry powder to drive those yields lower. And we expect to retain the vast majority of those balances, largely in deposits, with some trickling out into support for the wealth business and going into managed money in AUM. But that gives us a good amount of dry powder for thinking about the first-half of the year of bringing deposit yields in the CD book down."
},
{
"speaker": "Bruce Van Saun",
"content": "Great."
},
{
"speaker": "Erika Najarian",
"content": "Great. That's helpful. And just secondly, just a quick follow-up, and I just wanted to ask a bigger question of Bruce. One, John, given all those elements and the fact that you're entering at 2.87% for the year and you have a 3% net interest margin guide for the full-year, does that mean the exit is somewhere between 3% to 3.10%? And if so, Bruce, that tees you up for a very strong year, not just mechanically but strategically. I think the question that I was getting this morning is where are we in terms of the investment horizon with regard to the private bank and the private wealth initiative? In other words, you're setting up for great NII growth in 2026 and investors are wondering if you're going to continue to front load some of the investment spend in the wealth and private bank initiative?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. So just to your favorite question, exit rate on NIM, I would bump that up a little bit and say probably more like 3.05% to 3.10%. So that's that. Just in terms of how we think about the private bank, we've launched this back in the middle of ’23. And it's been a tremendous effort to get folks in place and support them appropriately and have them transition in customers. And it's been a really great success story, certainly not the finished article, more to do to get to White Glove Service, but feeling good about the trajectory that we're on. I want to just make it clear, though, that we're very committed to delivering our financial commitments on this business. We want to demonstrate that it is a profitable business that can deliver attractive returns and we're running it a bit differently than the way it ran at First Republic. So we have some guardrails around the kind of nature of the business we want to take on and the spreads we hope to achieve et cetera, et cetera. Over, you know, one thing that we wanted to deliver this year was to be profitable in the fourth quarter. We said we'd be profitable in the second-half of the year. We got to that in August. We had enough headroom that we felt confident that we could add another team in Southern California. As you know, Erika, when you bring in these private banking teams, they show up and they're all expenses initially, and then over time they transition in customers, and then the lines cross and they become profitable. So we still delivered a profitable fourth quarter, about a $0.01 of EPS. And so when we look at next year, depending on how fast that business is growing if we're hitting our targets, there may be opportunities to add additional teams, while still delivering the profitability of the 5% accretive to the bottom line. And by the way, that translates, now we're starting to get up towards that 20% ROTCE target for the business already by the end of next year. So we're keeping those guardrails in place as we grow the business. But you know, it's, there's such a big opportunity there. There's some great people out there who want to join the platform that we have to be thinking about and how to fill the void in the market and really build a great franchise. So I think we have that balance right and you can expect us to be disciplined in how we approach that and I'd like to see if we're running faster than projected that we're going to be leaning in and adding some additional teams. The wealth teams typically are accretive right from the get-go. So those we can keep doing throughout the year. It's more kind of the private banking locations, PBOs, and additional teams that we just need to fit into the overall financial dynamic that we're trying to deliver."
},
{
"speaker": "Erika Najarian",
"content": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Matt O'Connor from Deutsche Bank. Please go ahead."
},
{
"speaker": "Matt O'Connor",
"content": "Good morning. Just on the timing of the ROTCE targets that you laid out, medium term, is that implied for 2027 or just on the liquidity on that?"
},
{
"speaker": "Bruce Van Saun",
"content": "And which targets, the MTO, the…"
},
{
"speaker": "Matt O'Connor",
"content": "Sorry, your -- sorry the 16% to 18% medium term. Any way to frame the timing?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, well, I think the medium term to us is by 2027 and, you know, we'll be on an arc upwards arc through ‘25 and ‘26 in order to get to that destination. So I don't necessarily want to put a pin in it as to whether we could get there in ‘26. There's possible scenarios that that could happen, but certainly by ‘27 we feel quite confident that we'll be there, Matt."
},
{
"speaker": "Matt O'Connor",
"content": "Okay. And then you laid out the waterfall in terms of how you get there, and just to clarify, the operating leverage of 1.5% this year, obviously there's a nice improvement in that in the next couple of years to support that ROTCE level, right?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I think clearly as we continue to see the benefit of the kind of swap runoff and non-core runoff and the NIM lift, that really juices your positive operating leverage. And that, there's a big, you know, there's some contribution from that in ‘25, but it actually accelerates in ‘26. And so we would expect positive operating leverage to be even more in 2026."
},
{
"speaker": "Matt O'Connor",
"content": "Okay, thank you."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your next question comes from Gerard Cassidy from RBC Capital Markets. Please go ahead."
},
{
"speaker": "Gerard Cassidy",
"content": "Hey Bruce. Hi John. How are you?"
},
{
"speaker": "Bruce Van Saun",
"content": "Hi, good."
},
{
"speaker": "Gerard Cassidy",
"content": "Bruce, can we take a step back for a moment? Obviously, we have a new administration coming in, and we're going to get a number of new heads of the different regulatory agencies. Maybe the most important change coming from the Vice Chair of safety and soundness at the Fed, with Barr stepping down about two weeks ago. When you look at it, how are you kind of thinking about what can change to the benefit for not just Citizens for the banking industry? What are you looking or hoping for that these new leaders can come in and really enable the banking industry to the Treasury Secretary nominee in his testimony get the banks more involved in the U.S. economy?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Well, I think we've started to make some headway already on that this year, Gerard, as some of the proposals that were a response to what happened in 2023 seem to be kind of overdone, overcooked in terms of, you know, changes to capital liquidity and funding frameworks that I think the industry pushed back and thought that they needed to be dialed back. And we were starting to make progress on that in any event. So I do think like putting that to bed and coming up with what are the final Basel III capital rules, what are we going to do with liquidity, what are we going to do with funding, and making sure that tailoring remains central to how the framework is set. That's kind of job one on the prudential side. I would say the other benefits could be just a refreshed look at supervision. There's a lot of folks who work really hard and we get really good advice and input from the supervisors, but sometimes things get overcooked a bit and you lose the forest for the trees. So just kind of making sure that, that is focused at the right level and trees is up to, have a little more flexibility in how we operate. That could be positive as well. And I'd say some of the pressure on fees that we've seen come out of the CFPB, they're not always net beneficial. They may make good headlines, but squeezing a balloon and you close down this and then the banks have to make a return, so they have to charge somewhere else. And so just having a, kind of, a more insightful view as to how to allow banks to operate with well-disclosed fees that actually benefit their customers, as opposed to constantly pushing on that. That would also be helpful. And then I'd say last thing, there's probably a need for more consolidation in the industry, particularly at the smaller end of the spectrum. And so kind of taking the sand out of the gears on that and allowing that to take place with more certainty, I think that would also benefit the industry. So I think a number of all that should allow banks to continue to have the capital to lean in, support economic growth. I think we've done a good job of that, and we want to continue to be able to do that."
},
{
"speaker": "Gerard Cassidy",
"content": "Just quickly, in what you just said, Bruce, consolidation at the smaller end of the spectrum, how do you define smaller end? $10 billion in less asset-sized banks or something smaller?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I don't know where to draw that line, but certainly, you know, I'd say banks that are even in the 25 to 50 category just have a lot of investing to do to keep up with technology changes, business model going digital, cyber defenses, a lot of regulation. And so I just think there's a lot of great banks in that size category, but ultimately I think there'll be some, who feel that they can gain some benefits from scale. And so I think if the framework were more certain that you'd start to see consolidation all the way through from the very smallest banks, maybe up to those smaller regionals."
},
{
"speaker": "Gerard Cassidy",
"content": "Great. And then as a follow-up question, can you guys, you give us very good detail on your commercial real estate portfolio and how you're working through the issues that the industry confronts on commercial real estate office in particular. Can you give us an update on using the baseball vernacular? What inning do you think we're in, in getting through this kind of pig in the python situation in commercial real estate and specifically office?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I'm going to start and turn it over to Don, but I'd say when we saw this happening, it kind of kicked off in the early part of ‘23 and we said this is a multi-year process to kind of work this out just based on the nature of the terms of the leases and kind of return to office dynamics, et cetera, that this was going to take a lot of play out. And so we've seen that consistently through the rest of ‘23 through ‘24. I think looking into ‘25 will still be in workout mode, but I think we're probably past the midpoint at this point, so maybe middle innings of the game and hopefully you know we see that start to really drop off as we exit ‘25. But I'll leave it over to Don."
},
{
"speaker": "Don McCree",
"content": "Yes, Gerard, I think that's right. I'll channel my Bob Uecker, since we're memorializing him and you're analogizing baseball. But I think the good news on the real estate side, as Bruce said, we still have kind of ‘25 to work through. We are seeing almost no incremental deterioration based on the entirety of the portfolio over the last year or so. So everything like we've identified as problematic, needing to go through the workout cycle, estimation of losses is pretty much playing out as we expected. And we are getting toward the back end, as Bruce said, in ‘25. The good news is across the board in the real estate complex is liquidity is really coming back. And we're seeing, you know, this not necessarily in the office portfolio, but in the rest of the real estate portfolio. And that can ripple over as we get into later portions of ’25. So we're seeing the CMBS market very active, we're seeing the life companies very active, we're getting taken out of criticized assets at par, you know, in the non-office space, but in the multifamily space. So there are a lot of kind of encouraging signs that we're seeing across the board. And I think as John said in his remarks, we're seeing no new migration into our workout team. So there's a lot to be a little bit more optimistic about. We've got a ways to go to work out. And interestingly, a lot of the sponsors think that there's some, you know, brightness at the end of the tunnel. So they're dribbling in cash to keep the properties alive, because they think there might be an opportunity down the road. So it's elongating the workout cycle a little bit more than past cycles. But I think we feel like we have a really good handle on it and it's trending reasonably consistent with lower expectation."
},
{
"speaker": "Bruce Van Saun",
"content": "And John, you have a stat. So the overall criticized assets came down sharply in the fourth quarter led by the drop in CRE."
},
{
"speaker": "John Woods",
"content": "Exactly, yes, criticized levels down significantly. And overall, actually overall criticized is down 17% led by a reduction in general office, so that's great news."
},
{
"speaker": "Bruce Van Saun",
"content": "That was in the order of like 30%."
},
{
"speaker": "John Woods",
"content": "Yes, exactly, we got that. And Don mentioned inflows to outflows have really flipped around rather than inflows exceeding outflows. That's flipped around in the fourth quarter significantly. So inflows slow to a trickle and then upgrades outpace all of that in the fourth quarter. So turning the corner in the game back to the imagery was nice to see in 4Q."
},
{
"speaker": "Gerard Cassidy",
"content": "Appreciate all the color. Thank you."
},
{
"speaker": "Bruce Van Saun",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question comes from Manan Gosalia from Morgan Stanley. Please go ahead."
},
{
"speaker": "Manan Gosalia",
"content": "Hi. Good morning. I wanted to ask about the belly of the curve. How much of an impact does that have on both the asset and the liability side of the balance sheet? So I'm thinking from an asset side it gives you some more benefit from fixed asset repricing, but on the liability side maybe it makes it a little bit harder to drop those CD rates further. Is that something you guys are focusing on? You know, does it, is there a risk that if the belly of the curve keeps moving higher, could that weigh on some of those deposit betas from here?"
},
{
"speaker": "John Woods",
"content": "Yes, I'll go ahead. I appreciate the question. I'll comment on that. I mean, I'd broadly just make the point that we're asset sensitive, and we're basically asset sensitive across all of the key rates across the curve for the most part. When you look at the belly of the curve, that's actually driving our fixed asset repricing and when you see our net interest margin progression through time, that's consistently a positive. And so on a net basis, if the belly of the curve is rising, we're net beneficiaries of that. You know, on the funding side, when you think about CDs, you know, that out of the gate that's typically in a less than a one-year term, that can turn over. But net-net, our asset repricing would overcome even if the belly of the curve was consistently higher, that would be a net positive for us through time. And you can see that in our net interest margin. We've built in the curve that we see basically out the window through the medium term progression. And the fixed rate asset repricing is 15 to 20 basis points. You know, by the time you get to 2027 and that's consistently building through ‘25 into ‘26 and ‘27. So that's a net positive. I think the only place that our funding comes into play on the belly is maybe in the senior debt space. And we're really well positioned there. We're north of 4% of our WA. And so that's not a huge driver for us. But again, the asset sensitivity, higher rates basically is a net positive for us."
},
{
"speaker": "Manan Gosalia",
"content": "Yes, I'm just thinking with you guys were actually ahead of the curve when the Fed was cutting rates and you were able to drop those deposit rates sooner. So I'm just thinking now that there's not as many rate cuts in the forward curve and the belly of the curve is higher, whether that's weighing on deposit costs at all?"
},
{
"speaker": "John Woods",
"content": "Yes, no, as I mentioned, we'll be able to get deposit betas up to the low to mid-50s from where we are today at around 50%. And if -- and that's based on the curve that where we have a cut in the second quarter and a cut in the fourth quarter. If, however, there are no cuts in 2025, our deposit betas would flatten out, but that's a net positive for us, because of our net floating position and loan yields would more than make up for the fact that deposit betas might not be quite as high, because we're asset sensitive. And I should mention that our asset sensitivity actually grows in ‘25 and ‘26 and ‘27. So on an all-in basis, our net interest margin is a beneficiary of rates being higher, because loan yields more than offset what the impact on deposit data might be because we're overall asset sensitive."
},
{
"speaker": "Manan Gosalia",
"content": "Got it. Perfect. Thank you. And if I can just ask a follow-up on loan growth. You're looking for mid-single-digit spot loan growth, excluding non-core loans. Can you talk about the catalyst there? And also like where do you see loan growth coming from? Is it sponsors? Is it traditional middle market? Is it both?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I'll start and then John can give you more details. But I think we have been quite disciplined in making sure that where we're putting out loan capital that we're getting good returns. And so we haven't really sought to force the action. In fact, we've, through balance sheet optimization, have actually exited a number of relationships. In commercial, we're certainly trying to run down the CRE book a little bit, and then we have non-core set up to run down assets. I think the catalyst that we're looking for to actually get back to loan growth, which is certainly desired and desirable. The main building block here, the private bank, is I think likely to put on about $1 billion a quarter to get to the targets at the end of the year. So that's pretty idiosyncratic to us in having a startup business that's growing that we can count on for that kind of growth and not only in loans, but also in deposits. So if you take out that growth, then the spot loan growth drops, John, from mid-single-digits down to low-single-digits or something like that. So I think we're not really calling for any aggressive resumption in loan growth. We're anticipating that things will be relatively subdued, continuing into the first-half of the year, and then start to pick up in the second-half of the year in commercials. So we saw line utilization go down quite a bit in Q4, particularly subscription lines. So that new money deal machine, private equity, putting money to work, waiting for [Indiscernible] on that. That didn't happen in Q4. We don't expect it just because the calendar flipped the page to pick up right away in 2025. But I think that will begin to happen and we'll see all the benefits of that, higher capital markets fees, loan growth that comes along with that. But we're being cautious in terms of how much of that we put in to the forward forecast. And then on consumer, we just have a few of the areas that have consistently been able to grow, mortgage, e-lock, our card business, no great shakes there either, just some moderate level of growth. So, when you look across that, we've got some things running down. We have private banks steady as she goes. We have a resumption in the second-half of commercial and a little lower level of steady as she goes in consumer. So, John, I don't know if you want to add any color to that."
},
{
"speaker": "John Woods",
"content": "No, I just had another point or two to emphasize. I agree with that. We said mid-single-digits, ex-non-core. If you think about a three legs of the stool, you hit all three. But if you private bank on its trajectory really is a huge driver, and is the largest driver getting us to that mid-single-digits. But if you look at it excluding the private bank and excluding non-core, we would be in a low-single-digits trajectory as Bruce mentioned. And when the consumer legacy is half of that and the other half of it is in commercial. Consumer legacy, you mentioned, Bruce, and in commercial, subscription and M&A activities likely to pick up."
},
{
"speaker": "Bruce Van Saun",
"content": "In expansion markets and middle market."
},
{
"speaker": "John Woods",
"content": "Exactly. So we've got expansion markets contributing as we see in 2025. The other important part is subscription line utilization is about as low as we've ever seen it. It's in the low-40s, typically in the mid-50s. And so we see some of that partial, we see some of that coming back, not all the way back. Fund finance, you know, that we've been successful at in the past will contribute, as well as asset-backed. And then, you know, I mean, I would just say that, you know, all of that put together keeps us in a good spot. And as we mentioned earlier, to the extent that this doesn't happen, as we mentioned earlier, we've been able to navigate a lower loan growth environment in ’24 quite well. We would run that playbook back, and you'd see more buybacks out of us with a stock price that's attractive as we see it below intrinsic value. And we'd at the margin likely deliver even better deposit performance, if that were to be the case. So I think we've got some nice optionality in 2025 to stay on our trajectory."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I would just say one final thing is that really the NII guide is as it was, as you saw in the fourth quarter, it's really driven by the NIM expansion. And so it's not as dependent on volume growth in order to deliver that. And then as John said, if you have -- if you don't see the volume growth, you have other levers such as you can repurchase your shares and then you won't push on deposits as much. And so you can be a little more disciplined on your deposit pricing. And so I'd say we feel quite confident overall in that NII guide for next year."
},
{
"speaker": "Manan Gosalia",
"content": "That's really helpful. Appreciate the detail on here. Thank you."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay, is that it? I guess that's it for the questions. We've got a lot of banks reporting today, so I hope everybody got a good night sleep last night and it makes it through the day. So thanks again for dialing in today. We appreciate your interest and support. Have a great day. Take care."
},
{
"speaker": "Operator",
"content": "That concludes today's conference call. Thank you for your participation and you may now disconnect."
}
] |
cfg | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, everyone and welcome to the Citizens Financial Group Third Quarter Earnings Conference Call. My name is Alan, and I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now I'll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin."
},
{
"speaker": "Kristin Silberberg",
"content": "Thank you, Alan. Good morning, everyone and thank you for joining us. First, this morning, our Chairman and CEO, Bruce Van Saun and CFO, John Woods will provide an overview of our third quarter results. Brendan Coughlin, Head of Consumer Banking and Don McCree, Head of Commercial Banking are also here to provide additional color. We will be referencing our third quarter earnings presentation located on our investor relations website. After the presentation, we'll be happy to take questions. Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on Page 2 of the presentation. We also reference non-GAAP financial measures, so it's important to review our GAAP results on Page 3 of the presentation and the reconciliations in the appendix. And with that, I will hand over to Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Thanks, Kristin, and good morning, everyone. Thanks for joining our call today. We continue to execute well through an uncertain environment. We've made good progress on our strategic initiatives, our balance sheet remains strong across capital, liquidity, funding and loan reserves and our profitability has stabilized and is poised to move higher. Let me start with an update on our initiatives. First, the private bank delivered another terrific quarter. We reached $5.6 billion in deposits, up from $4 billion in Q2, and our assets under management reached $4.1 billion. During the quarter, we opened two new private bank offices in the San Francisco Bay Area, and we added a new private banking team to cover Southern California. We reached breakeven in August and September and expect to be profitable in Q4 with good momentum entering 2025. Next, our commercial bank continues to demonstrate its capacity to serve private capital well. For the quarter, we were number two in the league tables for sponsor leveraged loan arrangements and we remain number one over the past 12 months. We continue to add quality talent to our coverage and our capital markets teams. Our New York City Metro initiative continues to show nice growth. We had 5% year-on-year growth in households and 7% growth in deposits. We look forward to being a key sponsor of the upcoming New York City Marathon as we continue to raise our brand profile in the market. We've executed well on TOP 9, achieving a Q4 run rate benefit of $135 million and we're finalizing the details of TOP 10, which should have a $100 million plus run rate benefit by end of 2025. Our BSO actions continue to proceed as planned. Non-core reduced by $1 billion in the quarter and we continue to use the liquidity generated to pay down higher cost funding like brokered CDs. We continue to execute actions in commercial to exit lending-only relationships and we're focused on our medium-term plan to reduce CRE exposure. With respect to our balance sheet, our CET1 ratio is at 10.6%. Adjusting for AOCI puts us at 9.2%. We repurchased $325 million in stock during the quarter. Our spot LDR was 80.8%, and our Federal Home Loan Bank advances remained low at well under $1 billion. We are not seeing much loan demand, but we remain hopeful this should start to pick up in coming quarters. Our P&L was impacted by the drag from forward starting swaps, which commenced in July as well as some fees that pushed out to Q4. Nonetheless, we did a good job managing expenses and credit is performing broadly as expected. Our Q4 guide shows a nice rebound in both NII and fees, leading to positive operating leverage in the quarter. We expect credit to remain broadly stable and we will continue to repurchase shares. For the full year, we will hit most of our beginning of year guide with the exception of balance sheet volume impacting NII and a modestly higher ACL build. We continue to have strong confidence in our medium-term outlook and we've added to the materials in the appendix to show more detail on our NIM progression. Lots of uncertainty in the environment remains, but we feel good about our capacity to manage through that and continue to execute on our broad strategy. Our strategy rests on a transformed consumer bank, the best positioned super regional commercial bank and the aspiration to have the premier bank-owned private bank. We will continue to execute with the financial and operating discipline that you've come to expect from us. With that, let me turn it over to John."
},
{
"speaker": "John Woods",
"content": "Thanks, Bruce, and good morning, everyone. As Bruce mentioned, third quarter saw continued strong execution of our initiatives. And importantly, we believe the third quarter represents a trough in earnings as NIM tailwinds, strengthening fees and continued expense discipline will result in positive operating leverage prospectively. We continue to maintain a strong balance sheet with excellent liquidity and capital levels and a healthy credit reserve. This positions us well to continue to execute on our strategic initiatives, which should help drive strong momentum in 2025 and performance over the medium-term. First, I'll start with some highlights of the third quarter financial results, referencing Slides 5 and 6. We generated underlying net income of $392 million for the third quarter, EPS of $0.79 and ROTCE of 9.7%. This includes a negative $0.11 impact from the non-core portfolio, which will continue to steadily run off, creating a tailwind for overall performance going forward. The private bank is making strong progress towards profitability reaching breakeven mid-third quarter and we expect it to start being accretive to earnings in the fourth quarter. Our capital position remained strong with CET1 at 10.6% at September 30 and/or 9.2% adjusted for the AOCI opt-out removal and we executed $325 million in stock buybacks during the quarter. We also maintained a strong funding and liquidity profile. Our pro-forma LCR is 122%, which is well in excess of the large bank Category 1 requirement of 100% and our period end LDR is 80.8%. Our ACL coverage ratio of 1.61% is down 2 basis points from the prior quarter, given an improved macroeconomic outlook and ongoing front book activity driving a mix shift, which lowered expected loss content in the loan portfolio. We increased our general office reserve to 12.1%, up from 11.1% in the prior quarter. Now I'll talk through the third quarter results in more detail, starting with net interest income on Slide 7. NII is down 2.9% linked quarter, primarily reflecting lower NIM and slightly lower interest earning assets. With respect to NIM, our margin was down 10 basis points to 2.77%, largely reflecting the impact from the increase in hedge costs as forward starting swaps kicked in during the quarter. Other NIM impacts were largely offsetting. Moving to Slide 8. Our fees were down 2.7% linked quarter with seasonality in capital markets and solid card and wealth results. On the heels of a very strong second quarter, our capital markets fees decreased 30% as deal activity slowed given seasonal trends and some M&A deals pushed into the fourth quarter. Year-on-year, however, capital markets fees were up 40%, led by bond underwriting and M&A advisory fees. Our client hedging revenue was down slightly as some clients delayed their interest rate hedging plans, given the potential for a faster pace of rate cuts after the Fed eased aggressively in September. Mortgage banking fees are down modestly given the decline in MSR results net of hedging. This was offset by securities gains we took in making adjustments of the investment portfolio. Our wealth fees were up slightly given growth in AUM from the private bank, which was somewhat offset by lower transactional sales activity. We continue to focus on building out our wealth business in both our branch based financial advisory activity as well as in private wealth, where we are adding teams in our private bank office geographies. Total assets under management now approximately $30 billion. On Slide 9, we did a nice job on expenses, which were down 1.3% linked quarter notwithstanding continued investment in our strategic initiatives. Our TOP 9 program is on target to deliver $135 million pretax run rate benefit by the end of the year. And we are planning to launch our TOP 10 program, which will target more than $100 million in run rate efficiencies by the end of 2025. We will provide more details for you on our next earnings call. On Slide 10. Period-end loans are broadly stable and average loans are down 1% linked quarter, reflecting limited loan demand as well as continued balance sheet optimization. We continue to run down the non-core portfolio to the tune of about $1 billion in the quarter. The core loan portfolio was up about $800 million with solid contributions from the private bank and growth in retail mortgage and home equity. On a period-end basis, the private bank is making good progress with loans up about $630 million to $2 billion. Excluding the private bank, retail loans were up about $750 million, reflecting growth in mortgage and home equity, while commercial loans were down about $580 million, reflecting paydowns driven by corporates continuing to issue in the debt markets, exits of lower returning credit-only relationships and generally lower client loan demand. Next on Slide 11 and 12, we continue to do a good job on deposits in a very competitive and dynamic environment. Average deposits are broadly stable with period-end deposits down 1%, driven by the paydown of higher cost treasury deposits tied primarily to non-core rundown. This was partially offset by $1.6 billion of attractive growth in private bank deposits. Our interest-bearing deposit costs were up 4 basis points linked quarter. However, total deposit costs were up only 2 basis points, while total cost of funds was stable. DDA balances were effectively flat linked quarter with growth in the private bank being offset by lower commercial. We anticipate that migration of lower to higher cost categories will drop off now that the Fed has commenced the cutting cycle. Overall, our deposit franchise continues to perform well in a very competitive environment. Our estimates indicate we ended the upgrade cycle with a terminal interest bearing deposit beta better than the peer average. Our deposit franchise is highly diversified across product mix and channels. About 70% of our deposits are granular, stable consumer deposits and roughly 68% of our overall deposits are insured or secured. Moving to credit on Slide 13. The net charge-offs rose 2 basis points to 54 basis points, primarily reflecting seasonal impacts in auto. A decline in commercial real estate charge-offs was offset by the resolution of several non-performing credits in C&I. Non-accrual loans increased 10% linked quarter, primarily reflecting an increase in CRE general office, as we proceed with workout actions on a handful of loans. We believe we are near the peak of NPAs as criticized classified loans have been broadly stable for four quarters and loans and workout get resolved. Turning to the allowance for credit losses on Slide 14. Our overall coverage ratio stands at 1.61%, which is a 2 basis point decline from the prior quarter, reflecting an improving macroeconomic outlook and better loan mix given the runoff of the non-core auto portfolio and lower loss content originations in retail, real estate secured and commercial categories. The general office portfolio was down $150 million to $3.2 billion at the end of the third quarter and our reserve of $382 million represents 12.1% coverage, up from 11.1% in the second quarter. On the right side of the page, you can see some of the key assumptions driving the general office reserve coverage level. While rate cuts may be beneficial at the margin, we continue to expect this sector to be challenged. We believe our current reserve represents a severe scenario that is much worse than we've seen in historical downturns. So we feel the current coverage is very strong. Additionally, since the second quarter of 2023, we have absorbed $364 million of cumulative losses in the general office portfolio. When you add these cumulative losses to the reserve outstanding, this represents an almost 20% loss rate based on the March 2023 balance of $4.1 billion. Over the past six quarters, we have continued to work down the exposure to general office, with the portfolio down roughly $1 billion over the last 18 months to $3.2 billion at September 30, given paydowns of about $600 million in addition to the charge-offs I just mentioned. Moving to Slides 15 and 16. We have maintained excellent balance sheet strength. Our CET1 ratio is a strong 10.6%, which compares with 10.7% in the prior quarter. And if you were to adjust for the AOCI opt-out removal under the current regulatory proposal, our CET1 ratio increased from 9% to 9.2%. Both CET1 and TCE ratios have consistently been above the average of our peers. Given our strong capital position, we repurchased $325 million in common shares and including dividends, we returned a total of $516 million to shareholders in the third quarter. Moving to Slide 17. Our strategy is built on a transformed consumer bank that best positioned commercial bank among our regional peers and our aspiration to build a premier bank-owned private bank and wealth franchise. First, we have a strong transformed consumer bank with substantial wealth revenue potential that is set to drive further deposit growth while efficiently managing costs and we are well positioned to continue gaining market share in the important New York metro market. Next, we believe we have built a leading commercial bank among the super-regional banks. We are focused on serving sponsors and middle market companies and high growth sectors of the economy. Our investments over the years in capital markets capabilities and coverage of the private capital space have positioned us well to take advantage when market activity picks up. With the Fed beginning to ease and fears of a recession subsiding, the movement in our commercial client base is decidedly more positive, which has us optimistic that we'll see a strong finish to the year and good momentum into 2025. And we are pleased to report that for the third quarter in a row, our capital markets business sits the top of middle-market lead tables, holding the number one sponsor middle market book runner position on a trailing 12-month basis. Moving to the private bank. I'm pleased to report that the effort is going very well and continues to gain momentum. We are growing our client base and now have about $5.6 billion of attractive deposits. This is a $1.6 billion increase from the prior quarter with roughly 34% non-interest bearing. Also, we are now at $2 billion of loans and continuing to grow. We recently announced the addition of a top private banking team in Southern California and we have plans to add new offices in the Bay area, which adds to the offices we've already opened in San Francisco and Mill Valley, California, Palm Beach and Boston. You should expect to see us opportunistically adding talent to bolster our banking and wealth capabilities. Notably, our private bank revenue rose 64% to $49.7 million in the third quarter breaking even by mid-quarter. We are on track for the private bank to start contributing to earnings in the fourth quarter and add meaningfully to EPS next year. Moving to Slide 18. We provide a guide for the fourth quarter. This outlook contemplates a 25 basis point rate cut in each of November and December. We expect NII to be up about 1.5% to 2.5%, driven primarily by a 5 basis point improvement in net interest margin, reflecting the benefit of swaps given lower rates, deposit repricing, non-core runoff and favorable front book back book dynamics, partially offset by lower asset yields. Spot loans should be up slightly paced by private bank and commercial sponsor activity. Non-interest income should be up mid- to high-single-digits reflecting expected seasonal strength in capital markets. Our deal pipelines are robust and we expect to see a strong finish to the year. We also expect modest improvements across other key categories. Non-interest expense is projected to be up about 2%, and we expect to achieve positive operating leverage. Net charge-offs are expected to be broadly stable, while the ACL should continue to benefit from non-core runoff and improving loan mix. Our CET1 ratio is expected to be broadly stable with about $200 million to $250 million of share repurchases. I called your attention to an updated slide in the appendix on our medium-term NIM walk, which projects us to be in the 3.25% to 3.4% range in 2027. To wrap up, we delivered a solid quarter in a dynamic environment with strong results in capital markets, wealth and card and credit performance that continues to play out largely as expected. We are playing strong defense maintaining a robust capital and reserve position, a high level of liquidity and a more structural long-term funding profile, as we prepare for potential regulatory changes and any challenges the environment may bring. Importantly, we are also playing offense as we pursue our unique multiyear strategic initiatives, which will drive improving performance over the medium-term. We remain confident in our ability to hit our medium-term 16% to 18% return target. With that, I'll hand back over to Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Thank you, John. Alan, let's open it up for some Q&A."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, we will now begin the Q&A portion of the call. [Operator Instructions] Our first question will come from the line of Scott Siefers with Piper Sandler."
},
{
"speaker": "Scott Siefers",
"content": "I wanted to start off with a couple of questions both related to the margin progression and that medium-term walk to which you alluded on Slide 23, as we kind of start to march upward. Maybe first, in the immediate term, can you sort of walk through the puts and takes that allow for the 5 basis points or so of margin expansion into the fourth quarter? And then, I guess, more importantly, as we sort of start the journey upward and think about that next year or so, it looks like that 18 basis points of time based benefits is largely programmatic, which all else equal would get us to like a 2.95.But of course, the wild cards are like the timing of the ebbs and flows of the swaps and the rate based impact. So maybe if you could sort of help, I guess, narrow the cone on the moving parts as we think about the next few quarters, please?"
},
{
"speaker": "John Woods",
"content": "Yes, sure. Thanks for the question, Scott. I'd say starting off with the fourth quarter. I mean, I think when you think about the progression there, one of the drivers -- several drivers of tailwinds that we're seeing. First off, I would highlight non-core, which continues to contribute about 2 basis points a quarter. And so that's the starting point. I think the second big driver is broadly the active balance sheet management, fixed asset repricing and front book back book that continues to play out on -- will continue to play out every quarter going forward. And that's a huge contributor. I'll offer up one of the highlights of the balance sheet transition as you get into the fourth quarter also relates to deposit migration. We've had negative deposit migration throughout the cycle. That's been kind of declining over time. And we're seeing late third quarter, early fourth quarter trends that tell us that, that's going to flip around to be more of a neutral, maybe a slightly positive going into the fourth quarter. And that's really significant for that to become less of a headwind than it's been. And given what's been going on in the past."
},
{
"speaker": "Bruce Van Saun",
"content": "Just on the color on that let me just jump in here, John. But we have the private bank continuing to generate very attractive deposits and they've been growing well over $1 billion in $1.5 billion range the last two quarters. So that will be positively benefiting that mix. And then typically, seasonally, in the fourth quarter, we'll see an uptick in both commercial and consumer in terms of demand deposits. So we're counting on that as part of the equation."
},
{
"speaker": "John Woods",
"content": "Absolutely. And I think just playing on that a little further. I mean, I think we are -- the other big category, we are slightly asset sensitive, but based on the non-core and those balance sheet trends that we just talked about those are more powerful. And are -- you got to keep in mind that the receipt swaps, which have been a headwind are going to flip over to a tailwind and be a mitigant to our asset sensitivity going forward. So they'll actually contribute into the fourth quarter. And so one of the important things we're also doing is being extremely proactive on down betas. Just taking all the learnings from prior cycles and what you've seen from our deposit portfolio, where our deposit betas on the up are now better than peer average from what we can tell. We're flipping all of that energy and capability into the down beta management being highly proactive in the consumer side of things. And on the commercial side, most of our deposits there are -- the majority of them are 100% beta anyway. But we're feeling really good about how we're really pouncing on this transition to a downgrade cycle. And all of that, when you add all that up, that gives us confidence that we're going to achieve that 5 basis points. And as I may mentioned earlier, the late 3Q trends and the early 4Q trends are very consistent with that trajectory. So that's the 4Q. I think the second -- there are similar themes, but the second question was taken me out to the fourth quarter of 25%. And you're right. If you look at the $277 million in 3Q, you're at the 18 basis points that's really time based, and it's just really baked in. We'll get to $295 million. And there's another, call it, I'd say in the neighborhood of 5-ish basis points of benefit that we can really expect such that we can get in that neighborhood of 3% NIM in the fourth quarter of '25 and the drivers are very similar. The tailwinds related to the growing front book back book. And when you think about our fixed loan portfolio and securities as that turns over under a wide range of rate scenarios, which is more kind of focused on longer end rates where the 10 year is going to end up in five year rates. We end up with anywhere from 200 basis points to 300 basis points of front book back book benefit for as that turns over every quarter, so over the next five quarters, that's a driver that we feel very good about. Our strategic initiatives on the deposit side with respect to private bank at New York Metro continue to contribute. And when you add all that up, we end up with what we think is something nearing 3% by the end of '25 and we still have a lot of down rate protection on. Keep in mind, we've got our swap portfolio is largely intact through the middle of 2026. So, we remain pretty well protected and slightly asset sensitive. But all those other factors offset it and give us a net positive as you get into the end of '25."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, the one other thing is to the fourth quarter lift and then would add to that target as well."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Matt O'Connor with Deutsche Bank."
},
{
"speaker": "Matt O'Connor",
"content": "I guess just to drill down on the net interest income coming in weaker than kind of your thought maybe a month ago. Was that a bigger Fed cut and a little bit less loan growth? And kind of and then all the positive trends that you said is what we should expect from here? Or was there something help to throw out there, too?"
},
{
"speaker": "John Woods",
"content": "Yes. I'd say we are slightly asset sensitive. So 50, maybe a little bit more kind of than we expected. But I'd say that the deposit trends 3Q, in the trajectory of low-cost migration came down during the quarter, but they may be a little bit than we expected. And so, I think we got to the end of the quarter where we expected, but the average for the quarter in terms of migration was a little higher than we were thinking. But as I mentioned, that is now flipping around and as you look at the late September, early October trends that it was almost -- the bell went off there when the Fed pull the 50 basis point lever, we really are seeing that low-cost migration really flip to more of a neutral to slight positive. And so that's really what you can see going into 4Q."
},
{
"speaker": "Bruce Van Saun",
"content": "And then on volume, too, I think we anticipated a little more loan growth that, I'd say, we had nice loan growth in the private bank, but not maybe quite as much as we thought. I think that's really just timing. And as rates come down that will continue to pick up similarly on commercial bank. We thought we'd see a little faster rebound in line utilization, particularly on the sponsor side. We're starting to see that. So again, I think that's kind of on the come and should -- that's why we have an outlook in the guide that fourth quarter, we should start to see slight growth in our spot loans, even comprehending the non-core rundown."
},
{
"speaker": "Matt O'Connor",
"content": "And then separately, how do you think about operating leverage kind of more medium-term? Obviously, like net just income could be a bigger driver dollar-wise, if we just look at fourth quarter to kind frame it, you're guiding to revenues up about 3.5% versus costs up to 150 bps of operating leverage, but that's more driven by fees. Just thoughts on medium-term, how much operating leverage would you envision?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean I think we'll talk more about this in January. But I mean, I think we have significant opportunity for operating leverage. When you look at the net interest margin reflating to that $3.25 to $3.40 range provides significant tailwinds and consistent operating leverage over time. We'll come back in January and frame that for you a little more in terms of what we expect in 2025."
},
{
"speaker": "Bruce Van Saun",
"content": "The best thing about the NIM reflation is that there's no real cost of goods sold in terms of the impact on expenses. So that pretty much drops straight through. I think there's clearly going to be continued growth in fees led by capital markets, some of the things we're doing in the payments business, some of the exciting developments in our wealth business but those usually come with payouts and investments on the expense side. But nonetheless, I think the operating leverage should be quite positive when we look out over that 25 to 27 period. Brendan, maybe you could add couple comments."
},
{
"speaker": "Brendan Coughlin",
"content": "One other comment I mentioned on the private bank is just remember that the cost base that we're working our way through right now is fixed on the short-term basis with the comp guarantees that we've given to the team. So as the revenue grows, we're kind of earning our way through the comp guarantees. So that's all straight positive operating leverage linked quarter where the revenue is coming without necessarily incremental expenses because we've essentially put that in. And then over time, that will work their way through the guarantee and we get the right scale, they'll grow with further linkage together. But right now, it's just straight revenue growth on top of the fixed expense base."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Good point."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of John Pancari with Evercore."
},
{
"speaker": "John Pancari",
"content": "Bruce, you just talked about the loan growth dynamics a bit. And maybe if you could just elaborate a little bit more on your confidence in that you're seeing this inflection in demand here that should drive a modest growth in the fourth quarter. What is the bigger catalyst? Is it the rate cut? Is it clarity you expect around the election? And then -- can you maybe help us think about where like the type of acceleration in overall loan growth that you expect you could see going into -- or as you look at 2025?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Let me start, and then I'm going to pass it to Don and Brendan to talk about their segments and their outlooks. But we're not calling for any heroics here in fourth quarter. So I think the guide is pretty much derisked from meeting significant step up in loan growth. But it is, I think worth noting that we're starting to see things build a bit. We said our biggest quarterly increase in the private bank and the pipeline is looking pretty good. So I think that will continue. And I think there, as rates come down, folks are willing to transact and borrow. I think it's a similar thing in the commercial bank, where there's lots of interest in private equity kind of starting to realize some exits and put some money to work -- that's -- so we see it by the amount of conversations that we're privy to with clients, but it's starting to build. But really, the dam has not broken yet. And so, I think we'll see that trend continue to flex up. But let me start first with Don and then maybe, Brendan, you could pick up a second."
},
{
"speaker": "Don McCree",
"content": "Yes. I think you said it, Bruce. The leader in the clubhouse is subscription lines, where we saw some very strong growth late quarter and we're continuing to see it into the fourth quarter. And that's not really leveraged by us that we're doing. It's just activity in the private equity space that we're seeing build and we've seen a pretty nice utilization bump in that business. We haven't really seen it in C&I yet, but the conversations we're having with our core C&I clients, particularly in the middle market, with the economy kind of stabilizing rates coming down, it's just a general level of confidence that the business environment is going to be better as we get into '25, and that will result in more working capital utilization, more investment in their businesses. And remember, one of the things John said, one of the downdrafts we've had against kind of core loan growth has been a lot of activity where companies have been refinancing in the public securities markets. So we've seen stuff that's been on our balance sheet being refinanced and good for our fee lines. But it's put a little bit pressure on core asset levels. So -- we think a lot of that is behind us now. So the net growth we'll see in the core book should begin to grow as we get into '25."
},
{
"speaker": "Bruce Van Saun",
"content": "Brendan?"
},
{
"speaker": "Brendan Coughlin",
"content": "Yes, I'll quickly hit on consumer and then private banking. On the consumer side, I just would remind folks at the pace of rundown on non-core is turning into a net positive. So last year, at this time, we were running off $1.2 billion, $1.3 billion a quarter and now we're in the consumer book and now we're in the $800 million to $900 million. So that's -- the linked quarter rundown is slowing a bit and that will continue into the future. And when we look at the growth portfolios, we're seeing decent growth in mortgage and home equity. And as rates pull back a little bit, we expect to see a modest pickup in mortgage originations activity. But as everybody knows, the majority of the country is locked into 3%-ish mortgage rates. And so our HELOC business is incredibly well positioned. We've got a real strength in that business where we're the very top of the league tables and national HELOC originations in the super prime space and you'll continue to see that grow. And I believe that product, it will be a main lever for U.S. consumers as the economy gets more confidence in footing for consumers to borrow against record equity in their homes that's been built up over the last five or six years. So we expect that to continue. The other tailwind -- headwind moving to a tailwind is likely student in a modest way with high rates student loan refinance product has been all that sidelined. And now with the federal government not collecting payments again on that portfolio and rates coming back down, we should see more late 20s, early 30 year olds who have great credit coming back in the money that see value in restructuring their student loan debt. So we're expecting that to modestly pick up, as we get into next year. On the private bank side, it's a little bit of the same story. Rates pulling back should really put more customers an attractive place to use credit. And right now, we're seeing a lot of cash transactions, whether it's on the resi side or business is sitting on the sidelines and we're hearing very strong feedback. But as rates pull back, they'll be more comfortable using credit versus just going cash temporarily on whether it's an investment home or facilitating business growth given that high net worth and ultrahigh net profile of that customer base. So we've got good confidence that the rate dynamic should drive a decent amount of embedded demand. And as everybody knows, we've also went to market very strong on the deposit side. We've been very focused on getting the operations up. There's a progression here on earning the customer's full wallet of do the day-to-day banking really well. Now they'll come from borrowing needs and then we'll build a dislodge well. So there's a natural sort of earned wallet share gain that we anticipate getting as we get into next year on the private banking side that will be supported by the rate environment."
},
{
"speaker": "John Pancari",
"content": "And then a quick second one on credit. Can you just talk about the confidence that I believe you indicated that you've seen, you believe NPAs are peaking here this quarter. Maybe your confidence there, what gives you that? And then also on the confidence in the broadly stable charge-offs with the third quarter as you look at fourth quarter. I know your auto delinquencies were up pretty sharply year-over-year. So that would be beyond the seasonality. So I'm interested in what drove that and then thoughts on the reserve going forward?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Maybe I'll start, and then we'll pass it around whoever wants to jump in, feel free. But yes, I'd say the big issue that's well known that we've been managing through is the general office portfolio. And that one is going to -- it's a multi-quarter workout that has commenced in '23, it's with us all through '24. It will be with us for a good chunk of 25%. And we think we've got our arms fully around that. We've got very heavy reserves there. We've got our best people working with borrowers to try to come up with mutually satisfactory outcomes. But the timing of when you recognize the charge-offs and when something might go NPA moves around a bit and it's not always in our control. If a borrower decides to put a property up for sale then there are certain actions we have to take in terms of NPA recognition or charge-off recognition. So this quarter, we were on the low end of CRE charge-offs and we had a blip in CRE NPAs. But having said that the problem loan population that we're managing is pretty consistent. And so one of the things we take comfort in is when we look at criticized and classified loans across the board in commercial, they've been pretty stable now for four quarters. So that's the big thing. I'll see, Don, if you want to add any color on the CRE and then Brendan, if anything on the delinquencies."
},
{
"speaker": "Don McCree",
"content": "I think that's exactly right, Bruce. I think that we've seen like zero surprises in our credit book for the last four quarters, and it's playing out exactly as we thought it was going to play out. And as Bruce said, we'll have charge-offs going through the general office portfolio for the next several quarters, but it's pretty much playing out as we expected. We had a little bit of a blip in C&I charge-off this quarter, which was things that have been in the workout teams for literally five, six, seven years, and they just happened to resolve this quarter. So I don't worry a lot about NPA moves, what I focus on is the class levels and the fact that those have been stable. The other thing we're seeing in the general real estate area is not in general office, but in general real estate. There's a lot of liquidity coming back into the marketplace. So it's accelerating our ability to move down the overall exposures in the book, which you know is a strategic matter or something that I want to do. And we're seeing nothing in the C&I book and broadly that is disturbing to us at all, that's quite healthy from an overall credit standpoint."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes. Consumer is broadly normalized and pre-COVID we're between 50 basis points and 55 basis points in net charge-offs. And that's where we are now. And while there's always a little bit of puts and takes. There's nothing that we're observing in the portfolio that's making me lose any sleep. And your question on auto, a couple of comments. One would be -- last quarter was -- on the charge-off side was very low, seasonally impacted, but also we had a very strong recovery month in used value. So this quarter was much more just a reversion to the mean. The other dynamic I would mention in auto, it's tough to read into published delinquency numbers, even though delinquency is relatively in check. But when you're not originating anymore, it takes 12 months to 18 months for a vintage curve to build up to its appropriate steady state and delinquency. So when you shut the pick it off on new originations, it's just a denominator issue that you've got other origination vintages that are normally progressing along their lines to our ultimate expected loss number and you're not getting the denominator benefit of a bunch of new flow coming in that has zero delinquencies. So when you decompose all that there's really nothing that we're worried about whatsoever in the auto portfolio. It's performing exactly as we priced it and exactly as we've expected it to."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Erika Najarian with UBS."
},
{
"speaker": "Erika Najarian",
"content": "My first question is for you, John. On the 10-Q, you had $30 billion of notional received fixed peso for swaps for both 3Q and 4Q and $30.9 billion for 2025. Obviously, Slide 24 would indicate lower notionals. Could you give us an update on whether you terminated those swaps. And maybe confirm the accounting for the swaps and that you would just -- those losses are crystallized and they would be in your NII for the duration of the swap life and then just as a follow-up, you mentioned a 3% NIM by 4Q '25. How many rate cuts would you need to ensure yourself of getting to that 3% level?"
},
{
"speaker": "John Woods",
"content": "Yes. I'll take those. So yes, I think during the third quarter, as you may recall, there was a period of time when the yield curve was discounting as many as seven or eight cuts over -- through the second quarter of next year was pretty aggressive, expectation of the pace of Fed rate cuts. We happen to have about $4 billion of short-dated receive-fixed swaps that were maturing in May of '25. And so what we opportunistically chose to do was to terminate $4 billion of swaps during the third quarter in an environment where there was approximately seven or eight cuts that we locked in that benefit, given the swaps are very short dated and really, we're only providing down rate protection through May, we felt like that was a good risk reward to lock in that benefit and lock in the contribution and protection against lower rates that the swaps were there to cover in the first place. Out the window, there are fewer cuts through May. So at least at this point, that was a round trip positive for us to move on from those swaps and they did exactly what they were intended to do, was to create that protection. The accounting aspects of it are that we amortize the impact of that over the remaining life of the swaps through May. So that will be amortized through but that impact will be, again, a lower impact or a more favorable impact than otherwise would be the case that we were to have held the swaps. And so that was the point of the terminations. So that's that one. And I think the second question was about 3% -- how many cuts. And the rate environment that we would -- there's a range of rate environments that would still be consistent. With that I mean I would say that we have a slightly asset sensitive position. So net interest margin is stable across a range of rate environments into '25 given the swap portfolio, it doesn't begin to drop off until mid-2026. So I mean, the forward curve out the window implies getting to around 350 by the end of '25, but we would be able to achieve that 3% at rate environments that would be below that level as well."
},
{
"speaker": "Erika Najarian",
"content": "And my follow-up question is two-fold. First, could you explain the more favorable impact? I think I was thinking that as I amortize that impact of the terminated swap, it would just be the difference between the SOFR and received fixed rate through May 2025. So John, maybe give us some insight on what the more favorable treatment would be? And then just secondly, I just wanted to follow-up. I think that there are a lot of questions over being able to achieve that NIM expansion for next quarter, which you've explained well. I just wanted to sort of nail down what kind of deposit beta you are assuming in that 2.82% number for next quarter?"
},
{
"speaker": "John Woods",
"content": "Yes. So again, so when you terminate the swap, you basically terminate based upon the forward curve that's assumed at the time. And so the forward curve at that."
},
{
"speaker": "Erika Najarian",
"content": "That's the difference. Got it."
},
{
"speaker": "John Woods",
"content": "And then on the NIM expansion into the fourth quarter, highly proactive focus on this is going to get our deposit beta to be up to around nearing 40% by the end of the quarter. You've got all of the 100% beta stuff in commercial leading the way, but we're being highly proactive in consumer as well and just really taking all the learnings over the cycle over the last many years and applying that to how we continue to be able to drive solid deposit growth at a really attractive cost of funds. So that's the number that's baked in about 40% deposit beta in 4Q."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Manan Gosalia with Morgan Stanley."
},
{
"speaker": "Manan Gosalia",
"content": "I wanted to follow-up on the deposit beta question. Do you have any more specifics on what your spot deposit rates are now that we're a month past the Fed rate cut how you expect that deposit beta to traject as we get further into the Fed rate cut cycle, right? So as we get -- as we get as more Fed rate cuts are behind us, does that make it easier or more difficult to continue to drop your deposit rates going forward?"
},
{
"speaker": "John Woods",
"content": "I mean I think if you kind of do the math there, if you -- based on the forward -- from the forward curve that we'll have two more Fed cuts in 4Q and we're using a curve that was after non-farm payrolls from a week or two ago. But after non-farm payrolls, you've got the 2 cuts. Based on that curve, and if you apply a 40% beta to what you think the average SOFR rate would be in 4Q versus 3Q, you can come up with the decline in net interest-bearing deposit costs on that basis. And second question, what was the second part of that question?"
},
{
"speaker": "Manan Gosalia",
"content": "The second part of the question was just as we get into -- as we get into, say, the middle of next year and we have a series of Fed rate cuts behind us. Does that make it easier to continue to drop deposit rates? Or does it make it harder to drop deposit rates because there's fewer cuts in the forward curve front there?"
},
{
"speaker": "John Woods",
"content": "I think the way to think about that is the longer the down cycle lasts, the more you can continue to contribute to ongoing lowering of deposit costs, but broadly, I think what we've said in the past was that our down cycle betas are going to approximate our cycle, so around 50% to 55%. And so we're going to be around 40% by the end of the fourth quarter, and it will gradually migrate to that 50% to 55% over the cutting cycle that's going to proceed over the -- in the coming years. And so you can kind of think about that gradual improvement in that way, I think."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. But there was acceleration in the up cycle towards the later part of the cycle, which I think you mirror that on the downside."
},
{
"speaker": "Manan Gosalia",
"content": "That's what I was getting to. That's really helpful. And then maybe just on the front book back book, I think you noted the 200 basis point to 300 basis point spread benefit. Can you talk about what balances we should apply that to? What are the fixed rate securities and loans coming due over the next year or so? And is there any room to use some of the excess capital for any securities positioning from here?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean I think that's a good metric to use that this will be growing over time. So when you see when you see the activity and loan growth picking up over time, you're going to see this being a contributor over the next couple of years. I mean, I'd say that the what turns over in the back book quarterly basis in resi mortgage, call it around $750 million a quarter and that's a similar number for securities as well. When you talk about what turns over those are the balances that you would apply it to is the front book, back book, but that will continue to contribute and build on itself over the next couple of years."
},
{
"speaker": "Manan Gosalia",
"content": "That's right. And would you do as securities repositioning from here? Is there any room to that?"
},
{
"speaker": "John Woods",
"content": "I mean that's not in our plans. I mean we'll look at -- we actively manage the securities portfolio and we -- on an ongoing basis but we don't have a large single repositioning."
},
{
"speaker": "Bruce Van Saun",
"content": "And I would also just point to Slide 23 and some of the built-in momentum that we have to raise NIM, so that the need to expend capital to shift the timing on that NIM walk is not something that we need to avail ourselves of."
},
{
"speaker": "Operator",
"content": "And at this time, you have no further questions in queue."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Great. Well, thanks again, folks for dialing in today. We appreciate your interest and support in Citizens. Have a good day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that concludes our conference call for today. Thank you for your participation. You may now disconnect."
}
] |
cfg | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, everyone, and welcome to the Citizens Financial Group Second Quarter Earnings Conference Call. My name is Alan and I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now I'll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin."
},
{
"speaker": "Kristin Silberberg",
"content": "Thank you, Alan. Good morning, everyone, and thank you for joining us. First this morning, our Chairman and CEO, Bruce Van Saun and CFO, John Woods will provide an overview of our second quarter results. Brendan Coughlin, Head of Consumer Banking and Don McCree, Head of Commercial Banking are also here to provide additional colour. We will be referencing our second quarter earnings presentation located on our investor relations website. After the presentation, we will be happy to take questions. Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on Page 2 of the presentation. We also reference non-GAAP financial measures, so it's important to review our GAAP results on Page 3 of the presentation and the reconciliations in the appendix. With that, I will hand over to you Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Thanks, Kristen, and good morning, everyone. Thanks for joining our call today. We announced solid results today and we continue to execute well through an uncertain environment. Highlights for the quarter include very strong fee performance, good deposit cost management, tight expense control, and credit metrics which were within expectations. Our balance sheet remains robust with a CET1 ratio of 10.7%. Our loan to deposit ratio was 80%. Our ACL ratio was 1.63%. And Federal Home Loan Bank advances are now below $600 million. Of note, we saw our revenues tick up relative to Q1. Our underlying PPNR grew by 2% over Q1. Our underlying net income grew by $13 million or 3%. We repurchased $200 million in shares over the quarter with our sequential EPS up 4%. The combination of our strong capital position, solid returns, and capital freed up from non-core rundown has allowed us the capital flexibility to support our customers and return capital to shareholders. Share count is down over 5% versus a year ago. Our fee growth was relatively broad as capital market fees continued their rebound, led by low syndications and bond underwriting. Wealth and card fees, both hit record levels. We also are seeing nice momentum in our well-positioned payments business. Our private bank had a terrific quarter. We reached $4 billion in deposits, up from $2.4 billion in Q1, and tracking well towards our year-end 2025 goal of $11 billion. We brought in two leading private wealth teams in the quarter, one from San Francisco and one from Boston, and we've reached $3.6 billion in assets under management at quarter end with nice momentum. Our commercial bank hired a middle market leader for Florida and for California during the quarter, two increasingly important states for us. Our overall commercial franchise continues to be well positioned in serving the middle market, private capital, and key growth verticals, and we look for our strong performance to continue in the second half. I should pause to give a shout-out to Don McCree for his appointment as Senior Vice Chair in June. Great recognition for his efforts over the years at Citizens. We have done a good job in executing on our strategic initiatives. TOP 9 is tracking well to targets, and we have commenced work on TOP 10, which will push into new areas like AI. Our BSO work is progressing well. Non-Core ran down $1.1 billion in the quarter. Commercial C&I is refocusing on deep relationships, and we have a medium-term plan to reduce our CRE exposure. Credit metrics are holding up fine outside of General Office. We continue the lengthy workout of General Office, which will take several more quarters before we see improvement. Roughly 70% of our office exposure is suburban versus central business district, where loss given defaults have been about half of CBD properties. The good news is that, we have our arms around the issue and we don't expect to see major surprises. Looking forward, we continue to be upbeat about our prospects. While there are still many uncertainties in the external environment, we feel we are in good position to navigate the challenges that may arise, and we maintain a positive outlook for Citizens over the balance of the year, as well as the medium term. Our strategy rests on a transformed consumer bank, the best positioned super regional commercial bank, and the aspiration to have the premier bank-owned private bank. We will continue to execute with the financial and operating discipline that you come to expect from us. With that, let me turn it over to John."
},
{
"speaker": "John Woods",
"content": "Thanks, Bruce. And good morning, everyone. As Bruce mentioned, second quarter results were very solid in a number of key areas, starting with the excellent fee performance driven by strong capital markets fees and record results in Wealth and Card. Also, we managed our deposit portfolio quite well, with stable balances and lower interest bearing costs in a competitive environment which positively impacted NII and NIM. Rounding out quarterly results, expenses and credit came in largely as expected. With respect to balance sheet strength, we continue to maintain a healthy credit reserve position and capital and liquidity levels near the top of our peer group. And importantly, we are executing well against our various multi-year strategic initiatives, including the buildout of our private bank. I'll summarize further highlights of the second quarter financial results, referencing Slides 3 to 6. We generated underlying net income of $408 million for the second quarter, EPS of $0.82, and ROTCE of 11.1%. Maintaining a strong balance sheet position is a top priority, and we ended the second quarter with CET1 at 10.7% or about 9% adjusted for the AOCI opt-out removal. We also maintained our strong funding and liquidity profile in the second quarter. Our pro forma LCR is 119%, which is well in excess of the large bank Category 1 requirement of 100%. And our period end LDR improved to 80.4%. On the funding front, we've reduced our period end FHLB borrowings by about $1.5 billion linked quarter to $553 million. We continued our programmatic approach to increasing our structural funding base with a successful $750 million senior debt issuance during the second quarter, and we added about another $1 billion of auto-backed borrowings. That was our fourth issuance, essentially completing our auto program, and it was executed at our tightest credit spreads to date. We also refinanced preferred stock in the second quarter by issuing $400 million of new preferred and redeeming $300 million of higher-coupon floating rate preferred on July 8. Credit losses of approximately $180 million were in line with our expectations. The NCO rate rose a little to 52 basis points reflecting loan balances coming in a little lower than expected. Our ACL coverage ratio of 1.63% is up 2 basis points from the prior quarter. This includes an 11.1% coverage for General Office, up from 10.6% in the prior quarter. Regarding our strategic initiatives, the private bank is doing very well, having generated $4 billion of deposits and $3.6 billion of AUM through the second quarter. Also, our investments over the years in the private capital and capital market space are playing out nicely, as demonstrated this quarter. Finally, we are excited about our top of house initiatives, including the ongoing benefits from BSO and TOP, as well as growing contributions expected from data and technology-related initiatives, such as generative AI and cloud migration. Next, I'll talk through the second quarter results in more detail, starting with net interest income on Slide 7. As expected, NII is down 2% linked quarter, reflecting lower net interest margin and loan balances. With respect to NIM, as you can see in the walk at the bottom of our slide, our margin was down 4 basis points to 2.87%, reflecting a 6 basis point increase in swap expense due to the 60 basis point decline in average receive rate in the quarter. This is partly offset by a net increase in NIM of 2 basis points from all other sources, including higher asset yields, non-core runoff, and good deposit cost performance, with interest bearing deposit costs down 3 basis points. Overall, our deposit franchise continues to perform well in a very competitive environment with our interest-bearing deposit data at 51%, which was down from 52% in Q1. Moving to Slide 8, our fees were up 7% linked quarter given strong results in capital markets and record card and wealth results. Our capital markets business improved 14% linked quarter with higher bond underwriting and loan syndication fees given strong refinancing activity. M&A advisory fees were down slightly off a strong first quarter. However, our deal pipelines remain strong and we expect to see positive momentum in the second half of 2024. It's great to see our capital markets business holding the number one middle market sponsor book runner position for the second quarter in a row. This reflects the benefit of the investments we've made in our capabilities since the IPO and demonstrates the diversification of the business. Card fees were a record, primarily given the full quarter benefit of the first quarter transition to a new debit card platform as well as seasonally higher purchase volume. We delivered record results in Wealth driven by increased sales activity, as well as higher asset management fees given the constructive market environment and contribution from the private bank which will continue to grow given the AUM increase in the second quarter from our wealth team hires. Mortgage banking fees are up modestly with a benefit from the MSR valuation net of hedging and an improvement in servicing P&L. Production fees were down slightly given a decline in margins. On Slide 9, underlying expenses were down slightly as we saw the normal seasonal benefit in compensation and we did a nice job managing our expenses while continuing to invest in our strategic initiatives. Our TOP 9 program is progressing well and we continue to expect to deliver a $135 million pre-tax run rate benefit by the end of the year. We have commenced work on our TOP 10 program and will provide more details later this year. On Slide 10, period end and average loans are down 1% linked quarter as we continue to optimize our balance sheet and prioritize relationship-based lending. The linked quarter decline was driven by the runoff of our Non-Core portfolio of $1.1 billion. Core loans were broadly stable with a slight reduction in commercial balances, largely offset by an increase in retail. The decrease in commercial loans reflects paydowns and exits of lower return in credit only relationships, lower client loan demand, and corpus continuing to issue in the debt markets. Next, on Slides 11 and 12, we continue to do an excellent job on deposits in an extremely competitive environment. Period-end deposits are broadly stable linked quarter as seasonally lower retail deposits was offset by strong growth in the private bank. We continue to see a slowing rate of migration from demand and lower-cost deposits to higher-cost interest bearing accounts with the Fed holding steady, as well as the benefit of deposit market share gains with the private bank. As a result, non-interest bearing deposits are stable at about 21% of total deposits. Our deposit franchise is highly diversified across product mix and channels. About 69% of our deposits are granular, stable consumer deposits, and approximately 70% of our overall deposits are insured or secured. This attractive deposit base has allowed us to efficiently and cost-effectively manage our funding costs in the higher rate environment. Our interest bearing deposit costs were down 3 basis points linked quarter given proactive management of our pricing strategy. Moving to credit on Slide 13. Net charge-offs were 52 basis points, up 2 basis points linked quarter reflecting broadly stable charge-offs and lower average loans. The commercial charge-offs in the quarter were largely driven by CRE General Office and the fact that C&I recoveries were higher in 1Q versus 2Q. This increase in commercial was largely offset by a decrease in retail, primarily due to seasonal trends in auto and runoff. Non-accrual loans increased 4% linked quarter, driven by increases in CRE General Office and multifamily, which has been reflected in the reserve level for the quarter. Turning to the allowance for credit losses on Slide 14. Our overall coverage ratio stands at 1.63%, which is a 2 basis point increase from the first quarter, reflecting broadly stable reserves and lower loan balances given non-core runoff and commercial paydowns and balance sheet optimization. Our reserve of $369 million for the $3.3 billion General Office portfolio represents 11.1% coverage, up from 10.6% in the first quarter. Additionally, since the second quarter of 2023, we have absorbed $319 million of cumulative losses in the General Office portfolio. When you add these cumulative losses to the reserves outstanding, this represents roughly a 17% loss rate based on the March 2023 balance of $4.1 billion. Over the past six quarters, the General Office portfolio was down roughly $900 million to $3.3 billion at June 30, given paydowns of about $500 million and the charge-offs I just mentioned. The loss experienced so far has been concentrated in the central business district properties with approximately 2 times the loss rate of suburban properties. Suburban exposure is 70% of our total at this point. On the bottom left of the page, you can see some of the key assumptions driving the General Office reserve coverage level, which we believe represents a severe scenario that is much worse than we've seen in historical downturns, so we feel the current coverage is very strong. Moving to Slide 15, we have maintained excellent balance sheet strength. Our CET1 ratio is a strong 10.7%, up 10 basis points from 1Q. And if you were to adjust for the AOCI opt-out removal under the current regulatory proposal, our CET1 ratio would be 9%. Both our CET1 and TCE ratios have consistently been among the top of our peers. You can see on Slide 16 where our CET1 stands currently relative to peers. Given our strong capital position, we repurchased another $200 million in common shares and including dividends, we returned a total of $394 million to shareholders in the second quarter. Moving to Slide 17, our strategy is built on a transformed consumer bank, the best positioned commercial bank amongst our regional peers, and our aspiration to build the premier bank-owned private bank and wealth franchise. First, we have a strong transformed consumer bank with a robust and capable deposit franchise grounded in primary relationships and high-quality customer growth. Notably, the transformation of our consumer deposit franchise is the chief reason that our deposit performance has dramatically improved from the last upgrade cycle. We are much more nimble in our deposit raising capabilities now with more levers to pull and better analytical tools. And where our beta performance lagged our regional peers last time, so far this cycle we are better than peer median. We also have a differentiated lending platform where we are prioritizing building durable relationships with our customers and we are focused on scaling our Wealth business. Importantly, we continue to make great progress improving digital engagement with our customers and increasing deposit shares we build our customer base, particularly in New York Metro. Next, we believe we have built the leading commercial bank amongst the super-regional banks. We are focusing on serving sponsors and middle market companies in the high growth sectors of the economy and we have full set of product and advisory capabilities to deliver to our clients. In particular, we are uniquely positioned to serve the private capital ecosystem which appears poised for a strong recovery after one of the slowest dealmaking periods in decades. We are starting to see a more constructive capital markets environment develop and our consistent position near the top of the middle market and sponsor league tables gives us confidence that we have a right to win as activity picks up. Finally, we're building a premier private bank, and that is going very well and gaining momentum. We're growing our client base and now have about $4 billion of attractive deposits, a $1.6 billion increase from the prior quarter, with roughly 30% non-interest bearing. Also, we are now at $1.4 billion of loans and continuing to grow. We recently opened private banking offices in Mill Valley, California and Palm Beach, Florida, and we are opportunistically adding talent to bolster our banking and wealth capabilities with our Citizens Wealth Management business as the center piece of that effort. We added two exceptional asset management teams in the second quarter, one from San Francisco and the other from Boston, bringing the total private bank AUM to $3.6 billion, well on our way to hit our $10 billion target by the end of 2025. Importantly, our private bank revenue increased 68% to about $30 million in the second quarter, and we are on track to break even on the bottom line later this year. Moving to Slide 18, we provide the guide for the third quarter. This outlook contemplates a 25 basis point rate cut in each of September and December. We expect NII to be down 1% to 2%, driven by one last step up in swap costs this cycle. Noninterest income should be up slightly, reflecting seasonally lower capital markets, more than offset by a pickup across other categories. We expect non-interest expense to be stable. Net charge-offs are expected to be down modestly, and the ACL should continue to benefit from non-core runoff. Our CET1 ratio is expected to come in about 10.5% with approximately $250 million to $300 million of share reports currently planned. With respect to the full year 2024 guide we provided in January, we feel good about the overall level of PPNR. Revenues are tracking broadly in line with some puts and takes. NII is expected to come in at the upper end of the down 6% to 9% range, reflecting lower loan balances, with NIM trending modestly better. Fee should come in modestly above the range of 6% to 9% originally expected. You should expect us to continue to do well on expenses, which will be broadly in line with the January guide. We expect NII and net interest margin to rebound in the fourth quarter given swap costs that peaked in the third quarter with a return to positive operating leverage in the fourth quarter. In addition, net charge-offs are trending in line with our January expectations. We continue to expect to end the year with a target CET1 ratio of approximately 10.5% and the level of share repurchases will be dependent on our view of the external environment and loan growth. To wrap up, we delivered a strong quarter with good momentum in capital markets, record results in wealth and card, and credit performance that continues to play out largely as expected. Our capital levels are strong, near the top of our peer group, and we are maintaining robust liquidity and funding. Our unique multi-year strategic initiatives, including the buildout of our private bank are progressing well, and our consumer and commercial banking businesses are well positioned to drive strong performance over the medium term. Given these tailwinds, combined with strong execution and tight expense management, we remain confident in our ability to hit our medium-term 16% to 18% return target. And with that, I'll hand it back over to Bruce. Bruce Van Saun Thank you, John. Alan, let's open it up for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you, Mr. Van Saun. We are now ready for the Q&A portion of the call. [Operator Instructions] Our first question will come from the line of Peter Winter with D.A. Davidson. Go ahead."
},
{
"speaker": "Peter Winter",
"content": "Good morning. Can you provide an update on the loan outlook in the second half of the year and maybe just talk about customer sentiment and what it's going to take to kind of move them off the sidelines?"
},
{
"speaker": "John Woods",
"content": "Yes, I'll go ahead and jump on that one. So, I mean, I think we're seeing pretty positive signs, for 2H as it relates to loan growth. When we look at the three different businesses that really will drive that, we've got the private bank, which has demonstrated the ability to not only grow deposits and AUM, but the private bank is actually penetrating its customer base and growing loans in the second quarter, and we expect that to actually continue and begin to accelerate into the second half. In the commercial space, customer activities picking up, we do expect to see, particularly in our sort of, you call it, M&A, advisory-related driven finance arena, we're seeing some opportunities in the subscription line space as well as some pick up in fund finance. And then in retail, we've been seeing some opportunities in HELOC and mortgage. So all three legs of our stool, as we call it, are starting to demonstrate the ability to really deliver on that loan growth expectation as you look out into the second half."
},
{
"speaker": "Don McCree",
"content": "Yes, John, I'll jump in on that. It’s Don. I think one of the interesting things we've seen, and this goes to capital markets also, is a real pick up in new money activity over the last six to eight weeks as the interest rate cycle appears to be abating and the economy seems to be okay. So that's driving growth in subscription lines. That's driving a little bit more bullishness among our core C&I customers and it's certainly driving opportunistic activity among the PE firms. So, I think we'll see some decent growth in the second half of the year. Exact timing, I'm not exactly sure, but we did see at the end of the second quarter the beginnings of some pretty significant draws on our subscription loans."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, and I'll jump in too on the consumer and private banking side. The consumer story is a little complicated given the non-core run down. We're running down $800 million to $1 billion each quarter, but if you put that aside, the fundamentals of our core loan business are actually growing at a reasonable clip, really led by residential lending and a little bit in card. Our HELOC position remains incredibly strong. And with rates being higher than we had expected going into the year and our customers having the most home equity in their personal balance sheet in the history of the United States, our HELOC market position is reaping a lot of benefits for us. So we're seeing very strong HELOC growth despite the mortgage challenges, some modest growth in the mortgage portfolio. And we're starting to see a bit of a tick-up on the card book. And then turning to the private bank, really our offering is much broader than what the team that we hired was used to. So we're starting to see a diversification of that book. Early days it was really led by private equity and venture capital call lines. That's still a strength of the business model. We did see in this last quarter in Q2 a diversification towards consumer. So consumer is now 36% of the loan book versus in the low 20s earlier in the year. So mortgage is starting to pick up, some HELOC lending, and still continued strength in business banking and private equity. We expect that trend to continue."
},
{
"speaker": "Peter Winter",
"content": "That's a great color. Thank you. And just on a separate question, the stress capital buffer came in higher than I was expecting. I'm sure it's higher than what you were expecting. Are there any plans to kind of reassess any of the businesses to help drive a lower [SCB] (ph)? Bruce, you mentioned some plans over the medium term to reduce the CRE exposure."
},
{
"speaker": "Peter Winter",
"content": "Yeah, I guess we were a bit disappointed in the SCB result. And I'd say, I think the Fed overall does a pretty good job on credit. They are very conservative, but they have a lot of data to work from. And where we've consistently been frustrated has been on their modeling of PPNR. And so, our own modeling of PPNR is kind of much more robust. I think we do things like we pick up forward to starting swaps. We tailor the situation to the scenario where if rates are much lower, then we're going to see a pickup in mortgage fees and a pickup in capital markets fees, depending on the scenario. But anyway, I'd say the good news is, we have sufficient capital. We run at a conservative level. So having a higher SCB than we think is appropriate isn't really hindering our strategy. And so, I don't think, Peter, that we need to make significant changes to the business model. I think we're on the right track. Having said that, the balance sheet optimization is still places where there's work to do to optimize the risk-adjusted return that we make off the balance sheet and to hopefully improve some of the stress results on the credit side. And so, CRE, we can see, that run down, we popped up after we did the investors acquisition. A lot of that was low risk, multifamily. But certainly, we want to create the capacity to lend in areas that really further deeper relationships and we'll have more C&I kind of fill some of that void as we bring down CRE would probably be the biggest shift that you'd see on the balance sheet over time."
},
{
"speaker": "Peter Winter",
"content": "Got it. Thanks, Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Next question, Alen."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Erika Najarian with UBS. Your line is now open."
},
{
"speaker": "Erika Najarian",
"content": "Hi, good morning. This question -- this first question is for John. John, I think you were at a conference in June, and you talked about, very positively, about an exit rate for the fourth quarter of 2024 and the net interest margin. I'm wondering if you could readdress that again and maybe put it in context of -- you noted that the swap costs were peaking in the third quarter. If you can give that in context on how you expect asset yields to traject as we think about that September and December rate cut. And obviously the 3 basis point improvement in interest bearing deposit costs are notable. It's often the trajectory from here, whether it's in context of the rate cuts and without."
},
{
"speaker": "John Woods",
"content": "Yes, sure, Erika. I guess what I'll start off with is that, at the beginning of the year, we did indicate that we thought the exit NIM would be in that neighborhood of 2.85% or so. I'd say that as we've gotten into the middle part of the year, we expect that to come in a little better. So I think I did mention that at conference earlier last quarter and I think we can confirm that those trends continue to be looking good that we're going to end up a little better than what we expected. And broadly, what we said at the time was that, we saw loans coming in a little lower and pushed out a little bit more than we had originally expected, but that was getting offset, in part from better net interest margin trends, we were pleased to be able to print a very strong interest-bearing deposit costs number that was down 3 basis points this quarter. I think it's very likely that our interest-bearing deposit costs have peaked in the first quarter, that we had some nice opportunity to kind of price our rollovers of CDs in the second quarter, and that was a tailwind. I think there'll be some variability there, but I think 1Q is probably the peak, and that will provide a nice tailwind as you get into the second half of the year. I mean, broadly, the trends when you get into the fourth quarter are along the following lines. Every quarter, we're generating a couple of basis points of positive benefit from all other sources outside of swaps. And so given the third quarters, the last time that we'll see a step up in swap costs, really that the rest of the bank will be able to drive net interest margin rising off of that NIM trough in 3Q into 4Q. And the big drivers would be, there's a number of them. I mean, we've got non-core, which continues to run off and is providing about 2 basis points a quarter of net interest margin all by itself. You've got asset yields around 5 basis points or so, ex-swaps, given the front book, back book dynamic that we're seeing, which is in that 200 basis point to 300 basis point range from the standpoint of what's happening with securities and loans. And then, you have the initiatives with the private bank, which is accretive across the board, which is contributing. So all of those things I think you'll see contribute. And I'd say that getting that first Fed cut in late September would be also helpful. It's not necessary for us to stay on track for having a really strong rebound in 4Q, but it does help, I'd say, address the higher for longer pressures that -- pricing pressures on deposits that will continue to bump along until that first cut comes out from the Fed. So let me stop there and see if that addresses the number of the points that you made."
},
{
"speaker": "Erika Najarian",
"content": "That does. And as you lay out the past, and you said a third -- from a rising past for the net interest margin from what you mentioned as a 3Q 2024 trough. I'm wondering about the size of the balance sheet. Do you feel like your mix is optimized? In other words, as your investors think about a normalizing NIM and multiply that by your balance sheet, is your balance sheet growth going to be in line with business growth, or will there be moves that you're making in terms of wholesale funding or whatever else that could move balance sheet growth sort of underneath business growth or above business growth?"
},
{
"speaker": "John Woods",
"content": "Yes, it's a good question. I'd say, I think there might be two different answers here. One is, in the second half of 2024, we have a -- at the balance sheet date here at June 30, we have a significant amount of excess liquidity. And so, you could see us deploy some of that into lending through the second half. And that's very powerful in terms of the ability to drive net interest margin. And so, we're pleased to be able to do that, given how strong our balance sheet position is at June 30. But I'd say when you zoom out and think about the median term, we without a doubt have opportunity to grow the balance sheet over time in line with business growth adjusted for the balance sheet optimization initiatives that we have in place, but that powerful combination of net interest margin reflating into that, call it, what do we say, 3.25% to 3.40% range plus the opportunity to grow the balance sheet over the medium term is really one of the -- is the primary and majority driver of our ROTCE targets over the medium term. So, I think maybe a little bit of transition in 2H where we'll probably deploy some liquidity, but then growing into 2025 and 2026 and beyond."
},
{
"speaker": "Bruce Van Saun",
"content": "I would just add to that, Erika, is I do think we have one thing that's pretty unique to us, which is the launch of the private bank. So, if we just grow at kind of nominal GDP, kind of in the medium term for consumer and commercial, we should grow a little faster, because the private bank is scaling up. And certainly as the customer base grows and we keep adding and investing in the business, we should see additional growth there."
},
{
"speaker": "Erika Najarian",
"content": "Well said, guys. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Ryan Nash with Goldman Sachs. Your line is now open. Mr. Nash, if you could please check your mute feature on your phone."
},
{
"speaker": "Kristin Silberberg",
"content": "Alen, maybe we can come back to Ryan. Let's move on to the next question and we'll circle back to Ryan. Operator Yes, one moment please. [Operator Instructions] We'll go next to Scott Siefers with Piper Sandler. Your line is now open."
},
{
"speaker": "Scott Siefers",
"content": "Thanks for taking the question. Maybe we could sort of pivot to the fee story for a moment. That's been a pretty solid story this quarter. And John, it sounded like we'll see maybe some seasonal capital markets weakness in the third quarter, but it feels like it's on a good trajectory. So just maybe some thoughts on the overall investment banking pipeline, how it looks, and then just broader thoughts on the main drivers as you see them for the fee-based outlook?"
},
{
"speaker": "John Woods",
"content": "I'll start off with the broader picture and maybe let Don tell us a little bit more about the capital markets pipeline outlook. But more broadly, I mean we're really pleased with our performance in the second quarter and printing another number one middle market sponsor position on the table. It's nice to see the second quarter in a row. 3Q is the typical seasonal period where it's a little down for capital markets and we expect that that may play out as it's done in prior years. But I think the floor in that seasonally down period is actually higher this year than it's been in prior years. So that's something to keep in mind, that given all of the investments, we actually sure will be down off a great 2Q, but the floor is probably higher than prior years, number one. Number two, the diversification not only within capital markets but outside of capital markets and all the investments we've been making in wealth. We had those two significant asset management teams that we brought on board plus all of our organic investments inside the private bank and broadly is really driving wealth fees. So here to see wealth fees be a bigger contributor in the third quarter. And just as you see the rate environment moving around, we're seeing opportunities in helping our customer hedge the exposure to rates. And so, we expect to see some benefit there. And just a number of other categories, including service charges and ability for possibly some mortgage banking opportunities, as rates seem to be stabilizing and down. So there's just a number of other categories, given the diversification of the platform, that will allow us to stay on track here as you head into the third quarter."
},
{
"speaker": "Bruce Van Saun",
"content": "And also, just to add to that, we did take some regulatory cleanup items in other incomes, so that was suppressed in the quarter, which should bounce back next quarter. But with that, Don, why don't you give a little more color on kind of…"
},
{
"speaker": "Don McCree",
"content": "Yes, so it's interesting. The characteristics of the market are very favorable right now. There's enormous amounts of liquidity. And that drove really the first half of the year, which was primarily like a refinancing market. So if you look at transactions done in the core capital markets being syndicated lending and bonds, it was about 85% refinancing of existing exposures that were on people's balance sheet and extending maturities and the like. What we didn't see and what we're beginning to see is new money activity led by the private equity team. So as we move into a more favorable interest rate environment, a decent economic environment, we're starting to see the pipelines really grow on the PE side of the business. And frankly, that's where the big underwritings are, and that's where the profitability drives. M&A is hanging in there pretty well. Remember, we are primarily a middle market investment bank, so we do the mid-sized deals, $100 million valuation to $1 billion valuation, $100 million capital raise to $1 billion capital raise. So those have actually been more resilient than the really big ticket M&A deals, which are getting government scrutiny and getting held up in regulatory approval. So those seem to be moving along reasonably well. The place we haven't seen a lot, we've seen actually more than we saw last year, is in the IPO side of the business. There are a lot of IPOs that are kind of prepped and ready, but people aren't pulling the trigger and going to market. And some of that's been the aftermarket performance of the IPOs that have happened so far. But if we can continue to get the broadening of the equity markets and the high rise of the equity markets, you could see some of that begin to come. And then we have a pretty decent pipeline in the convert side and the follow on side. So it's broad-based. It's pretty encouraging. And I think the backdrop is very favorable for a good second half and a great 2025, frankly. And we think we've got all the pieces we need to take advantage of the markets."
},
{
"speaker": "Brendan Coughlin",
"content": "I'd maybe just very quickly add on the consumer side, our improvement is very durable, sticky fee revenue. So the card changes that both John and Bruce mentioned, we reissued 3.5 million debit cards last quarter in a new contract that just drops directly to the bottom line. It's predictable and will stick around. Service charges has bottomed out. Mortgage we think will be in the zone, it could get a little bit of favorability if rates drop a little bit. And then the wealth AUM growth is sticky, durable, repeatable fee income. So that's what we're calling for, a steady continued upward momentum on consumer without a lot of volatility."
},
{
"speaker": "Bruce Van Saun",
"content": "I'll just add one more thing, as we're beginning to see, it's interesting because the private banking teams never had a capital market business at their prior employer. And so we're starting to see some crossover activity among the private banking clients here coming on board into capital markets. I don't know if that's a second half thing, but I think that's a brand new opportunity from a client base that was never really resident at Citizens before."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. Thank you for that color. And then wanted to ask a little bit about the reserve and specifically the office reserve. I think we're up at 11.1% now, which is, of course, very, very high. I guess I'm curious about the factors, as you might think about them, that would allow you to start sort of absorbing losses with that existing reserve. In other words, what sort of allows that office reserve to start to come down rather than to continue to take off? I think when you talk about the reserve more broadly, you've pointed to non-core runoff as being the thing that might allow the reserve to benefit, but just curious about how office fits in there in particular."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I would say -- I'll start and let John add color, but I'd say that office, there's still a lot of uncertainty in that space. Just what we're seeing in terms of valuations, cap rates, the path of future interest rates. And so, I think we've played it conservatively with having a big reserve and then just kind of letting the charge-offs run through, while maintaining the reserve. I think you'd have to get to a point where you started to see things solidify a little bit and start to move in the right direction, so to speak. And I don't really see that happening actually for certainly this year. It will happen maybe sometime in next year. So we're kind of prepared for a slog here on office that we've got our arms around the properties. We know what the maturity schedules are. We've got good people working with the borrowers to deliver good outcomes. I don't expect we'll see any big surprises, but we'll continue to, I think, just work our way through it. At the point where we hit a kind of feel better moment when things start to look like they're moving in the right direction, that's when we'll be able to start to draw down on the reserve and we'll reap a nice benefit when that happens. John?"
},
{
"speaker": "John Woods",
"content": "Yes. I would just echo that point. I mean just having some growing confidence in valuations and seeing maybe transactions occur could be a likelihood of 2025 outcome. And so this is a multi-quarter probably multiyear journey that we're on. But given all the balance sheet strength, that we have with our capital position, we feel really confident that any uncertainties are expressed in the reserves and any other -- anything else would be supported by the capital. I would also mention that we're working the book down. I mean we started out at $4.2 billion, we’re down to $3.3 billion. So we're lowering the exposure every quarter we're working..."
},
{
"speaker": "Bruce Van Saun",
"content": "That's a good way through repayments and some of it is through [indiscernible] Nonetheless, it is coming down."
},
{
"speaker": "John Woods",
"content": "Exactly. And we're getting some kind of payoffs and paydowns. We're getting -- we're working through the riskier credits and we're having conversations that have been accelerated given our maturity profile that we've had the opportunity to really lean in with our borrowers and when and if we've come to sort of extensions, we've been able to extract, in many cases, better positioning and collateral. So this is, as I said, a multi-quarter journey, and we're feeling good about our [indiscernible]."
},
{
"speaker": "Bruce Van Saun",
"content": "I’ll just elevate too, to the second part of your question is that, away from that, away from the General Office, we're still feeling good about what we're seeing in the consumer metrics, in commercial C&I and we run our reserve calculations based on scenarios. And clearly, the risk of recession seems to be less than it was a couple of quarters ago. And so, our need to keep adding to reserves for rest of the book would seem to be abating somewhat. So that's why when we say we'll continue to see -- we're calling out a slightly lower charge-off number in Q3, and then we have the trend of being able to draw down on those reserves, which I think will accelerate in coming quarters."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. All right. Thank you all very much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Usdin with Jefferies. One moment please while we open your line Mr. Usdin. Your line is open, go ahead."
},
{
"speaker": "Ken Usdin",
"content": "Okay, great. Good morning. Hey, John and Bruce, on the cost side, so you guys are doing early job keeping costs flat. You mentioned earlier, you're hiring some bankers. You obviously have the wealth management people. And I'm just wondering if you can help us understand like the growth that you have there and like where the top and extra cost program are in terms of the offsets to be able to kind of still hold the line? I know that it's kind of in line with your full year guidance, but just the puts and takes of kind of where we are at this point of the year in terms of -- is there just more to come on top to offset those hires and the growth and the strong investment banking results, et cetera? Thanks."
},
{
"speaker": "John Woods",
"content": "Yes. Thanks, Ken, for the question. Just talking about TOP, it's been emblematic of who we are, as you know, for a number of years. The top line program is going to generate, call it, $135 million or so of run rate benefits when you get to the end of this year in 2024, the underpinnings of that program, we often have vendor contributions. That's a big driver. We launched the data and analytics contribution this year, which will continue into future years. We've had a really interesting ability to invest in our [fraud] (ph) program and a number of other opportunities, including branch rationalization that have underpinned a really strong TOP program this year. And that, of course, is the way over time, we have been able to invest in entrepreneurial and innovative initiatives, while not needing to cover that and to sell fund, those kinds of things. The TOP 10 program we're working on. And we're feeling good about the early opportunities. I think we have launched some analysis in the generative AI space, and we're live on a couple of use cases. And I think we're going to see an ability to broaden out there pretty nicely in terms of underpinning the next TOP program. There's a half a dozen of other areas, expanding data and analytics. What we're doing in our technology space, which converging our platforms with our ability to converge our mainframes and so I do think that we feel very good about the ongoing ability to make investments and self-fund those investments to the TOP program in -- as you get into the end of 2024 and into 2025 and maybe I'll just stop there and see if there's anything else I would like to add."
},
{
"speaker": "Ken Usdin",
"content": "Okay. Great. All right. Second question, I know that you issued 400 preferreds and redeemed 300 at the -- in early July. And I think with that, you're still kind of in the 1.2%, 1.3% zone, maybe 1.3%, preferred to RWAs as you contemplate the buyback as you think about the SEB and all of that, like how do you just think about the overall capital stack in terms of like what your ultimate goals are for optimization of your capital position? Thanks."
},
{
"speaker": "John Woods",
"content": "We're feeling pretty good about where we stand in the capital space. I mean, I think we basically think that around 1.25% is fine. We end up with -- we probably have more CET1, so when you look at the overall Tier 1 stack, we've got higher quality capital given the fact that we have more CET1 driving our overall Tier 1. 1.25% is fine, it’s probably -- we probably won't go much below that and a range of 1.25% to 1.50% of RWAs is probably where we'll operate. We have a number of issues out there that are coming into the ability to -- into call periods and into 2025. And so there could be some opportunities to refinance, just like we did this year, there are some very interesting refinance opportunities to lower our preferred coupon that we're paying on the preferred capital. So that's something we'll keep an eye on as we go forward into 2025."
},
{
"speaker": "Ken Usdin",
"content": "Okay. Great. And sorry, just one to follow up on that last one. Just the -- so the RWAs have been coming down and your average earning assets have been kind of flat. And I know you talked a little bit about this earlier. But is kind of flattish on total balance sheet size, average earning assets. Is that the right way to think about things going forward given all the moving parts on both sides of the balance sheet?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean, for 2024, I think the answer to that is yes, with growing RWAs. As I mentioned, we have excess liquidity at June 30 and you could see the overall balance sheet being basically in the same zone as where we are today, but the ability to basically deploy some excess liquidity into lending in the second half is really the plan. So we would see RWAs and loans growing from June 30 to the end of the year."
},
{
"speaker": "Bruce Van Saun",
"content": "We can see some growth, though, in I'd say, spot deposits and spot loans in Q4 above that, about just deploying the liquidity. So just to be clear."
},
{
"speaker": "John Woods",
"content": "Yes, agreed. We're going to see deposit growth and loan growth. It's just that given the excess securities that we have on balance sheet overall interest-earning assets are about where they will be maybe just a little bit higher."
},
{
"speaker": "Ken Usdin",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Manan Gosalia with Morgan Stanley. Your line is now open."
},
{
"speaker": "Manan Gosalia",
"content": "Hey, good morning. If I try to back into the 4Q NII number using your full year guide and the 3Q guide, it implies 3% to 4% quarter-on-quarter increase in NII in 4Q. My question there is, what do you need to see that uptick in NII? I know there's some benefit from the -- on the swaps front, but do you also need to see loan growth. Do you need to see deposit costs continuing to come down? Do you need any help from rates? Can you help us frame that?"
},
{
"speaker": "John Woods",
"content": "Sure. Yes. And I'd say broadly that the majority of the increase in 4Q is really coming from net interest margin rebounding. So just allowing all of those positive tailwinds from net interest margin across the whole platform from noncore, the front book, back book dynamics and all of those drivers is the majority of the increase in NII for 4Q. However, there is a meaningful contribution expected from loan growth as well, and we talked about loan growth earlier in the call and how all three businesses, Private Bank, consumer and commercial are all expected to contribute to that in terms of how that plays out for the second half. When it comes to just that net interest margin number, as I mentioned, noncore front book, back book -- you also have increase in deposits that you just heard Bruce talk about that increase -- that's a better funding mix where we'll have more deposits and less wholesale funding as you get into the second half. Your other question about that deposit pricing and the rate cut. I think we're somewhat well balanced around whether the Fed cuts or not. We tend to have some offsetting forces there where we have some asset sensitivity and a net floating position that benefits with rates being a little higher, but then that often the higher for longer impact on deposit migration tends to keep us close to neutral. And so, whether we get a cut or not, I think we're feeling pretty good about the fourth quarter NII being a nice rebound and a meaningful increase versus 3Q. And then the last part I'll throw out there is, again, all the initiatives and how -- for example, balance sheet optimization and Private Bank are all accretive to net interest margin on a quarterly basis."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. And I would just add to that as well that we also think that reminder that the Q4 is a seasonally strong quarter for fees. So I think there could be that rebound in NII kicking in Q4, strong feed quarter, continued discipline on expenses, credit seemingly moving in the right direction. So -- and then continued share repurchase. So you put that all together, you could have kind of a nice uptick in the Q4 results."
},
{
"speaker": "Manan Gosalia",
"content": "That's really helpful. And then as a follow-up on the commercial middle market side, you outlined several positive drivers for lines picking up in the back half. Does that come with higher utilization? Or do you need to see lower rates for utilization to pick up? And maybe how does the uncertainty around the election? How is that factoring into your conversations with clients?"
},
{
"speaker": "Don McCree",
"content": "Yes, what we're assuming in our utilization growth as it's largely in the capital call and subscription lines. So we're seeing a little bit in the middle market. So I think the middle market trend will be a little bit longer. What we've seen our middle market companies do is kind of take their leverage levels down with economic uncertainty. So as the economy begins to show signs of stabilization, more certainty stabilization, maybe they get a little more aggressive investing in their businesses. And I was with a whole bunch of middle-market CEOs last week and every single one of them said they have were new investment plans over the next 18 months. So that will take a little bit longer. And I don't really see massive impact of -- from the election. I think you may get some market volatility based on what someone says day in, day out. But I think the medium-term trend is intact. And we are seeing -- I mean, the playbook we're going to run in California and Florida, which Bruce mentioned, is going to mirror the playbook we ran in New York, where we're having just extremely strong client acquisition as we bring experienced market bankers onto the platform, and they their clients with them. So very early days, but those pipelines are building kind of literally within two months of hiring the new bankers. So there won't be huge numbers of the asset, but that will be another tailwind for us, I think."
},
{
"speaker": "Manan Gosalia",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of John Pancari with Evercore. Your line is now open."
},
{
"speaker": "John Pancari",
"content": "Good morning."
},
{
"speaker": "Bruce Van Saun",
"content": "Good morning."
},
{
"speaker": "John Pancari",
"content": "Bruce, I think you talked about the expectation, the medium-term plan to shrink the CRE exposure incrementally from here. Just wanted to get an idea of where you think that could settle out? I mean, right now, your commercial real estate loans are about 130% of your risk-based capital plus reserves, where do you think it goes from that perspective post this expected runoff."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I'd say over the medium term, we'd probably take the pure commercial book down at least 25%. And that will come across the asset classes, obviously, want to be smaller in office, multifamily, we can lead that down a bit since we took a big upsurge with the investors deal. We will make room for some CRE opportunities with the private bankers since it's important part of their customer base. And so, there'll be a little bit of offset to that. But that kind of directionally gives you a sense as to kind of what the plans are. And as I said earlier in the call, I think we're making room for more C&I growth that we'd like to kind of flex and have a bigger loan capital allocation to C&I and a smaller to CRE over time."
},
{
"speaker": "John Pancari",
"content": "Right. Okay. Thank you. That's helpful. And related to that, my second one is on the private banking side. First, on the deposit side, the $4 billion in deposits, I know 81% of that is commercial, 36% of that is DDA. How much of those deposits are deposits with venture capital and private equity firms are related to that industry."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes. Of the commercial and business banking oriented deposits, the majority are from private equity and venture firms. But I would note that it's heavily led by operating deposits. And so the way that the relationship actually works is starting as their cash management operating bank, which is why the DDA and [indiscernible] percentages is so high in the business. So they're stable, predictable and generally lendable deposits. So we're pleased with the profile. If you think of the loans that have come in, obviously, the LDR of the private bank is quite low, and we've got a good amount of liquidity padding when you look at the lendability of the deposit base to continue to drive loan growth even within the profile of just the private bank. So we're pleased with the quality that you're seeing the loan book diversify to consumers. The deposit book has still remained in that sort of 80-20 split. But given the pace of growth, that obviously suggests that the consumer business is also growing at a pretty healthy clip. That just takes some time, and we do expect that to catch up. And it will diversify over time to more of a 60-40, maybe over the longer-term horizon 50-50. But…"
},
{
"speaker": "Bruce Van Saun",
"content": "With both deposits and loans..."
},
{
"speaker": "Brendan Coughlin",
"content": "Both deposits and loans, I mean the higher rates have held back on mortgage, obviously, and then the business banking and commercial deposit growth is quicker and lumpier, but we do expect that to continue to change over time, and we're pleased with the strength of the consumer opening these private banking offices, which should attract more of a high net worth individual as well."
},
{
"speaker": "John Pancari",
"content": "Okay. Thank you. Then one last one. If you could just maybe update us on the likelihood of additional team hires on the private banking side. And then the Wealth AUM going up to about $3.6 billion there. I know you acknowledged that might be a tougher slog and -- but it looks like towards the end of the quarter that you had that big jump in AUM. Just curious if you could give a little bit of color around what's driving that recent upturn."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I'll start and pass it to Brendan. But I just want to make an overriding point is that, we want to demonstrate that we can run this as a profitable business. And so, when we initiated the launch of the private bank, we put some markers out there as to where -- what we were going to do this year, hitting breakeven in the fourth quarter. And then next year getting to numbers that had $9 billion of loans, $10 billion of AUM, $11 billion of deposits. That translates to 5% accretion to our bottom line. And so, we're still building the business. We're building the service levels. We're making investments in more support people, and we feel really good about the trajectory that we're on. We want to get that right, we want to get that flywheel running and hit those numbers before we start going crazy making investments in other regions and other opportunities. Having said that, if there are particularly unique situations that we can kind of fit in and execute over the next 18 months that are important locations, and they don't affect our ability to hit the numbers, we'll be open to that. And then the other thing is on the Wealth management side, we had a strong base with Card sell. We knew ultimately that we were going to have to expand the capabilities that we had by bringing in more teams. And the focus has been on a geographically situated teams that can be contiguous with the private banking teams that we've set up in San Francisco, Boston, New York and Florida. And so, so far, we've been able to bring two great teams like quality, everything, one in San Francisco, one in Boston. That's accounting for a big chunk of that rise in AUM with more to transfer in from their customer base. So we have momentum there. We also have a ton of folks interested in joining our platform. So we can have those conversations and keep bringing those wealth teams in because they don't really impact the near-term financials negatively that usually come in around breakeven with an opportunity to quickly turn into profitability. So Brendan, you can add to that."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes, you nailed [indiscernible] what you said. I would just say on the wealth side, we'll be very selective on the banking expansion until not only we make have confidence in hitting the financials, but also it's still built, and we're very pleased with how the build is going and we're attracting clients. The market is still quite disrupted both on the client side as well as the talent side. We're going to be very thoughtful and make sure that we're only attracting the highest of quality teams. We're being very selective on that. On the Wealth side, I would just say, look, for really the first time in our history, I think our right to win in private Wealth is at an all-time high. And there's a lot of inbounds we're getting from some of the highest quality advisers in the market. We're also being very selective there. I'd remind you all that we have long been on hunt for scale here, and we've looked at a lot of acquisitions. We've obviously done one or two over the years, but the economics have been a little out of reach with 10 plus your paybacks on tangible book value when you're buying RIAs, given the multiples that some of the private equity firms are paying. So the economics of the talent acquisition are significantly more attractive to us. Obviously, with de minimis tangible book value hit. And to Bruce's point, there's not really a large J-curve in the short term. So we're very pleased with the inbounds and talent that we're getting. We expect to continue to selectively add top end market, wealth talent to really round out the bankers that we hired. So we're looking forward to a strong second half of the year there."
},
{
"speaker": "John Pancari",
"content": "Great. Thanks, Brendan."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Gerard Cassidy with RBC. Your line is now open. Go ahead."
},
{
"speaker": "Gerard Cassidy",
"content": "Thank you. Good morning, Bruce. Good morning, John. John, you talked and gave us good detail about the office portfolio of commercial real estate. And I think you said that some of your assumptions in the bottom left-hand corner of Slide 14 show that this downturn is far worse than historical downturns. Can you share with us two ideas or two answers. First is, when you look back, I think you guys have been aggressively attacking this portfolio for just over a year now. When you look back at those early workouts in the second quarter of 2023, how are the assumptions that you're using then compared to today? And then second, and I'm with Bruce that maybe this office problem doesn't resolve itself until sometime next year. What are you seeing incrementally in terms of valuations or losses? Is it still deteriorating in office? Or has it just stabilized and we just got to work through these portfolios?"
},
{
"speaker": "John Woods",
"content": "Yes. I'll go ahead and start off, Gerard. I mean, I think that earlier -- what's evolved over the last year or so has been our outlook with respect to valuations and NOI and what the rent rollovers would actually entail and at what speed we would see deterioration. So of course, our reserve levels are higher now than they were a year ago. Every quarter, we endeavor to put a ring fence around our exposures and give it our best attempt at forecasting what we think the evolution will be in valuations and NOI. I'd say that this quarter, we've done that again. And we feel like we've leaned in with this 11.1%, which really -- when you look at the property valuations steep to trough, that 72% has grown over the last year. And those have been the main drivers for why after charging off, we still end up with this reserve of 11.1%. But I'd say that there's still a lot of uncertainty left, but I think the variability, we're hopeful that the variability in this will start to decline as we continue to work through our maturities and have conversations with our borrowers and extract additional collateral and work through paydowns where we can -- this will be a multi-quarter event and it will take into 2025 [indiscernible]"
},
{
"speaker": "Bruce Van Saun",
"content": "I would just add that I do think the Fed starting to move rates lower will certainly be help here. So part of the reason the losses ended up higher than what potentially we thought back in early 2023 because those cap rates going up at inflation that was impacting NOI and things like that. And so, I think we've seen inflation now leveling off. And if the Fed starts to move rates down, that could also start to move things in the other direction. It's too early to call a victory here, but there are some positive signs. And I think lease up rates generally are actually holding or potentially getting a little better as return to office picks up. But again, that's not that significant in the big scheme of things."
},
{
"speaker": "Gerard Cassidy",
"content": "Can we -- is it fair to say that the second derivative of the rate of deterioration that you guys are seeing, is it slowing in the office or…"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Yes. Definitely."
},
{
"speaker": "Gerard Cassidy",
"content": "Okay. It’s yes. Okay, good. Thank you. Okay, and then as a follow-up, you guys talked a lot about private equity in your Slide 17, you show some great numbers. Obviously, number one in the sponsor business and your capital markets business is benefiting from that. So the question I have is, and it's not on the capital call or subscription lines, but it seems over the years for banks to win in this capital markets business with sponsors, you have to use your balance sheet to win this business. You've got to lend money to the sponsors. So can you share with us your exposure to, I guess, one of the line items and one of the regulatory reports is non-depository financial lenders that you lending to them. Can you share with us your exposure there? How you manage that risk? Because it seems like banking initial has been derisked, but maybe it's in the private credit side and the indirect exposure for the industry could come through that channel. Can you give us some color there, Bruce, or Don?"
},
{
"speaker": "Don McCree",
"content": "Yes. Hi, Gerard, why don't I take that? It's Don. So we bank the private capital sector in several different ways. We obviously have capital call and subscription lines, which are based on LPs, we have financing lines to some of the private credit organizations, which are kind of structured as almost like asset-backed lending, where we have diversified pools of loans underneath it, we have advance rates and the like. So it's actually relatively safe, almost investment-grade like lending, even if those complexes begin to take some losses on their underwriting portfolios. So we like those two businesses a lot. We're probably not going to grow them too much more across the entirety of the company because it is a large concentration already. But when you look at those non-bank financial numbers that includes insurance companies. There's a whole bunch of other exposures in there also. And then, of course, we land the riskiest stuff we do is to the underlying leverage buyouts and our strategy there forever has been very large holds. It's an underwrite to distribute business. The average outstanding is like $12 million on a given deal. So very diversified across a large group of leveraged credit. The book is actually shrinking, given the lack of market activity over the last kind of 1.5 years or so. So we feel like we're very well diversified and I've been doing this business, as you know, for a very long time and where you get really hurt is when you have big concentrations in leveraged loans and we see that with some of our competition, but we're not going to go there just because that's the way you run those businesses. So those are the really big pops."
},
{
"speaker": "Gerard Cassidy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Matt O'Connor with Georgia Bank. One moment while we open your line Mr. O’Connor. Your line is now open."
},
{
"speaker": "Matt O’Connor",
"content": "Thank you. Good morning. Can you guys talk about how you think deposits will reprice down. I guess, the first kind of, call it, two or three Fed cuts versus and more sustained reduction?"
},
{
"speaker": "John Woods",
"content": "Yes, sure. I'll take that. I mean I think what we're likely to see under the first couple of cuts we're modeling out approximately 20% to 30% down betas in those first couple of cuts. The way the forwards have it playing out overall. The longer those cuts are in place, the more there's the opportunity to see rollovers of CDs, et cetera, and to lean in and price down. So the fact that we have, I think the forwards get down to around 4% by the end of 2025 and may start to get into the 3.50% range in terms of our outlook when you get out into 2026 and beyond. Through that full tightening cycle, we think that the full round trip could be -- could approach -- the down beta is good approach where up betas were. Our up beta is around 51%. I think the down beta could get up to that level over the full cycle, but it will be $20 million to $30 million for the first couple."
},
{
"speaker": "Matt O’Connor",
"content": "Okay. And then thoughts on does deposit growth pick up a bit for, I guess, the industry and you've got some specific initiatives, obviously, but do you see some pickup in kind of broader deposit trends as well with some Fed cuts?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean, I think broadly, we believe we're going to have deposit growth in the second half contributing from all three of our businesses. So 2Q is a seasonally down quarter. We saw that, and we're expecting that plus all of our initiatives that we have in place are going to contribute to deposit growth in the second half. We've got that one cut in September, and our outlook that will be helpful. I don't think that it's absolutely necessary to have that cut in order to continue to have deposit growth. But certainly, it would be helpful to get that deposit growth to stop kind of the migration aspects and the mix shifts that the industry has been seeing. And then as you broaden that out, when we have overall deposit growth and average deposits are higher, that will be consistent with a very positive funding mix because wholesale funding can be lower in terms of funding the balance sheet, and that's a tailwind for NII and NIM into the second half as well."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I would just add some color there, the uptick in private bank deposits in the quarter was $1.6 billion. And so you can see that we've really got a cadence and a rhythm in terms of kind of growing the book there and the private bank and bringing in the customer base. So we would expect to have again, something that most other banks don't have to drive deposit growth and having that unique business opportunity. And then there's generally some seasonality that's favorable in the consumer business and the commercial business. So I think the outlook for deposit growth in the second half is pretty solid."
},
{
"speaker": "Brendan Coughlin",
"content": "The one point I would add on the consumer side is that, we a number of years in a row where we've outperformed on a relative basis on DDA low-cost deposits and with benchmarking that we see so far this year, we believe we're number one in the peer set and consumer for relative DDA performance, and we see that continuing. So we think the trends have stabilized up so much of our deposit strategy is grounded in the health of our DDA base and we expect whatever the market throws us that we'll continue to outperform peers and doing that for a long time now. And certainly, this year has been a real strength."
},
{
"speaker": "Matt O’Connor",
"content": "Okay. Thank you."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. I think that's it for the queue. Thank you, everybody, for dialing in today. We certainly appreciate your interest and your support. Have a great day."
},
{
"speaker": "Operator",
"content": "That concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
cfg | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, everyone and welcome to Citizens Financial Group First Quarter Earnings Conference Call. My name is Alan and I’ll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now I’ll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin."
},
{
"speaker": "Kristin Silberberg",
"content": "Thank you, Alan. Good morning, everyone and thank you for joining us. First, this morning, our Chairman and CEO, Bruce Van Saun; and CFO, John Woods, will provide an overview of our first quarter results. Brendan Coughlin, Head of Consumer Banking; and Don McCree, Head of Commercial Banking, are also here to provide additional color. We will be referencing our first quarter earnings presentation located on our Investor Relations website. After the presentation, we will be happy to take questions. Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on Page 2 of the presentation. We also reference non-GAAP financial measures, so it’s important to review our GAAP results on Page 3 of the presentation and the reconciliations in the appendix. With that, I will hand over to you, Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Thank you, Kristen. Good morning, everyone. Thanks for joining our call today. We were pleased to start the year with a solid quarter. We continue to play strong defense through an uncertain environment with a CET1 ratio of 10.6%, our LDR at 81%, our allowance for loan loss ratio of 161%, and general office reserves now at 10.6%. On the P&L, we are still seeing a modest decline in NII though our NIM was stable at 2.91%. Fees picked up by 3% sequential quarter, led by capital markets and card and expenses were flat. Our credit trends are in line with expectations. We repurchased $300 million of shares during the quarter as we free up capital from our non-core rundown. Our guide for Q2 and full year remain consistent with our expectations at the outset of the year. Our strategic initiatives are making good progress. The Private Bank is off to a good start, reaching $2.4 billion in deposits at quarter end. We expect momentum to accelerate further over the course of the year. We are also focused on building out private wealth management through further investment in Clarfeld plus several imminent team lift-outs. Our New York City Metro initiative continues to go well with the fastest growth of any of our regions and really strong net promoter scores. Our focus in the commercial bank of serving the middle-market, private capital and key growth verticals has put us in great position to benefit from a pickup in deal activity, which we expect to build further over the course of the year. And our TOP 9 program is being executed well, allowing us to self-fund our growth investments while keeping overall expense growth rate muted. While there are still many uncertainties in the external environment, we feel we are in good position to navigate the challenges that may arise and we maintain a positive outlook for Citizens over the balance of the year as well as the medium term. Over the past decade, we have undertaken a major transformation of Citizens. Our Consumer and Commercial Banking segments are positioned for success, and we are now looking to build the premier bank owned private bank and wealth franchise. Our balance sheet has been repositioned with an exceptionally strong capital liquidity and funding profile and we are deploying our loan capital more selectively to achieve better risk-adjusted returns. Our expense base has been tightly managed with AI offering the potential for further breakthroughs. Lots accomplished with more to do, clearly, exciting times for Citizens. With that, let me turn it over to John."
},
{
"speaker": "John Woods",
"content": "Thanks, Bruce and good morning, everyone. As Bruce mentioned, the year is off to a good start. First quarter results were solid against the backdrop of a more constructive macro environment, which supported an improvement in capital markets, stability in our margin and credit performance that continues to play out largely as expected. We continue to maintain a strong balance sheet with capital levels either top of our peer group, excellent liquidity and a healthy credit reserve position. Importantly, this positions us to execute well against our multiyear strategic initiatives, including the build-out of our private bank. Let me start with some highlights of our first quarter financial results, referencing slides 3 to 6 before I discuss the details. We generated underlying net income of $395 million for the first quarter and EPS of $0.79. This includes a negative $0.03 impact from the private bank, which is a significant improvement from the $0.11 impact last quarter as we start to see revenues pick up and we progress to our expected breakeven in 2H ‘24. It also improved the impact of the non-core portfolio, which contributed a $0.13 negative impact. While our non-core portfolio is currently a sizable drag to results, it is steadily running off, creating a tailwind for performance going forward. Our notable items this quarter were $0.14, which primarily consists of an adjustment to the FDIC special assessment and TOP and other efficiency-related expenses. Excluding these notable items, our underlying ROCE for the quarter was 10.6%. Playing through defense remains at the top of our priority list, and we ended the quarter with a very strong balance sheet position with CET1 at 10.6% or 8.9% adjusted for the AOCI opt-out removal. We also continue to make meaningful improvements to our funding and liquidity profile in the first quarter. Our pro forma LCR strengthened to 120%, which is well in excess of the large bank category 1 requirement of 100% and our period-end LDR improved to 81% from 82% in the prior quarter. On the funding front, we reduced our period-end FHLB borrowings by about $1.8 billion linked quarter to a modest $2 billion. We also increased our structural funding base with a very successful $1.25 billion senior issuance and another $1.5 billion auto collateralized issuance during the quarter. And we have another $1 billion of auto backed issuance expected to settle this week. This is our fourth issuance, and it was executed at our tightest credit spreads to date. In addition, we expect to be a more programmatic issuer of senior unsecured debt going forward. Credit trends have been performing in line with our expectations, with NCOs coming in at 50 basis points for the first quarter. Our ACL coverage ratio of 1.61% is up 2 basis points from year-end. This includes a 10.6% coverage for general office, up slightly from 10.2% in the prior quarter. We are well positioned for the medium term with expected tailwinds to NIM that support a range of 3.25% to 3.4%. Regarding strategic initiatives, the Private Bank is doing very well. We continue to make inroads in the New York Metro and our latest top program is progressing nicely. In addition, we are poised to benefit from an improving capital markets environment with our investments in the business and synergies from our acquisitions positioning us to capitalize as activity levels continue to pick up. Next, I’ll talk through the first quarter results in more detail, starting with net interest income on Slide 7. As expected, NII is down 3% linked quarter, reflecting a stable margin on a 2% decrease in average interest-earning assets given lower loan balances and day-count. As you can see from the NIM walk at the bottom of the slide, our margin was flat at 2.91% as the combined benefit of higher asset yields and non-core runoff and day count were offset by higher funding costs and the impact of swaps. As expected, our cumulative interest-bearing deposit beta remains in the low 50s at 52%. And although we continue to see deposit migration, the rate of migration is slowing. Overall, our deposit franchise has performed well with our beta generally impact the peers. Moving to Slide 8. Our fees were up 3% linked quarter given a notable improvement in capital markets and good card results. The improvement in capital markets reflects a nice pickup in M&A activity and strong bond underwriting results. Our Capital Markets business consistently holds the top 3 middle market sponsor book renter position and this quarter, we achieved the #1 spot. Our deal pipelines remain strong, and we continue to see positive early momentum in capital markets this quarter with strong refinancing activity continuing in the bond market. In card, we had a nice increase, primarily driven by the benefit of a strategic conversion of our debit and credit cards to Mastercard. Our client hedging business was down a bit this quarter with lower activity in commodities and FX. The decline in mortgage banking fees was driven by a lower benefit from the MSR valuation net of hedging and a modest decline in servicing P&L, partially offset by higher production fees as margin improved while lot volumes were stable. On Slide 9, we did a nice job managing our underlying expenses, which were stable. We will continue to execute on our TOP program, which gives us the capacity to self-fund our growth initiatives. On Slide 10, period end and average loans are down 2% linked quarter. This was driven by non-core portfolio runoff and a decline in commercial loans, given paydowns and generally lower client loan demand, our highly selective approach to lending in this environment, along with exits of lower returning credit-only relationships. Commercial line utilization continued to decline this quarter as clients remain cautious and M&A activity was limited in the face of an uncertain market environment. Next, on Slides 11 and 12, we continue to do well in deposits. Year-on-year period-end deposits were up $4.2 billion driven by growth in retail and the private bank. Period end deposits were down slightly linked quarter given expected seasonal impacts in commercial largely offset by growth in the private bank and retail branch deposits. Our interest-bearing deposit costs were well controlled, up 6 basis points, which translates to a 52% cumulative beta. Our deposit franchise is highly diversified across product mix and channels. About 68% of our deposits are granular, stable consumer deposits and approximately 70% of our overall deposits are insured or secured. This attractive deposit base has allowed us to efficiently and cost effectively manage our deposits in the higher rate environment. With the Fed holding steady, we saw the migration of deposits to higher cost categories continue to moderate. And with the contribution of attractive deposits from the private bank, non-interest-bearing deposits are holding steady at about 21% of total deposits. Moving on to credit on Slide 13. Net charge-offs were 50 basis points, up 4 basis points linked quarter. This includes increased commercial charge-offs related to pre general office, which were in line with our expectations. In retail, we saw a modest seasonal improvement. Non-accrual loans increased 8% linked quarter driven by general office. The continued runoff of the auto portfolio drove a modest decline in retail, while other retail categories were stable. Turning to the allowance for credit losses on Slide 14. Our overall coverage ratio stands at 1.61%, which is a 2 basis point increase from the fourth quarter, reflecting broadly stable reserves with lower loan balances given non-core runoff and commercial balance sheet optimization. The reserve for the $3.4 billion general office portfolio represents 10.6% coverage, up slightly from 10.2% in the fourth quarter. On the bottom left side of the page, you can see some of the key assumptions driving the general office reserve coverage level. We feel these assumptions represent a severe scenario that is much worse than we’ve seen in historical downturns, so we feel the current coverage is very strong. Moving to Slide 15. We have maintained excellent balance sheet strength. Our CET1 ratio is a strong 10.6% and if you were to adjust for the AOCI opt-out removal under the current regulatory proposal, our CET1 ratio would be 8.9%. Both our CET1 and TCE ratios have consistently been among the top of our peers, and you can see on Slide 16, where we stand currently relative to peers in the fourth quarter. Given our strong capital position, we resumed common share repurchases and including dividends, we returned a total of $497 million to shareholders in the first quarter. On the next few pages, I’ll update you on a few of our key initiatives we have underway across the bank, including our private bank. First, on Slide 17, we have a strong transformed consumer bank with a robust and capable deposit franchise, a diverse lending business where we are prioritizing relationship-based lending and a meaningful revenue opportunity as we scale our wealth business. Importantly, we continue to make great progress taking deposit share with retail deposits up 20% year-on-year as we continue building our customer base in New York Metro. Slide 18. Let me update you on our progress in building a premier private bank, taking the opportunity to fill the void left in the wake of the bank failures last year. Our build net is going very well and gaining momentum. We are growing our client base and now have about $2.4 billion of attractive deposits with roughly 30% non-interest-bearing. Also, we are now at just over $1 billion of loans and $0.5 billion of investments and continuing to grow. We just opened our newest private banking office in Palm Beach, Florida, and we are opportunistically adding talent to bolster our banking and wealth capabilities with our Clarfeld Wealth Management business as the centerpiece of that effort. Next, on Slide 19, we have built a formidable full-service commercial bank, which consistently punches above its weight. Our multiyear investments in talent, capabilities and industry expertise put us in an enviable position to provide life cycle services to middle market, mid-corporate and sponsor clients in high-growth sectors of the U.S. economy. In particular, we are uniquely positioned to serve the private capital ecosystem. As evidenced by our consistent standing at the top of the sponsored lead tables, we are well positioned to take advantage of a more constructive capital markets environment and we are excited to start seeing the synergies from our acquisitions coming through in our results this quarter. Moving to Slide 20, we provide the guidance for the second quarter. We expect NII to decrease about 2%. Non-interest income should be up approximately 3% to 4%. We expect non-interest expense to be stable to down slightly. Net charge-offs are expected to be about 50 basis points and the ACL should continue to benefit from the non-core runoff. Our CET1 is expected to come in at about 10.5% with approximately $200 million of share repurchases currently planned. We are broadly reaffirming our full year 2024 guide. We expect NII to land within the range of down 6% to 9%, consistent with our January guidance, with margin coming in a little better than expected, offsetting the impact of lower loan demand. The other components of PPNR are also tracking to our January guidance. In addition, NCOs are trending in line with our expectations of approximately 50 basis points for the year. Our target CET1 ratio for 2024 is approximately 10.5%, and the level of share repurchases will be dependent on our view of the external environment and loan growth. Given the changing rate outlook, I wanted to update you on how the swaps and our non-core portfolio are expected to impact NII and NIM as we look out further in 2024 and beyond. We’ve included Slide 25 in the appendix, which shows the expected swaps and non-core impact through 2027. By 4Q 2024, we expect higher swap expense to be partly offset by the NII benefit from the non-core rundown. Looking out further, we expect a significant NII tailwind and NIM benefit from the impact of non-core and swaps over the medium term given runoff and lower rates. This will be partially offset by the impact of the asset-sensitive core balance sheet, resulting in a medium-term NIM range of 3.25% to 3.4%. To wrap up, we delivered a solid quarter, featuring stable NIM, strong fee performance led by capital markets and cards, tight expense management and in-line credit performance. We have a series of unique initiatives that are progressing well. Our consumer bank has been transformed. Our commercial bank is exceptionally well positioned and we aim to build the premier bank-owned private bank and wealth franchise. We enjoy a strong capital liquidity and funding profile that allows us to support our customers while continuing to invest in our strategic initiatives. Given several tailwinds, combined with continued strong execution, we are confident in our ability to hit our medium-term 16% to 18% return target. With that, I’ll hand it back over to Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Thank you, John. And Alan, let’s open it up for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from the line of Ryan Nash with Goldman Sachs. Your line is open."
},
{
"speaker": "Ryan Nash",
"content": "Hey, good morning Bruce. Good morning, John."
},
{
"speaker": "Bruce Van Saun",
"content": "Good morning."
},
{
"speaker": "John Woods",
"content": "Good morning."
},
{
"speaker": "Ryan Nash",
"content": "Maybe to start off with some of the guidance, you broadly reiterated – can you maybe just flesh out how some of the expectations have changed, particularly around NII, John? I think you noted you still expect to be in the range. But what are the main drivers to get you there and what would it take to be better than the low end? And just as a follow-up on the margin, you held it flat and it sounds like it could be a little bit better. How have the expectations change relative to the 280 to 285 and the 285 you were expecting at the end of the year? Thank you."
},
{
"speaker": "John Woods",
"content": "Yes, sure. I’ll go and talk through that. I’d say, as you may have heard in some of the opening remarks, we do expect that net interest margin trends have been quite good. And so we do expect net interest margin to come in a little better, maybe at the high end of that range rather than where we were at the beginning of the year. And a lot of the drivers of that net interest margin can be pinned on the investments we’ve made in the deposit franchise over the years that are really starting to come to fruition. And when you look at it, deposit levels are better in the first quarter than we expected and interest-bearing deposit costs are a little bit better. So just – and funding overall, when you look at our borrowing mix has improved significantly. So that’s underpinning a lot of the net interest margin. And when you combine that with the other side of the balance sheet, where you see the front book back book dynamic playing out. It’s very powerful. And so we’re feeling better about NIM trajectory. And I think that’s what you’re seeing with respect to our confidence in hitting that that net interest income range, given the confidence around net interest margin. As you get towards the end of the year, as I mentioned, I think, previously, we said our guide would be around 280 to 285 in that range, I’d say we’re probably going to come in at the upper end of that range now when we look out and maybe a tad above, we’ll see as it plays out. And then we’ll see the loan just given where loan demand has started off the year, maybe average loans maybe towards the lower end of that original range. But those offset a couple of basis points of NIM equals about a percentage point on loans. So that math just works out to be right down the middle of the fairway in terms of our guide. What could cause it to come in a little better, continued execution of our strategic initiatives if we see our execution kind of accelerating across the private bank, and our other key initiatives on the deposit side. And let’s see how the second half commercial rebound plays out. We are expecting working capital starting to pick up in the second half. We’re expecting utilization levels to pick up. We’re expecting activity in general, even in the M&A front and M&A finance to be part of the story in the second half. And so if that starts a little earlier or it comes in a little stronger, you could see us coming in maybe towards the lower end of that original NII guide."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I would just add one thing, Brian, it’s Bruce. The fact that the loan demand is a little light is, I think, okay, given there’s a kind of loop to what we’re doing on the deposit side. So we’re not going to chase loan growth. And if, therefore, there’s a little shrinkage in the balance sheet, we can run off our higher cost source of either FHLB funding or broker deposit funding. So we’re taking full advantage of that, which is helping bolster the NIM. The other thing is with less loan growth, you end up freeing more capital. And so that gives us the wherewithal to step up and continue to repurchase stock. And I think our stock is great value here. So we’re all in on that."
},
{
"speaker": "Ryan Nash",
"content": "Got it. And thanks for all the color. And just maybe as a follow-up, just – any color in terms of what you’re seeing on the credit side, which seems to be tracking in-line with your expectations? And maybe specific to office where we saw a jump in the losses this quarter relative to the past few. Maybe just some color on what’s driving that? Was that increased severity? Are you front-loading some losses? And when inevitably do you think we could see the allowance in that portfolio peak. Thank you."
},
{
"speaker": "Bruce Van Saun",
"content": "Let me start and then flip to Don. But I’d say there’s no real surprises here, Ryan. So we can basically see all the office maturities. We’ve got kind of bespoke careful handling on all of the significant exposures that we have, and we’ve been working with the borrowers just to make sure that we can have a win-win situation. So we can come through getting the best return on our loans and borrowers can stay with their properties through a tough environment. And I think that’s all going well. So if you have one quarter where the charge-offs tick up $20 million or the next quarter, they go down $15 million, you’re going to kind of see some modest variation around that line, but basically to use a colloquialism, the pig is going through the python. And it’s going to take a few more quarters for that to fully work its way through. But we’re not seeing any surprises, which is the good thing about this. And so Don, with that, maybe you could pick up."
},
{
"speaker": "Don McCree",
"content": "No, I think that’s exactly right. We’ve taken our general office from about $4.2 billion to $3.4 billion. So it’s actually coming down nicely, and the charge-offs have actually been modest. The – most of the charge-offs are where we’re selling out of properties and doing AB loan structures and basically deciding to move on. We’ve had quite a few paydowns also. So it’s not all doom and gloom. But I’d go back to what Bruce said, it’s name by name, property by property. We’ve got our workout teams fully involved. It’s kind of playing out exactly as we expected it to be. If I took myself back 1.5 years ago and looked at the office portfolio, there was a lot of uncertainty. I think there’s a lot more uncertainty now. So remember, I’ve got a huge amount of absorption capacity just in my P&L for any losses that are materializing, and our reserve levels for the portfolio are well above where the severity of losses to date have been. So we feel we feel like we’re going to work through this, as we said, over the next few quarters and begin to peak at the loss levels."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. And I just – maybe, John, you can add to this, but in terms of where do we go from here – you can see that the coverage ratio on office remains high, and it’s gone from 10.2 reserves to 10.6, but that rate of increase is slowing and so we’ve been taking the full charge off through the P&L and holding the reserve at high levels. At some point, we’ll be able to start drawing down on that reserve. I don’t want to make the call on that. But just take note that, that build is starting to slow. And so I don’t know if it’s maybe later this year or beginning of next year. But we will eventually get to a point where we can start drawing down on those reserves, which will be good for P&L."
},
{
"speaker": "John Woods",
"content": "Yes, I agree with all that, I’d just add a point or two. So what’s built into the 10 you’ll see it in some of our slide materials is an expectation of a 71% decline in property values. And that’s what drives this 10.6% reserve for remaining losses."
},
{
"speaker": "Bruce Van Saun",
"content": "Which is more severe than anything we’ve seen historically, including the great financial recession by a wide margin."
},
{
"speaker": "John Woods",
"content": "Exactly. And I think we should also mention that just given what we put behind us, implies another 6% of losses that we put behind us. So we’ve got 10.6 in the reserve. We’ve charged off about 6. So you’re up over 16% in terms of coverage, we feel pretty good about it, and that’s where we think the losses are going to play out. And as Bruce mentioned, we’ll charge-offs themselves, maybe they peak later this year or early next. But we think we’ve got the reserves covered."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay, next question."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Scott Siefers with Piper Sandler. Go ahead."
},
{
"speaker": "Scott Siefers",
"content": "Good morning, everyone. Thanks for taking the questions. John, maybe just a thought on how much longer negative deposit migration continues. I think the prevailing wisdom is it’s slowing, but just curious to hear your updated thoughts on kind of when and why we might trough."
},
{
"speaker": "John Woods",
"content": "Yes. I mean, we’ve been saying for a while that things have been decelerating. And I’d say our deposit performance this quarter has been – has been excellent in terms of – versus what we were expecting coming into the year. So again, deposit levels overall look good. DDA flows and low cost to high cost, migration overall, continuing to decelerate. And I think you can – we can point to, if you look at where we are, we were at around 21% of DDA at the end of last year at 12/31 and that flattened out. We were at 21% at 03/31. So DDA for us is stabilizing. And the – however, the low cost to high cost, again, decelerating and as it will continue to decelerate. And what we’ve been indicating is that that’s going to continue until you see the first cut out of the Fed, which is historically what we would expect. But it’s getting to the point where it’s having a diminishing impact on net interest margin. And so when you elevate overall, the contribution that our deposit franchise is delivering for net interest margin trends is excellent. And we’re feeling very good about the trajectory, the DDA stability throughout the rest of ‘24 and getting back to growth because when you think about what’s idiosyncratic to us and the strategic initiatives that we’re launching, the private bank non-interest-bearing is accretive to the overall company. We’re at maybe around 30% or more. And so that’s dragging that number up. So I think we have some…"
},
{
"speaker": "Bruce Van Saun",
"content": "New York Metro offers another opportunity."
},
{
"speaker": "John Woods",
"content": "And New York Metro as well as a really good point. So the combination of those strategic initiatives, we have some expectation of DDA flattening out and growing as you get into the latter part of the year. And that underpins the net interest margin quite nicely."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. Maybe, Brandon, you can add some color."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes. Sure. We’ve been talking for a couple of years now around how – since so much of our deposit book comes through consumer that we believe that we’ve transformed the book to be pure like or better. And I would just reiterate that, that’s what we’re seeing. We were up modestly linked quarter on overall deposits in the consumer book with some benchmarking that we get from a variety of sources, we believe we were number one in our peer set linked order on DDA. So on a relative basis, we still have a lot of confidence that we’re outperforming peers and it’s demonstrating the franchise quality that we’ve built. When you look at the customer level, customer deposits have actually been quite stable around $31,000 per customer. And the remixing of, as John pointed out, is pretty dramatically slowing. And I think that’s kind of indicating that the COVID burn down is beginning to really run its course. So there may be a little bit more, but we feel pretty good that we’re getting kind of the end of that behavioral cycle. We look at overall deposits on an inflation-adjusted basis, they’re back to basically pre COVID. So I think we’re kind of nearing the operating floors here for consumer. Given the strength of low-cost deposits that we have had relative to peers. The other implication is how we’re managing interest-bearing deposits. I do believe that we’ve peaked in the consumer segment in Q1 in our cost of funds. And why do I believe that we had $3 billion in CD rollover in March alone that were priced around 5%. We’ve retained 75% of those as they flipped over and materially lower prices between 3% and 4%. So you start to see the tailwinds building in that you can imagine the cost of funds in the consumer segment potentially beginning to reduce. We’ll see how it plays out where rates are at. But I do believe we’ve sort of peaked here in Q1, and it’s really driven by the strength of our low-cost performance. So we don’t need to chase high interest-bearing costs as a result of that. So I feel really good about where we’re at."
},
{
"speaker": "Scott Siefers",
"content": "Alright, good. Thank you very much for the color."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of John Pancari with Evercore. Your line is open."
},
{
"speaker": "John Pancari",
"content": "Good morning. One just on additional color on the loan growth commentary, I know you said it could come in throughout the low end of your initial expectation for the year and you have cited weaker line utilization at this point, where – if you can maybe elaborate a little bit where you see some weakness in what pockets and where do you see some ultimate strengthening there in terms of timing? And then separately, a similar question around your deposit growth expectation, I think for the full year, you had figured out at around up 1% to 2%. Any additional color you can provide and how you’re feeling around that guidance at this point?"
},
{
"speaker": "John Woods",
"content": "Yes, I’ll just start off on loans and others can add. But I mean, what we’re seeing is that utilization coming in a little lower in the first quarter and that than was originally expected. But nevertheless, we still see the – in the second half, the interest around putting some working capital to work and commercial activity starting to pick up is really going to drive the reversal of that utilization trend as you get into the second half. On the retail side of things, we’re still seeing good opportunities in relationship mortgage and HELOC and in the private bank, where we’ve gotten a nice start in terms of – which is mostly a commercial lending driven amount of activity in the subscription line space. And that we see that picking up. So all in, one it is playing out about as expected, meaning we may be just a little bit lighter on loans, but we had expected that would be the case. And then the pickup in the second half will be coming out of the commercial business and private bank. Maybe any other color."
},
{
"speaker": "Bruce Van Saun",
"content": "That’s well said, Don, any color."
},
{
"speaker": "Don McCree",
"content": "Yes. No, I’ll – I think it’s across the board on the commercial side. And Part of it is due to the booming bond markets. I mean, we’re seeing a lot of customers access the bond markets as opposed to draw down existing lines. And then I think there’s a positive to it also, not for loan levels, but customers are running with lower leverage levels because they’ve been concerned about the economy. We’re seeing a broad, more positive view of the overall economy across really wide swaths of our client base. So that would indicate that they’re going to get more active in things like plant construction, working capital, growth, M&A, and so that should drive some bounce back in the back half of the year."
},
{
"speaker": "Bruce Van Saun",
"content": "Anything from you, Brendan."
},
{
"speaker": "Brendan Coughlin",
"content": "Yes. The only thing I would add is maybe just strategically that there’s a lot of ins and outs under the cover. So, as we run down auto by essentially $1 billion and other non-court getting replaced with high relationship, high-returning asset growth, whether it’s on the HELOC side or the private bank. So the headline numbers that you see around our loan growth, what you have to dig into is the transformative use of capital that we’re doing around a handful of areas that have more durable, sticky revenue sources that are going to create more cross-sell around fees and other things over time. So we’re pleased with how that’s going."
},
{
"speaker": "John Woods",
"content": "And then on the – you had a question about deposits. On the deposit side of things in the first quarter. as I mentioned before, we saw DDA flatten out for the first time in many quarters. So that is really good to see. We also saw low cost flatten out. So overall, we were at 42% last quarter in low cost, we’re at 42% this quarter and low cost plus DDA. So the deposit trends from a mix perspective have been favorable. And from a quantity level of deposits at the end of the quarter came in higher than expected. That’s driven by just strong execution and our strategic initiatives contributing as we mentioned earlier, New York Metro and Private Bank along with the blocking and tackling that Brendan and Don have been at for a number of years to invest in the franchise. And so all of those investments are paying off, and we do expect to see deposit growth supporting our loan growth in the second half of ‘24."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes, I would just – I would highlight that – just one last quick piece of color is that very pleased to see the Private Bank now has had kind of two quarters with $1 billion-plus of deposit growth and we certainly think that, that’s sustainable and could even accelerate. So the ship has landed, and we’re off to a great start, and we expect that to continue and even accelerate."
},
{
"speaker": "John Pancari",
"content": "Got it. Alright. Thanks, Bruce. And then on the capital front, I did to see the resumption in buybacks, the $300 million in repurchases this quarter. With CET1 here at around 10.6 or 8.9% when you dial in the AACI scenario, how do you look at the likelihood of incremental buybacks from here. In terms of a pace of buybacks, do you think that that could be reasonable given where you’re sitting right now on CET1. Thanks."
},
{
"speaker": "John Woods",
"content": "Yes. I think this capital position that we’ve generated and have maintained is really creating a lot of flexibility. And when you think about our capital waterfall, I mean our top priority is to put capital to work that is to support customers and clients that is accretive to our cost of capital over time. And that’s really what we want to do and that we’re expecting to do. And that’s what capital allows us that flexibility. It also cushions against uncertainties. And so there have been a number – we look at the macro and being at a very strong capital level to be there for our clients, but also to cushion the downside to the extent uncertainties manifest is another use of a strong capital position. When you get down into kind of other potential uses of the capital, we support our dividend, of course, at top of the list. And then if we’re left with elevated capital levels, then we’re able to give it back to shareholders, which we did in the first quarter, we’re planning to do that here in the second quarter. And that flexibility will continue into the second half. So as we monitor loan demand and the macro, that will play into the trajectory of buybacks in the second half."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. And I would also just go back to an earlier comment that we have I’d say, a front-loaded plan this year because there’s less loan growth. In fact, there’s loan contraction earlier in the year that then turns around and we start to see loan growth in the second half of the year, that would, by definition, mean we need capital to support the loan growth and there’ll be less capacity for share repurchases. But anyway, we gave the – you saw the 300 number in the first quarter, John mentioned 200 in the second quarter. And then we’ll see where we get to in the second half. If the loan growth fully doesn’t materialize, we can actually just turn around and keep repurchasing the stock."
},
{
"speaker": "John Pancari",
"content": "Alright. Thanks, Bruce. Appreciate it."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay, thanks."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Peter Winter with D.A. Davidson. Your line is now open."
},
{
"speaker": "Peter Winter",
"content": "Thanks. Good morning. You guys have maintained the net charge-off guidance for the year, but if we assume no rate cuts this year, could it lead to higher net charge-offs than forecasting just given kind of no relief on debt service coverage ratios or loans coming up for renewal at higher rates?"
},
{
"speaker": "Bruce Van Saun",
"content": "Well, what I would say on that is the broad credit quality is still very good. So if you look at our C&I book, that’s in really good shape. Companies weathered the pandemic and leaned our business models, locked in lower cost financing. They’re doing more of that now early in the year. So we don’t really see hotspots even with kind of a higher for longer scenario in C&I. Similarly, in consumer, we’re still in very good shape. The consumer is benefiting from still strong liquidity levels, a strong labor market. And so we haven’t seen any adverse migrations in delinquencies or NPAs or anything like that. So that’s the bulk of the loan portfolio. If you then kind of look at the commercial real estate and the general office in particular, that’s relatively small as a percentage of the overall loan book. And I think there’s potentially some trends. We’re watching the reports that return to office is picking up. And so maybe there’s a little counter trend in office that offsets the kind of additional burden of hire for longer. But I think at the margin, it’s not going to change that charge-off number materially."
},
{
"speaker": "Peter Winter",
"content": "Got it. And then…"
},
{
"speaker": "Don McCree",
"content": "Peter, I’ll just that from my side. We made no assumptions in our forecast that we’re going to benefit from lower rates. Because we just didn’t know and that’s our credit policy. We don’t go out on the future curve. We run all our scenarios based on where rates are today. So I think you’ve got a peak-ish kind of rate environment. If it lasts another couple of quarters or even another year, I don’t think it’s going to make a material difference to the way we forecast charge-offs."
},
{
"speaker": "Brendan Coughlin",
"content": "The only point I would add on consumer is that our delinquency levels are actually net down year-over-year. Q1 over Q1, led mostly by resi, but we’re seeing really no signs of stress on the book. As Bruce pointed out, so I feel really good and even in a higher for longer that unless there’s a big economic shock that we’re in really good shape."
},
{
"speaker": "Peter Winter",
"content": "And then just quickly, just a follow-up on office. I guess, I believe that more than half of the maturities on office happened this year. So do you think net charge-offs could peak towards the end of this year, maybe early next year and then start to trend lower?"
},
{
"speaker": "Don McCree",
"content": "I – it’s really hard to forecast that. I think they will be early next year or late this year probably, but it depends how much we extend, how the negotiations go, how much capital is put into some of these transactions and working through the book loan by loan. It’s – I don’t have the crystal ball, I say exactly when the peak is. But I’ll go back to what I said before is we’re comfortable how it’s kind of progressing is progressing according to our expectations."
},
{
"speaker": "Peter Winter",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Ken Usdin with Jefferies. Your line is now open."
},
{
"speaker": "Ken Usdin",
"content": "Hi. Good morning guys. Just a question on the fee side, it’s really nice to see the capital markets improvement as you would have been thinking as we are seeing more broadly. I am just wondering a couple of line items went well, a couple of items kind of went backward. Just wondering just how you are thinking about the fee progression, the drivers and what’s your pipeline look like relative to the better start point here for the first quarter capital markets. Thanks."
},
{
"speaker": "John Woods",
"content": "Yes, I will start off and Bruce can jump in here. But I mean the drivers – I mean you look at the big three for us, capital markets, card fees and wealth trust and investment services are all, they are trending well, and we expect to be significant contributors in 2024. So, each of those businesses have had significant strategic investment over the years and even more recently. So, it’s really nice to see that the investments made in the capital markets business come to fruition. We had a good strong quarter in the first quarter, number one in the lead tables on the sponsor side, big rebound from the fourth quarter. And early in the second quarter, the activity – the pace of activity has continued, and we feel very good about the trends there, not only for 2Q, but for the full year. In the card business, we have made a strategic conversion to Mastercard, and that’s driving a number of positive developments there. And in the wealth business, as you know, all of the advisor hires the Clarfeld acquisition from a number of years ago are all coming together along with the private bank to drive those flows throughout 2024. So, we are feeling quite good about the trajectory for fees."
},
{
"speaker": "Bruce Van Saun",
"content": "I would just say, to your point, Ken, also that there were those three strong areas. And then we had a little bit of weakness in some other areas, service charges, mortgage, the global markets, FX and interest rate lines were a little below our expectations. The good news there is there is nothing structural that we worry about. I think we will see bounce backs over the rest of the year, which will add to our overall growth and our confidence that we will maintain strong fee performance for the year."
},
{
"speaker": "Ken Usdin",
"content": "Okay. Great. And just one more follow-up on the NII and the swaps and just looking at your Pages 25 and 26 from the deck. And it’s pretty clear that you are saying the increases you have made to the swap book are all incorporated in the guidance. So, that first quarter to fourth quarter, $35 million cumulative net interest income impact, is that inclusive of everything that is both like active as of now and then will prospectively still come on as the year progresses?"
},
{
"speaker": "John Woods",
"content": "Yes, it is. And so what that is, that $35 million is made up of about $50 million, primarily driven from active swaps that are outstanding. So, there is about $20 billion notional of active swaps outstanding. That grows to about $30 billion by 4Q. That’s incorporated into that number. But then it’s offset by the positive benefit from non-core of about, call it, $17 million or so, or $15 million to $20 million coming from non-core and that gets you to the $35 million drag. But really, when you play it out for the rest of the year, again, broadly, net interest margin trends are coming in a little better, incorporating all of our swap activity, what you see on Page 25 is just the receive-fixed swaps. We actually have pay-fixed swaps in the securities portfolio that are offsetting this, as well as of course, everything that’s happening in the core balance sheet. So, you got to kind of think at the broadest sense that NIM trends are actually coming in a little better. And then as you get out to later years, you start getting all of this tailwind is really baked in. And you start seeing the fact that terminated swaps begin to contribute. It gets to the point where you get out into 2026 and 2027 that a majority of, a super majority, if you will, of the tailwinds are actually baked in and aren’t rate dependent. But you have that right in terms of the 4Q components that incorporates everything on the receive-fixed swaps side plus non-core."
},
{
"speaker": "Ken Usdin",
"content": "Yes. Okay. And I – yes, go ahead Bruce."
},
{
"speaker": "Bruce Van Saun",
"content": "And I would just add color there, Ken, is I think coming into the year, people were concerned about that step-up that we had forward starting swaps in Q2 and then more in Q3. The guide that we are giving and our confidence in the NIM outlook incorporate that. So, we are able to absorb that because higher for longer is better for the core balance sheet. We have some pay-fixed swaps we did in the securities book. So, we are able to absorb kind of that step-up in the swap book and continue to maintain confidence in the NIM outlook for the year."
},
{
"speaker": "Ken Usdin",
"content": "Yes. That’s great, Bruce. And if I can just bring that all together, so you broadly affirmed your broader guidance of down 6 to down 9, and we kind of know the first quarter and have the second quarter outlook. So, what would be the biggest swing factors within that range based on all these points that you are making about the NIM coming in better and now knowing more of this detail about how the swaps will work."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. To me, it’s really volume would be the key to where we land in that range. So, do we actually see that strong growth in the private bank accelerating that could be strong for deposits and attractive deposit funding, and then the spread that they are making on their loans is also very attractive. So, that’s totally accretive to front book, back book. Do we see the growth in commercial that we expect come in, and I think we – based on our kind of pipelines and our conversations with our customers and also a feeling that the sponsor community. Right now, there has been a lot of pull forward in refinancing, but I think you are going to start to see some more new money deals in the second half of the year. So, I think that those volume factors will have a big impact. But the way we kind of see it looking out the window today, we are highly confident that those things will materialize. I don’t know, John, if you want to add anything."
},
{
"speaker": "John Woods",
"content": "Yes, I agree with all of that. I would say that even with a little bit of lighter loan demand, we still think that range is good. Maybe it comes out at a higher end versus the lower end. But I mean I think that’s a swing factor. All the other components of the balance sheet are playing out well. Our outlook for deposit mix and funding mix is underpinning the net interest margin. I would hasten to add that those pay-fixed swaps that we added last quarter in 1Q and also in 4Q, have really driven really nice uptake in the securities yield. You see the securities yields up almost 40 basis points in the first quarter, and that’s offsetting – that’s a huge component of our balance sheet, and that’s a big driver. And then I should also make clear that the core balance sheet is contributing as well where we are seeing front book, back book on the loans side that is in the range of 300 basis points in the first quarter. And you are getting front book back on the securities book of around 200 basis points. So, there are good dynamics in the core balance sheet and all of the swaps were baked in."
},
{
"speaker": "Ken Usdin",
"content": "You said we could come in at the higher end. I think you meant the better end."
},
{
"speaker": "John Woods",
"content": "Yes."
},
{
"speaker": "Ken Usdin",
"content": "Just for everybody’s clarity on that plan. Okay."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Matt O’Connor with Deutsche Bank. Your line is now open."
},
{
"speaker": "Matt O’Connor",
"content": "Good morning. Most of my questions have been answered, but I am curious when you talk about kind of this medium-term net interest margin. What are your thoughts on the size of the balance sheet? And I guess, specifically, like do you think the overall balance sheet will grow or is there the remixing, Clearly, you are running off the non-core book [ph] on the private bank. But do you envision kind of net balance sheet growth as you look out the next few years? Thank you."
},
{
"speaker": "John Woods",
"content": "Yes. I would say that, we do expect the balance sheet to grow. It’s – I think we do have a balance sheet optimization program that’s turning over a certain portion of the portfolio. But when you look at the grand total of the initiatives that we are putting in place, I think you see interest-earning assets will be growing in the second half of the year. And as you get out over the medium-term, so I think that we have the opportunity to optimize and grow. And that’s our expectation."
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I would say the kind of flex point is kind of middle of the year when we have done a lot of that heavy lifting on the repositioning, and then we start to see the private bank growth in commercial bank as we discussed, start to kick in. So, we should see net growth already in the second half of the year. And then kind of looking out ‘25 to ‘27, we would expect in a strong economy that we could get back to reasonably strong growth rates. Again, being selective where we play, focusing on primary relationships and primacy, but there is no reason we couldn’t grow back at nominal GDP the way we did for kind of many years before we hit the pandemic, and that plays into math that, the delivery of positive operating leverage, which is part of how you get your return on equity up. And so that’s the model we would like to get back to."
},
{
"speaker": "Matt O’Connor",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Gerard Cassidy with RBC. Your line is now open."
},
{
"speaker": "Unidentified Analyst",
"content": "Hi. Good morning. This is Thomas Detry [ph] calling on behalf of Gerard. Circling back to capital deployment quickly, you guys were pretty busy in 2023 in terms of strategic actions. Can you update us on how you are thinking about further investment opportunities for the franchise and how you guys prioritize organic growth versus team lift outs or even outright M&A?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. So, I would say that right now, we have a very full plate in terms of the things that we are investing in the organic growth initiatives we have. So, I would not – we are not really looking much at inorganic situations or opportunities. And so I want to just stay focused on great execution. There is a big pay-off for getting these initiatives right and they are all kind of on the trend line. I would say team lift outs, you mentioned is something that we are hinting at, at this point because while we have the private bank in place, and we have kind of Clarfeld as part of a private wealth complex, we need to scale up our private wealth capabilities to a large extent. And so we are having discussions with teams. And you can watch this space because I think you will start to see us build that part of the business out. But again, it will be prudent. We will treat them like they are kind of M&A transactions that are accretive and they fit our strategy and they are good cultural fits, but that’s kind of the only thing I would say that we are looking kind of outside. And to some extent, that’s organic. You could argue whether that’s organic or whether it’s acquisition like, but we are kind of using the same acquisition lens on these as if they were small deals. I don’t know, Brendan, if you want to put any color on that."
},
{
"speaker": "Brendan Coughlin",
"content": "Maybe two quick points, one is that I would just say the interest in Citizens from a wealth management perspective is at a high, like we have never seen before. So, we are talking to some of the very best wealth managers across all the big brands in the United States. And so we are going to be very selective. But the interest in what we are doing here is quite unique and distinctive. So, we expect to board some top talent and really give a boost to our wealth strategy. But the point around capital that you mentioned, though, just to – even though we are mentally potentially thinking about the return metrics like we would an M&A deal. Keep in mind that a lift out or what we do with the private bank really is a very de minimis impact on capital. And so that’s why when you look – when we talk about the breakeven of the private bank being second half of this year, it’s really just eating through the expense guarantees and getting the revenue throughput. So, it has a very de minimis impact on capital. And the same will be true on wealth lift-outs where the teams we bring on board, it will be much more of a expense guarantee mindset and getting them through their revenue curve versus having any real material impact on our capital."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay. Great. That’s helpful color. Thank you. And then just separately on loan growth. C&I demand has obviously been pretty tepid despite pretty healthy growth in the economy as measured by real GDP, do you think that lack of C&I loan demand is being driven by just general customer caution, or are you guys seeing more competition from non-bank players like the private credit market and others?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I think it’s just a general caution about what’s going to happen in the economy, what’s going to happen with rates. And I think most of our companies have had good years, but they are still expressing caution. So, we are actually not losing business to private credit. It’s interesting. We are actually – it’s coming the other way because there has been opportunities to take loans that are out with private credit and move them over to the bank syndicated lending market, refinance those and kind of lock in lower cost financing. So, that’s been a big part of the story here in the first quarter, and it’s continuing into the second quarter. Don?"
},
{
"speaker": "Don McCree",
"content": "I think that’s right. I think the area that we see private credit most active is in the leverage buyout market, which we don’t hold a lot of that on our balance sheet anyway. So, they are a source of distribution for us. So, we have actually done a couple of deals in the first quarter where we have distributed into the private credit market. So, it doesn’t have a balance sheet impact that it helps drive some of our fee lines."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay. Great. Thank you for taking my questions."
},
{
"speaker": "Operator",
"content": "Your next question will come from the line of Dave Rochester with Compass Point. Your line is now open."
},
{
"speaker": "Dave Rochester",
"content": "Hey. Good morning guys. Earlier, you mentioned that the flows were a major driving swing factor of that NII guide. I know you mentioned expecting a little less loan growth this year. But you mentioned possibly hitting the better end of that NII range. If for whatever reason, net loan growth doesn’t materialize in the back half and C&I growth only ends up filling in for the run-off that you are expecting? Can you still hit that NII guide for the year?"
},
{
"speaker": "Bruce Van Saun",
"content": "Yes. I mean I would say that we are still confident in the range. And so if things break our way, we could be at the better side of that range. If they don’t, we could be at the lower end of that range. So, I would still kind of use that as the guardrails. You would have to have kind of quite a bit of deviation from expectation to fall outside of that range."
},
{
"speaker": "John Woods",
"content": "Yes. Great. And just to reiterate that point, what we have been saying is that we have an expectation that will come in at the better end of the range for net interest margin based on the trends that we are seeing and the performance we were able to generate in the first quarter. So, you would see us being at the upper end of that range, maybe a tad better. On net interest margin, that’s offsetting the fact that there is some lighter loan demand that we are also seeing that. You put those together, and we are right down the middle there in terms of that range, and we have got back to the point Bruce just made. And that’s our base case now that we are updating. And there could be puts and takes to that depending upon the volume point that Bruce made earlier."
},
{
"speaker": "Dave Rochester",
"content": "Yes. Perfect. Thanks guys."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Konrad with KBW. Your line is now open."
},
{
"speaker": "David Konrad",
"content": "Hey. Good morning. Sorry if I missed this earlier, but just kind of drilling down on the NIM discussion. Just looking at this quarter, curious on C&I yields dropped around 36 bps quarter-over-quarter. I didn’t think this was a heavy swap onboarding this quarter, but just curious where we are looking at that maybe in the next quarter before the swaps come on in the third quarter."
},
{
"speaker": "John Woods",
"content": "Yes. I mean really what’s going on, as you have hit it. I would say, just broadly, I would try to make the point that all the swaps are incorporated into the NIM guide. And when you look at the underlying fundamentals of the loan book, the front book, back book is driving an increase in loan yields ex swaps. So, that’s the first point. As it relates to when you pull the swaps together from an accounting standpoint, why there is a negative impact from a swap standpoint, is that there was a mix shift. We had the swap notional didn’t change much, but we had some maturities at higher receives being replaced by some forward starters coming in at lower receives. And that overall – that net receive rate fell in the quarter, and that’s why you ended up with that negative impact just on that line itself. But again, overall, net interest margin was flat for the quarter. And when you put it all together with all the components, we had quite a strong net interest margin performance even incorporating that swap drag."
},
{
"speaker": "David Konrad",
"content": "Yes, I agree. And then you talked about the securities book both the front book, back book and then the pay floaters coming out. But just curious your outlook for the growth of the securities book going forward?"
},
{
"speaker": "John Woods",
"content": "Yes. I mean I think we have gotten to the point where we had the liquidity build late last year. And that’s basically largely done. And so where you see the securities book right now as a percentage of our overall interest earning assets is about where we will be over time. As we grow loans, we will probably grow securities and cash on a similar mix basis from a volume standpoint, but the percentage of cash and securities to overall interest-earning assets at the end of the first quarter is about where we will be for the rest of the year. And I would hasten to add that when you look at that, that’s reflected of our deposit franchise and being primarily consumer and having a much higher proportion of insured secured deposits than most peers. And then if you crank it all through the way the Fed looks at standardized Category 1 banks, our LCR incorporating all of that at 03/31 was 120%, which is incredibly strong from a liquidity standpoint. And that’s played through based upon the balance sheet mix overall, including cash and securities."
},
{
"speaker": "David Konrad",
"content": "Perfect. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Manan Gosalia with Morgan Stanley. Please go ahead."
},
{
"speaker": "Manan Gosalia",
"content": "Maybe as a follow-up to the last question, is there any change in how you are thinking through positioning in the medium-term with the expectation for fewer rate cuts coming through? So, with loan growth being a little bit weaker right now, deposit growth being pretty solid, as you noted, are you willing to put on a little bit more duration on the securities side? And separately, has it got cheaper to put in some downside protection on NIM as you look into 2025 and 2026. And is that something you are considering right now?"
},
{
"speaker": "John Woods",
"content": "Yes. I would say on the securities side, I would say there is a couple of objectives being addressed, and it’s the interplay between capital and liquidity and interest favors management. So, what we did over the last couple of quarters is we have added $7 billion of pay-fixed swaps that has paid off quite nicely because of our view that rates were likely not to be down, whatever, however many cuts we thought they were at the beginning of the year, five, six, seven cuts, we thought that was probably a little overcooked. And so we put on those pay-fixed swaps in part related to that. But in part related to the multiyear objective to reduce the duration of the securities book given how it will likely be treated from a capital standpoint. And so both of those objectives came into play when we shortened the duration of the securities book, which right now is about 3.8 years. We are likely to continue to shorten the duration book of that securities book over time and get down to something closer to 3 years [ph] or thereabouts. And so that’s really the driver there. But you got to look at the overall balance sheet and from an overall balance sheet standpoint, it made sense to add a little asset sensitivity in the fourth quarter and the first quarter. And we had at 03/31, we remain an asset-sensitive balance sheet. When it comes to adding downside protection in the out years, we do note that we have a significant drop off of receive-fixed swaps when you get out into 2026 and ‘27. And I think entry points matter. So, if rates continue to stay elevated, and we think there is value there. We want to be careful that we don’t give up our upside that the C&I loan book provides us and we will do that when the entry points are attractive in terms of that trade and locking it in. And in general, that would be consistent with something that would be north of 4% of a receive rate out into ‘26 and ‘27, and we will be opportunistic as the rate environment plays out in terms of how we continue to protect the balance sheet over the medium-term."
},
{
"speaker": "Manan Gosalia",
"content": "Got it. Very helpful. And then this morning, one of your peers has suggested that they are seeing corporate behavior shifting from NIB to IB. Are you seeing some of your corporate clients take another look at optimizing their NIB balances in the higher for longer rate environment recently?"
},
{
"speaker": "Don McCree",
"content": "I think it’s pretty much run its course at this point. We have had a little bit of a shift in the book, but it’s really slowed down. I think the clients have been pretty opportunistic in terms of taking advantage of higher rates. So, I would say our book and our mix is pretty stable right now, and we expect it to stay here."
},
{
"speaker": "John Woods",
"content": "Yes. And I would say overall, you saw our DDA stable at 21% at the end of 1Q, 21% at the end of 4Q. That’s important. That’s the first time this has happened in a while. And so that stability we expect to continue as you get throughout the – for the rest of the year and actually see growth, as we mentioned earlier, based on other strategic initiatives and the private bank contributing."
},
{
"speaker": "Manan Gosalia",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "There are no further questions in the queue. And with that, I will turn it back over to Mr. Van Saun for closing remarks."
},
{
"speaker": "Bruce Van Saun",
"content": "Okay. Well, thanks everyone for dialing in today. We appreciate your interest and support for Citizens. Have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that will conclude your conference call for today. Thank you for your participation and for using AT&T event teleconferencing. You may now disconnect."
}
] |
chd | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to the Church & Dwight's Third Quarter 2024 Earnings Conference Call. Before we begin, I've been asked to remind you that on this call, the company's management may make forward-looking statements regarding, among other things, the company's financial objectives and forecasts. These statements are subject to risks and uncertainties and other factors that are described in detail in the company's SEC filings. I would now like to introduce your host for today's call, Mr. Matt Farrell, Chairman, President and Chief Executive Officer of Church & Dwight. Please go ahead, sir."
},
{
"speaker": "Matt Farrell",
"content": "Hi. Good morning, everyone and thanks for joining us today. I'll begin with a review of the Q3 results, then I'll turn the mic over to Rick Dierker, our CFO and Head of Business Operations. And once Rick is done, we'll open the call up for some Q&A. All right, Q3 was another solid quarter for Church & Dwight. Reported sales growth was 3.8%, which beat our outlook of 2.5%. And that was thanks to strong results from our domestic, international and specialty products businesses. Organic sales grew 4.3%, which exceeded our 3% Q3, outlook, with volume accounting for a very healthy 3.1% of our growth. Adjusted gross margin expanded 60 basis points. At the same time, we increased marketing spending, and we gained market share in the majority of our categories. Adjusted EPS was $0.79, which was $0.12 higher than our $0.67 outlook. So nice beat, the quality results were driven by higher than expected sales growth, and gross margin expansion. Our online class of trade continues to perform well, with online sales as a percentage of global sales at approximately 21%. Next, I'm going to comment on each of the three businesses. And the first up will be the U.S. business, with 3.3% organic sales growth. Volume growth was 2.6%, and this is the fifth consecutive quarter of volume growth in our U.S. business, with five of our seven power brands gaining market share in the quarter. Now let's look at a few important categories in the U.S., innovation of course is a big contributor to our success this year, and every year. As I comment on the categories, I'll highlight the success of the new product launches. I'm going to start off with Laundry Detergent ARM & HAMMER Liquid Laundry Detergent consumption grew 2%, which outpaced a flat category with ARM & HAMMER share in the quarter reaching 14.7%. The unit dose category declined 1.1%. However, ARM & HAMMER unit dose saw a consumption growth of 16.5%, and we grew a share of 70 bps, to 4.8% a unit dose. Regarding new products, this year we launched two new products into the detergent category, ARM & HAMMER Deep Clean and ARM & HAMMER Power Sheets. Deep Clean is our most proud premium laundry detergent, where we entered the mid-tier of liquid laundry. Deep Clean accounted for a little over 40% of ARM & HAMMER's liquid laundry detergent consumption growth in the quarter, and it's highly incremental to our franchise. The second new product is Power Sheets. This is a new form of laundry detergent, and you may remember in August of 2023, ARM & HAMMER was first major brand to offer this new unit dose form in the U.S. Our fresh linen scented sheet, is now the number two sheet on Amazon, and since launching this product into bricks and mortar this year, we have seen high consumer interest in the form. ARM & HAMMER is the number one sheet brand at Kroger. It's also the number two brand in whole food [ph]. We feel great about the future prospects for this new form. Now I'm going to switch over to litter. The category was flat in Q3. That's category consumption. As expected, ARM & HAMMER litter consumption declined 1.5% and this reflects the absence of a competitor out of stock situation, which benefited our prior year market share. The good news is we've held onto about half of our prior year share gains. Our new lightweight ARM & HAMMER Clumping Litter, which is our new product this year, is outperforming our expectations as our share of the lightweight category continues to grow. This is important, because lightweight accounts for 17% of the clumping litter category. Hardball, became the number two major brand in Lightweight segment in Q3. Now I'm going to switch over to personal care. The gummy vitamins business continues to be a drag on the company's organic growth. The gummy vitamin category declined 0.3%. We can call that flat in Q3, which is an improvement from the category declines in the past few quarters. The bad news is our consumption was down even greater. We were down 10%. The improvement of this business is taking far longer than we expected, and as you saw in the release has reduced our expectations about the long-term growth, and profit of the business. This resulted in a $357 million write-down of the book value of the assets. We continue to move forward with our stabilization actions, which include new packaging, upgraded formulas to improve the consumer experience, and higher marketing investments, which gives us some degree of optimism for the business is the innovation that we have coming in 2025. Next up is BATISTE, which continues to see strong growth with consumption up 6% in Q3, growing share to 46% BAPTISTE continues to be the global leader in dry shampoo. This year, we launched BATISTE Sweat Activated and BATISTE Touch Activated. These innovations continue to bring new users to the category, which is very important and already these two new products account for, or 2% of the dry shampoo category, and Sweat Activated is the number one new product on dry shampoo. Over in mouthwash, THERABREATH continues to perform extremely well. The mouthwash category was up 5% in Q3, but here's a few stats. Alcohol-based mouthwash was down 1%, while non-alcohol category grew 11%. THERABREATH is the number one alcohol free mouthwash with 35% share, and is the number three brand in total mouthwash with an 18% share. Again, over to new products, this year we entered the Antiseptic segment of the category with the launch of THERABREATH Deep Clean Oral Rinse. It's important to note that the antiseptic subcategory represents about 30% of the $2 billion mouthwash category, and our launch into antiseptics has accounted for 100 basis points, of our 400 basis points year-over-year growth in market share. So great indicator of the future, for the antiseptic ones. HERO is the number one brand in acne care, with a 22% share and continues to drive the majority of the growth in the category. The patch category grew 42% while HERO grew patch market share by 1.7 basis points to 57% shares. So HERO continues to launch innovative solutions, and patches and we're very bullish about the future of that brand. I'm going to provide you with a couple of remarks on promotional levels in our household categories. In the liquid laundry detergent, we've seen stable sold on promotion in the low 30s over the last few quarters. Over in unit dose pretty much the same story. Percentage sold on promotion, is also stable averaging in the low 30s over the last few quarters. Litter is a different story. In litter conditions are different and promotional levels have increased, and here's the trend line. So if you look at Q1, sold-on deal was 15.5%. Q2 was a little over 18%. In Q3, it was 19.5%, but it's going to be even higher in Q4. The increase in litter promotions is primarily driven by one major competitor, where sold-on deal exceeds 40%. All right, turning now to International and Specialty Products, our international business delivered organic growth of 8.1% in Q3. That's right on our algorithm of 8%. This was driven by strong growth in every one of our subsidiaries, as well as our global markets group. Finally, Specialty Products organic sales increased 7.5%. That's three quarters now of solid organic growth for this business. We're confident that this division will achieve 5% organic sales growth this year, and will hit our evergreen growth targets. So feel great about our progress in Specialty Products. This commentary on the consumer. In July, we noted a deceleration in consumption in our categories. This continued in Q3 as we expected, after seeing 4.5% growth in our categories for the first five months of the year, June, July and August were closer to 2.5%. Now in September, we saw consumption in our categories strengthen to about 3%. And then in October category consumption was up 5%. But let's all remind ourselves that the hurricane and the port strike, no doubt influenced those results. So we remain cautious in Q4, regarding the U.S. consumer and category growth rates. I want to wrap up my comments, by reiterating that the company is performing well with all three divisions, delivering strong growth. I want to thank all the Church & Dwighters out there, for doing such a great job each and every day. Great team. And now, I'm going to turn it over to Rick to provide more color on the quarter, and full year outlook."
},
{
"speaker": "Rick Dierker",
"content": "All right, thank you Matt, and good morning everybody. We'll start with EPS, on a reported basis we had a loss of $0.31 a share primarily, due to non-cash asset impairment of our vitamin business. Third quarter adjusted EPS was $0.79, up almost 7% from the prior year. The $0.79 was better than our $0.67 outlook and is a high quality beat primarily driven, by higher than expected operating profit. Reported revenue was up 3.8% and organic sales were up 4.3%. Organic sales were driven, by volume of 3.1% and positive price mix of 1.2%. Volume was again the primary driver of organic growth, and we expect volume growth to continue in Q4. Our third quarter adjusted gross margin was 45%, a 60 basis point increase from a year ago, primarily due to productivity volume mix, net of the impact of higher manufacturing costs. Let me walk you through the Q3 bridge. Gross margin was made up of the following: positive 140 basis points impact from volume and mix, a positive 130 basis point impact from productivity and a 10 basis points positive impact related to acquisitions. This was partially offset by 220 basis points from higher manufacturing costs. Moving to marketing, marketing was up $18 million year-over-year. Marketing expense as a percent of net sales was 12.3% or 80 basis points higher than Q3 of last year, and helped drive share gains. For Q3 SG&A, adjusted SG&A increased 20 basis points year-over-year, primarily due to international R&D and IT investments. Other expense decreased by $11.9 million. We now expect other expense, for the full year to be approximately $65 million on adjusted basis. In Q3, there was a tax benefit of 25.9%, and this was related to the vitamin impairment. Excluding that impact, our effective rate was 23.8% and that compares to 24.1% in Q3 of 2023. The expected adjusted effective tax rate for the full year, is now approximately 22.5% versus the previous outlook of 23%. And now to cash. For the first nine months of 2024, cash from operating activities was $864 million, an increase of almost $70 million driven by higher cash earnings. We now expect full year cash flow from operations to be approximately $1.1 billion. We're having a great year in regards to cash. CapEx for the first nine months was $125 million, almost a $4 million increase from the prior year. As capacity expansion projects proceeded as planned. We expect 2024 CapEx of approximately $180 million, as we complete the majority of those investments that were initiated in 2023. And we continue to expect CapEx, to return to historical levels of 2% of sales in 2025, and beyond. And now for the full year outlook. As Matt mentioned, while we saw U.S. consumption in our categories improve slightly towards the end of the third quarter, we remain cautious regarding the U.S. consumer and category growth rates, for the remainder of the year. We continue to expect our organic revenue outlook, to be approximately 4% and reported sales growth, to be approximately 3.5%. We continue to expect full year, adjusted EPS to be approximately 8%. Turning to gross margin, we now expect expansion of approximately 110 basis points, at the high end of the previous range and we now expect marketing as percent of sales, to be above 11%. And as you read in the release, to the extent our business does better than our outlook. We plan on incrementally investing behind marketing and SG&A, to help enter 2025 with momentum. And with that, Matt and I would be happy to take any questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And we will take our first question from Chris Carey with Wells Fargo Securities. Please go ahead. Your line is open."
},
{
"speaker": "Chris Carey",
"content": "Hi, good morning, guys. Thanks for the question. Hi, how are you? I'm going to start with the outlook for Q4. I want to understand, if there are any inventory timing dynamics, which are going into Q3 or Q4, or if this outlook is primarily reflecting, I guess, a view that consumption trends should start to decelerate through the quarter, as you lap some of these atypical benefits that maybe you've seen of late. And so, we should be expecting that, and perhaps just some lingering conservatism about not trying to call, any improvement in category growth rates versus, say again some sort of inventory, or shipment timing dynamic."
},
{
"speaker": "Rick Dierker",
"content": "Yes, I'll take the first one, part of it on inventory, and Matt will talk about the category consumption growth rates. We hear small things on retail inventory, but not anything that we would call out, and not enough to impact anything. There's small examples, but not enough to influence what we would be calling."
},
{
"speaker": "Matt Farrell",
"content": "Yes, and Chris, as far as the categories grow, if you just, you kind of look at Q1, Q2 and Q3, for some of our major categories. So if you look at liquid laundry detergent Q1, Q2, Q3, the category was up 3% up 1% flat. You look at litter up 5%, up 2% flat, and then go to mouthwash up 13%, up 9% and then 5%. Patches are pretty steady high double-digits. But the acne category is 14%, 8%, 7%. But obviously HERO being patches. So, we're somewhat unaffected by that. But if you just look at the trend, you can see a deceleration. So that's one of the reasons why we'll say, hi we're still cautious about the economy, that's the categories. We tend to be doing better, because we're taking share, but that's always the only lever you have when things are starting to slowdown. So yes, we feel good about our performance. We called 3% in Q3. We put up to 4%. We had some good performance in our brand, some share take, but kind of like where we are going into Q4."
},
{
"speaker": "Chris Carey",
"content": "Okay. That makes sense. Then one quick follow-up would be, there's an expectation over time for the U.S. business to be delivering 4% top line growth. Clearly you're still trying to figure out, what the appropriate level is in the current environment relative to where the categories are going. But how much visibility do you think you have in that top line growth objective in the U.S., from here it's not really a 2025 guidance question per se. But just the ability to deliver against an objective, which came up by about a point relative to past in the current environment. And if not, how long you think you'd need to get there again? So thanks so much."
},
{
"speaker": "Rick Dierker",
"content": "Yes, that was sort of a veiled attempt at 2025 guidance."
},
{
"speaker": "Chris Carey",
"content": "You take that how you will? Thanks."
},
{
"speaker": "Rick Dierker",
"content": "I want to correct you on one thing. As far as our algorithm goes, when we moved from 3% to 4% top line, the U.S. portion of that was going from 2% to 3%. So - and obviously that's the big dog. It's the lion share of our business. So the expectation is that we're going to grow at 3% going forward. So 3% for the domestic business, 8% for international, 5% for SBD. That's how we get to our 4%."
},
{
"speaker": "Chris Carey",
"content": "Yes, sorry if I didn't come across. That was really embedded in the question? Thanks."
},
{
"speaker": "Matt Farrell",
"content": "Yes. And look, we got to look at our portfolio and say when you have a long-term algorithm, it's not just '25, it's '25, '26, '27. And so, we look at the strength of our brands, we look at the innovation we have planned over a three year basis. '25, '26, '27. And consequently, we encourage that. If you look back, our history is we hit our algorithm just about every year. In fact yourself, over the last 10 years we've hit 4%. That one is one. It was one of the reasons why we said, hi, why don't we just make that our algorithm going forward?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. And I think just to add to that, why do we take share over time? Well one of the reasons, is we have great innovation and we're putting support behind innovation, to go drive trial to grow households. And that's kind of also where we're reinvesting, as we over deliver in 2024. So that's why, we think we're going to enter 2025 with momentum."
},
{
"speaker": "Matt Farrell",
"content": "Yes. So when you have contracting categories, the way home is always going to be innovation and share gain."
},
{
"speaker": "Chris Carey",
"content": "Okay. Thanks a lot, guys."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Rupesh Parikh with Oppenheimer. Your line is open."
},
{
"speaker": "Rupesh Parikh",
"content": "Good morning and thanks for taking my question. So just going back to the vitamin business. So an impairment this quarter. How are you thinking about the path to stabilization and then growth? Do you think in '25, we may start to see stabilization in that business, and just any green shoots maybe you're seeing with the efforts there?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. What would be - we've been at this now for probably more than a year and a half, and the things such as graphics and packaging and messaging, those things that we can control are in place. As far as innovation goes, that has not hit the market. We really haven't had any meaningful innovation for a few years now. And that's what, as I said in my earlier remarks, that's what gives us some optimism about stabilizing this business in 2025."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And maybe some other green shoots. As Matt said, we have probably 10 different things that are happening. The core of it is we got to get the consumer being delighted in our product again, right. And making sure that we're doing all of our reformulations so that consumers are picking our product, and our brand that they know and they love for a long period of time. But some green shoots, I would say we've seen some lifts, and some retailers where a few of these things are kind of ahead of the curve. And so that's been encouraging. We did, one of the 10 levers was looking at price gaps, and we adjusted a price gap in a couple areas and units are up dramatically. So there's good progress. Like Matt said, innovation really is coming in March, April of next year. So we got to give that a shot, and we're optimistic."
},
{
"speaker": "Matt Farrell",
"content": "Yes, if you're looking for green shoots, the one, this is a smaller part of the business, but L'IL CRITTERS has been really responsive so far. In fact, L'IL CRITTERS gained some share in the past quarter. So that's a good thing. But really the lion share of the business, is adult and that's where we need the innovation."
},
{
"speaker": "Rupesh Parikh",
"content": "Great. Thank you. I'll pass it along."
},
{
"speaker": "Matt Farrell",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Bonnie Herzog with Goldman Sachs. Your line is open."
},
{
"speaker": "Bonnie Herzog",
"content": "All right, thank you. Good morning. I had a question on your marking investments. You called out expected stepped up spend in Q4, and you raised your guidance a bit this year to more than 11% as a percentage of sales. So could you give us more color behind the greater investments in terms of types of spend, any changes with strategy, either channel, medium, et cetera. And then I would be curious to hear if more of the dollars will be shifted internationally. And then, if I may, finally just on a go forward basis, should we assume you're going to continue to step up this spend as a percentage of sales in the next several years, to support your 4% organic sales growth expectations, as you've called out in your evergreen model? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Hi, Bonnie, that's a good detailed question. I'll start and I'm sure Matt wants to add a couple thoughts. But when you look at our raise of marketing spend going to 11% to somewhere between probably 11% and 11.5% that's meaningful. That's $20 plus million in some cases, and some of that is international across markets, because we're driving different brands and they're doing really well too. But THERABREATH expansion, HERO expansion, STERIMAR BATISTE internationally, but in the U.S. we have a lot of places where we're spending, but most of that spends behind our innovation. Again, this is one of our best years of innovation. We believe that's why we're getting share in many cases. That's why we're doing so well and over delivering even our top line expectations. And so, a lot of the marketing spend goes behind things like Deep Clean on laundry, things like sheets on laundry, things like Hardball on Litter and our new BATISTE and I'll touch and move."
},
{
"speaker": "Matt Farrell",
"content": "Yes. And the other thing I would add to that is 85% of our advertising is digital right now. So we have a great ability to move around, and take advantage of different vehicles at different times of the year. So I wouldn't say any more than that and go brand-by-brand. But Rick's right. Internationally is part of where the spend is in the fourth quarter, as is domestic, even a little bit in specialty products."
},
{
"speaker": "Rick Dierker",
"content": "And as far as our future looking marketing as percentage, our algorithms around 11%. It all depends on how our share, share is the scorecard. So our shares are doing fantastically well. You heard in the release 5% of 7%, I think year-to-date we're 10% of 14% for all of our brands, all of our old power brands. So that scorecard is what really matters. And as long as we're gaining share, and more often than not, I think that's the right level. And if we feel like it's not, then we'll adjust."
},
{
"speaker": "Bonnie Herzog",
"content": "All right, thank you. I did ask multiple questions in one, so I'll pass it along. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Steve Powers with Deutsche Bank. Your line is now open."
},
{
"speaker": "Steve Powers",
"content": "Thanks very much. Actually to follow-up on that. Sorry, I might have missed it in your answer, but the marketing spend in the third quarter came in a little bit lower than least external expectations, you know, obviously made up for in the fourth quarter. But does any. Was there anything, from your perspective that shifted that marketing support from 3Q to 4Q, or was it just more of anomaly versus how we all on the outside modeled it?"
},
{
"speaker": "Rick Dierker",
"content": "Yes, I think it is more of an anomaly. I mean, we're getting very specific, but we were up 80 basis points in Q3, which is a significant increase. We had told everybody that we were going to be down a few hundred in Q4, because we were spreading that spend that was maybe a little higher in Q4 of last year over to Q1, Q2 and Q3, to better support innovation. And I wouldn't even call it timing. It was probably just a, disconnect between the outside models, and what we were going to do."
},
{
"speaker": "Steve Powers",
"content": "Okay. Cool. And I guess more of an overarching question, you've kind of touched upon some of this, some of what I think is going to be in your answer, but the perception among many investors of late is that Church & Dwight's in a relatively fragile position here navigating this second half and heading into next year. Just given that so much growth has been driven by THERABREATH and HERO, whereas investors view the core legacy business as being a bit more choppy, probably with added focus there on categories like vitamins and litter of late. But just how do you respond to that, either with respect to reasons to believe in the resilience of THERABREATH and HERO, or conversely, reasons for more holistic confidence in that legacy core business?"
},
{
"speaker": "Matt Farrell",
"content": "Yes, hey, I'll take a swing at that. Rick can kind of pile on. Look, we manage a portfolio and we're in lots of different categories. And yes, it's true that THERABREATH and HERO have delivering outsized performance over the past year, but this ebbs and flows over the years. If you look back over many years there's different times where different businesses pull the train. So I think the new products that we have in those, some of the categories that you may be referring to, like laundry and litter are going to be a big part of our growth in the future. That will be sheets and that would be hardball. And also the innovation and other categories outside of patches as well, but if you look long-term, the THERABREATH is not done. When we bought this business, we said, hey, this can be a $0.5 billion business over time. So whereas we'd say, yes, the distribution for that business has probably been achieved as far as number of doors we haven't done is spread out on shelf with other variants. So I think there's still significant growth ahead of us for THERABREATH. And as far as HERO goes, we don't want to get distracted by moving into other categories. We want to make sure we nailed and grew patches and created more awareness around that and more household penetration. But the HERO brand has the opportunity to spread into adjacent categories going forward. So I think the investors should be confident that those two brands will continue to grow in the future. And because of the innovation we have in laundry and litter, dry shampoo, et cetera, we have differentiated products that will drive growth in the future as well."
},
{
"speaker": "Rick Dierker",
"content": "Yes, and I would just echo a few of those comments. I think THERABREATH and HERO have years of runway, TDPs in some cases, but just household penetration like mouthwash is an example of 65% household penetration and THERABREATH is around nine. It's now the number two mouthwash. So there's lots of runway for those two. But really the crux of your question is, well, what about your base business? And so I would say a lot of optimism on how to have base business. Litter, for example, it's kind of messy right now as you look at year-over-year comps because some competitor was out of stock for such a long period of time. But if you look back before the outage that they had at our share and at our share today, we've maintained about 40% of those share gains. And so I don't really look at the week-over-week or month-over-month. Numbers are kind of meaningless right now. But if we look at baselines, that's what I look at. And so I feel like litter is strong and getting stronger. Innovation, as Matt said Laundry. Laundry, we're still at all time high shares. We feel like over a long period of time we have the same stair step up that we've experienced before. We're entering the mid-tier with Deep Clean. It's doing well. It's driving incremental category growth for retailers. Unit dose is hitting all time share highs and we're going into sheets and sheets is a category that's growing 30%. So a lot of optimism."
},
{
"speaker": "Steve Powers",
"content": "Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Dara Mohsenian with Morgan Stanley. Your line is now open."
},
{
"speaker": "Dara Mohsenian",
"content": "Hi, good morning, guys. So first, just to follow up on category growth. Matt, you didn't sound particularly excited about the pickup in category growth in September, October. Is that just because you think a lot of it was driven by hurricane volume and as you parse the underlying data, you didn't necessarily see as much of a pickup? Is it just a short enough period of time that you're not much more enthusiastic around category growth? And I know you touched on it a bit, but just trying to get a sense as we look beyond Q4, if we're in this more muted category growth environment given a lack of pricing or if you think you're starting to see some green shoots from a category perspective? Thanks."
},
{
"speaker": "Matt Farrell",
"content": "Yes, I guess I must have curbed my enthusiasm. So I would say this, Dara, that if you look at the first couple of weeks of October, you saw like double digit consumption growth in some categories. We said, well, that's not sustainable. And it was so different from what we saw in any week in September or since then. We would say the hurricane and the port strike no doubt influenced the results. So consequently, if there's some pantry loading that went on in the first couple weeks, that's just pulling forward from somewhere else in Q4. So we would say, hey, I'm going to kind of look at that as October is maybe an anomaly and maybe the quarter is more like September where we inflected from June, July, August, our categories up 2.5% versus 3% in September. But it's not -- our remarks are not necessarily a broad category, broad commentary on the U.S. economy. We're commenting on our categories. So we look at the -- our categories. That is what we're commenting on. I think, 3% to me is pretty healthy."
},
{
"speaker": "Rick Dierker",
"content": "Yes. If you look back at history, if we were growing 4% as a company, many times the categories would be growing, 2% or 3% would be taking share and that's how we got to the 4%. So I'd say, it's kind of in line with history."
},
{
"speaker": "Dara Mohsenian",
"content": "Great, that's helpful. And then on HERO and THERABREATH, can you give us an update on how much of the business is international today for each of those brands and how much incrementality you see looking out to 2025 in terms of expansion potential?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. What I can tell you without quoting numbers for sales is that we've been running really hard to get THERABREATH and HERO registered in other countries. And our goal was to have HERO registered in 40 countries by the end of 2024. And we're there. So we feel good about that. And the impediment, of course, is regulatory bodies and they vary from country-to-country. But we're pleasantly surprised that both brands do travel well, even THERABREATH. Now, THERABREATH is the highest priced mouthwash market today in the U.S. Naturally, when you go to international markets, there's a raised eyebrow about how you be successful with such an expensive mouthwash. But yet it has been. So we'll keep that in mind for maybe end of January when we talk to you guys who have an Analyst Day. And then we'll frame out a little bit better HERO and THERABREATH percentage, U.S. versus international, how many countries we're registered in and what expectations are."
},
{
"speaker": "Dara Mohsenian",
"content": "Great, thanks. I'll pass it on."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Peter Grom with UPS. Your line is now open."
},
{
"speaker": "Peter Grom",
"content": "Thanks, operator. Good morning, everyone. I just wanted to follow up on Dara's question there. I mean, maybe just to be clear, can you just help us understand what you are assuming for category growth in 4Q? Matt, I think you just said you're kind of assuming the September trends for the quarter rather than the stronger October or the weaker July and August. So just -- I just wanted to clarify that. And then I guess if that is the case, if you are assuming slightly stronger category growth this quarter, and I apologize if I did miss this, but can you maybe help us understand what's driving the sequential slowdown in the 4Q organic sales? Thanks."
},
{
"speaker": "Matt Farrell",
"content": "Well, look, let's go to your first question with respect to categories. It was 4.5 for first five months of the year. The next three months were 2.5. And then we'd say, hey, September was 3 and October was a really big number. We'd say Q4 on average would be 2.5. And we'll say, it will take -- will say, hey, the month of October is an anomaly and that November, December will be a lot like June, July and August. And that's no different than what we thought in July. So consequently, yes, we had a really good third quarter, but we beat our number organically. But we're saying, yes, for second half, we still feel good about 3% in total for the second half. And that's why we said 2 to 3 is fine as a call for Q4."
},
{
"speaker": "Peter Grom",
"content": "Got it. I'll pass it on. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Anna Lizzul with Bank of America. Your line is open."
},
{
"speaker": "Anna Lizzul",
"content": "Hi, good morning. Thanks so much for the question. I wanted to touch on gross margin which outperformed this quarter. The guidance for the full year seems a bit conservative. So I was just wondering if you could talk about your outlook on commodity costs and manufacturing. I think you noted in Q3 that manufacturing costs were a bit higher. Is that also expected to impact Q4? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, hey Anna, it's Rick. I think from a gross margin perspective, you're right. We're bit more conservative. If you say the full year is at 110, it means Q4 is up slightly. I would just remind everyone that Q4 a year ago was our high water mark at 44 6. That's part of it. Some of the commodities were flat in the first half, like ethylene. They're up in the back half around 9%, same for liner board. We have investments in our warehouse that we talked about at Analyst Day in our network and that built throughout the year. So yes, could that be a little conservative maybe? I think also we have -- as we look forward, we still are seeing inflation like that is -- that's what we're seeing. And our job is to offset that with productivity. So that's what we're focused on. And then the other thing on gross margin is, as we make investments to support these new products like in trade or couponing, that also impacts gross margin. So that's kind of an eclectic and wide ranging view. But those are the details."
},
{
"speaker": "Anna Lizzul",
"content": "All right, thank you, that's helpful. And just as a follow up on the category discussion here, are you seeing any difference in customer purchasing habits between retail channels or on quantities here? Thanks."
},
{
"speaker": "Rick Dierker",
"content": "No, I would say remember we've been growing volume for five quarters in a row and we continue to see -- most of the categories are volume driven growth. Our categories and purchasing patterns are the same."
},
{
"speaker": "Anna Lizzul",
"content": "Okay, great. Thank you so much."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Lauren Lieberman with Barclays. Your line is now open."
},
{
"speaker": "Lauren Lieberman",
"content": "Great, thanks. Good morning. Just want to talk a little bit about promotional environment and laundry in particular. In last year's fourth quarter you talked about pulling some of the unprofitable promotional activity and scanner sales were down. So just want to think about 4Q. Is it kind of like an easy comp as you get into fourth quarter or is it like the right base now and last year was the adjustment period? And anything else you'd add on kind of promo environment in laundry. Thanks."
},
{
"speaker": "Matt Farrell",
"content": "Yes, I'd say you're right about that, Lauren. We did eliminate some what we thought were just not profitable or uneconomical investments. What's different this year is we have such a great year in new products, particular in household with litter, with hardball and deep cleaning and large detergent. That will be one of the places we'll be investing in Q4 in trade promotion. One of the things that Rick called out in his response to gross margin."
},
{
"speaker": "Lauren Lieberman",
"content": "Yes, okay."
},
{
"speaker": "Matt Farrell",
"content": "Yes."
},
{
"speaker": "Lauren Lieberman",
"content": "One thing I noticed also, I know Deep Clean has been really successful and I may be me being too picky, but it was interesting to me that in some of the Q&A thus far, when you've been talking about laundry innovation you're putting, it seems like a bit more emphasis on sheets versus Deep Clean. Can you just maybe talk about the direction of travel you see for category development? How significant do you think sheets can be? Because Proctor, of course, has been doing a trial of this and as they go, probably really helps to amplify awareness in the category of this form. So just curious your thoughts on the relevance of sheets as a new form, and then the profitability of that versus the traditional liquid business, even the higher price point Deep Clean?"
},
{
"speaker": "Matt Farrell",
"content": "Yes, you're right. It is a good question. And it's true. We're very excited about sheets. But let me go back to Deep Clean. So the whole idea around Deep Clean was to have a good, better, best strategy. So the good is the orange bottle, it's the base ARM & HAMMER. The better is ARM & HAMMER with OXICLEAN. And the best is Deep Clean. And Deep Clean in mid-tier, it's our highest priced laundry detergent. Just to give you some sense, it's got 90% premium to the yellow box. Not the yellow box, but yellow bottle. And it's like a 40% premium for the ARM & HAMMER with OXICLEAN. But we're still at 15 plus percent discount to premium. And if you look at the trends, it's mid-tier that's been growing. So we feel good about the timing of our launch. It's important that that sticks so we have good, better, best going forward long term. And we think that Deep Clean can be a source of growth for us in the future. And that's, I would say if you go back to Steve Powers question about why you feel good going forward about your big businesses like laundry and litter laundry in particular, it's reasons like that. And then sheets. Sheets is a brand new form and it's efficacious. There's no plastic. Could it cannibalize some of your existing businesses? That's true. But we're the first major brand to launch in this form. It's good to be first. So we think that'll be a bigger emphasis for us going forward. Unit dose today is like 22%, 23% of the category. We have not had a big share in unit dose historically, which have been bouncing around between 4% and 5% of that very big subcategory. So sheets then, in addition to our existing pots, is the way home for us to grow and unit dose. So I appreciate the question because this all fits together and that's why we think we're in a good position going forward in the detergent."
},
{
"speaker": "Lauren Lieberman",
"content": "Great. Okay. Thanks so much for all that. I really appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Kevin Grundy with BNP Paribas. Your line is open."
},
{
"speaker": "Kevin Grundy",
"content": "Great, thanks. Good morning, everyone. Question on litter and the promotional environment there and how you potentially intend to respond. Matt, as you mentioned, Clorox has stepped up promotion levels to remarkably high levels. Most of the regained share that they're seeing with Fresh Step is coming at the expense of ARM & HAMMER. So a couple questions. Have you been surprised by the magnitude of the spend here on trade support from Clorox? It's taken dollars out of the category. It doesn't do anything to impact consumption. Seems like you're trying to get the share back in sort of one quick swing. And then how do you intend to respond? It kind of feels like it has year markings of a potential price war like we saw in laundry, like over a decade ago. But Rick, if I'm interpreting your tone correctly, it seems like you're generally okay relinquishing the share gains over the past year. So your thoughts there would be appreciated? And then I have an unrelated follow up. Thanks."
},
{
"speaker": "Rick Dierker",
"content": "Yes, I'll give you a couple comments and then Matt will chime in I'm sure. My comments, we're really happy with where we are at litter. This year-over-year as Clorox comes back in stock is what it is. Our baseline volumes are higher than they were. Our shares are higher than they were. We are really happy with 40% or so share gain, if you look back when this whole stuff started. We're not going to go chase share on a race to the bottom to go promote. If we promote, it's going to be behind our innovation to go drive a fair share in lightweight litter because we think that's where the opportunity is. So that's what we're doing. I'm optimistic that we're going to retain share because that over time it's difficult for cats to switch litters. It just is. After they've been out for a while and they have one product, that's what they get used to. So that's also why maybe the effectiveness of some of the competitor promotions aren't as high as they used to be because it's hard to switch litters or harder. So anyway, that's some context. Matt, anything like add?"
},
{
"speaker": "Matt Farrell",
"content": "No. When you see numbers like 40% to 45% sold on deal. So we're not going to chase that, Kevin. To the extent we promote, it's going to be behind hardball, which is our new product. And yes, obviously, when you're hit with a cyber event, obviously the expectation was that of course competitors are going to spend back to try to win back consumers, but we're going to be on the sidelines as far as spend a lot of money to chase that number."
},
{
"speaker": "Kevin Grundy",
"content": "Okay. Quick follow up and then I'll pass it on. Just on portfolio pruning. So, Rick, I think you've expressed an openness here which has generally not been part of the company strategy for a very long time. We naturally have the CEO transition which is going to be occurring in March. You need to bring a CFO on board. If you could just give us an update on potential parameters, scope, timing of what seems like it will be a potentially newer sort of leg to the stool, if you will, of the company strategy. And then I'll pass it on? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, I mean as a backdrop, we got to remember a lot of stuff that we do we're going to keep doing. The company is performing extremely well. The strategy is sound. We're leaders in ecom growth. As an example, M&A is best-in-class. We can identify, acquire, integrate and grow acquisitions. We do a few things uniquely in the company. Every year, we go value every brand that we have. And we know what brands or businesses are creating value, or destroying value. And we take that back and we usually have internal teams that, go turn that around or address root causes. And to the extent that we don't, then that's when things more strategic conversations are had. Now I'm not going to front run any of that. I'd say maybe in early to mid-next year, we'll talk more about that. But it's really, we've been doing it for a long time. It's what we do internally, and we got to hold kind of mirror up to all of our brands, just like we do when we do acquisitions. But remember, we have a great portfolio of brands. We have a high performing company. We're gaining share in most of our businesses. So, we're coming from a position of strength."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Hi Kevin, I want to remind everybody too. If I think back to when I got the job in January of '16, within a couple years I had a new Head of Marketing, supply chain, R&D, sales. Three of those four came from the outside. So we've been here before. We just got such a rock solid core of the company. This is a lot of talent here. There's no way we could get the numbers that we get, year-after-year we have a lot of talent up and down the line. So yes, I think we're all excited about a couple searches, and get some new people in the company, new ideas, new energy. So I think, we're in a real good place."
},
{
"speaker": "Kevin Grundy",
"content": "Okay. Very good. I appreciate it. Thank you both."
},
{
"speaker": "Matt Farrell",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Andrea Teixeira with JPMorgan. Your line is now open."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you. Good morning. So on the gross margin side, how should we be thinking about the puts and takes ahead of commodities, and the timing of certain contracts influence your view, especially in fiscal 2025, and a follow-up on the M&A? I think that's the only question we haven't answered, we haven't asked yet. In terms of like how you're seeing the landscape. I know you're very purposeful and cautious about what your targets are, but just as a, follow-up and an update on how you're thinking about inorganic growth? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, I'll take the gross margin question. I would say I kind of commented already on we do see inflation as we look forward, we see inflation, our job to offset that through productivity. As you take a big step back though, the different macroeconomic indications like China demand and really the U.S. economy, stable but not outsized growth. We have taken a position of not hedging as much as we usually do, believing that some of those commodities will come down over time. So I would tell you that's probably a good indication of our expectations as we go forward."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Andrea, could you clarify your other question about M&A?"
},
{
"speaker": "Andrea Teixeira",
"content": "Yes. No, Matt. I was just like thinking more how it's been -- I know it's part of your algorithm long term, not necessarily, of course, [ what you give in ] the evergreen model does not include that. But indirectly does, because you - as you create - as you buy these brands and companies, you create future growth, and is part of your long-term algorithm. So I was thinking like more it's been a while since you - and you're accumulating cash since you've done acquisitions. Of course, the last year were very good, very accretive. So just thinking of how we should be approaching that? Or we should be thinking you're focusing more inorganic at this point?"
},
{
"speaker": "Matt Farrell",
"content": "Well, look, we're always on the hunt. We generate so much cash. Of course, our criteria is pretty strict. So we do -- pretty fussy about the things that we'll buy. It is true that you can buy a couple of businesses that could be fast growing for a couple of years, but then they have to grow 3% to 4% or faster, depending on which categories are going forward. So I would say, no, we're not saying that we're focusing solely on the existing portfolio. But I'll remind everybody, if you go back in time, we've had periods where we've had droughts before, where we didn't buy a business. I think the longest one was probably between '08 and '11. When '08, we bought Orajel, and the next one was BATISTE in 2011. But so if you look at that through a three-year period, we had three great years. So it's - we're not - our algorithm isn't dependent upon going for an acquisition."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And the reason we - as you look back, the reason we are more successful than most to identify and acquire, integrate and grow acquisitions, because we're really fussy. And so that's part of the model, and that's what we're going to continue to be. We want to make sure, we do the right deal when we do the deal."
},
{
"speaker": "Andrea Teixeira",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Filippo Falorni with Citi. Your line is open."
},
{
"speaker": "Filippo Falorni",
"content": "Hi, good morning everyone. I wanted to ask you about innovation, and maybe you can give us some context of the contribution from innovation this year in laundry, and the rest of your business? And just any plans for 2025, and like areas of potential further innovation. And then a quick follow-up. So on the gross margin, as we think about elections and potential for tariffs, last time, there was some implication on the WATERPIK business from some portion that were reported from China. Maybe can you remind us any potential exposure on China tariffs? Thank you."
},
{
"speaker": "Matt Farrell",
"content": "Yes, thanks for the question. On innovation, we're actually super excited about innovation. It's close to around 2% incremental net sales for us in 2024. So remember, we have a high bar. We don't call gross sales. We don't call gross new product contribution, that's incremental net sales. So about half of our growth is kind of coming from innovation, which is fantastic. That's been accelerated. It used to be 1%, 1.5%. And so we've built that muscle. We have a lot of different inputs. Carlos, our leader in R&D; Leslie, our leader in NPP, all across the commercial team we are doing really well on innovation. I expect that to continue. I think as we look forward, we have great pipelines over the next two or three years. We're not really even talking about 2025 right now. We're talking about 2026 and even early conversations on '27. So that muscle's alive and well, and we're going to keep investing behind it and driving investment behind it. On China, right, just like everybody, we're well aware of implications there. I would say two things. One is we did reclass a lot of our SIC codes, import codes. And so that has helped and as you draw a circle around what may or may not be impacted. The second thing is we have moved some production outside of China. And so it's most material for the WATERPIK business, but there are plans in place and actions that we've taken to mitigate that impact."
},
{
"speaker": "Filippo Falorni",
"content": "All right. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Bill Chappell with Truist Securities. Your line is open."
},
{
"speaker": "Bill Chappell",
"content": "Good morning and thanks for squeezing me in. Going back to vitamins. So I guess I'm having a tough time at work. Help me understand two things. One, just from a business standpoint, I mean, are you now thinking you need to spend more money behind it in '25? Or is it because with you being down 10% and the category being down basically flat, I'm not sure I understand the green shoots. It seems like things are getting worse. And so you can either step, up and put a lot of money behind it or you can kind of ease back and manage it more and more for cash. So are we at that point in a decision standpoint? And then second, kind of related. I also don't fully understand maybe the impairment charge 10 years after acquiring the business. So maybe you can help me understand why that was there and the timing and what that says, if anything? Thanks so much."
},
{
"speaker": "Rick Dierker",
"content": "Yes. Sure, Bill. I would say, let me take the - I guess, the second one first, is when we do an impairment charge, all that is, is just looking forward of our model on what our growth rates growth rate assumption, is and that has -- what the category is growing at and what our expectations are as well as our margin expectations, and they've come down since we originally put all those assets on the book. And so it's kind of a reconciling of that, right? The original expectations to what our current number is, after we have amortization or - and we have value that versus the intangible numbers, and we say, oh, we have a gap and future growth and profits aren't as strong as they used to be. And so that's how you take a charge 10 years after. Your first question was on - why do we think - will we be putting more money behind it? We're not going to go chase incremental spending on promotions, and trade and advertising. That was a few of the levers that we pulled this year. And you're right, some of that is not working as we had hoped. Some of the things are working, and they do have green shoots the biggest, most important single thing that we can do is make sure that our core products are delaying the consumer. And that's why we're so focused on the innovation piece. We think -- this is the first time in a few years that we've put the full strength of the company on reformulating vitamins so that they -- we have our taste advantage back. We're hitting key marks in the market on sugar free, on plusing up our vitamins. So all those things are, I think, putting us in a better position to compete, and they're way more important than spending more on trade or getting displays or do another packaging spend."
},
{
"speaker": "Matt Farrell",
"content": "Yes. And the only thing I'd add to that is when you buy a business, the excess that we purchased pre-over-tangible assets is largely going to be goodwill. So that's always going to be a big part of any write-off, and it's all dependent upon the DCF model. And as far as green shoots, though, that was not in our commentary. I think somebody offered up that we're asking about green shoots, we would say that we've done the things we can control. We have seen some benefit and some growth in L'IL CRITTERS. It's not the lion's share of the business. And as we - this business really struggled through and post COVID, and realized by the retailers. And in the meantime, we've been just working on improving our supply chain, which is now we have in a good place and in doing the work on new products. So innovation is ahead of us. And we thought 2024 was going to be an inflection point, it was not. That was dependent upon all the things we have talked about, meaning packaging and graphics and positioning and messaging advertising. But in the end, it's going to be the innovation Bill, and as Rick went through the - some of the things, we're changing that's ahead of us in 2025. So this time next year, we hope we have a different conversation with you."
},
{
"speaker": "Bill Chappell",
"content": "Got it. Which leads me to just on next year, we won't be having a conversation. So congratulations on the - I know we'll have you for a few more months, Matt, on the retirement and Rick on the promotion? Thanks."
},
{
"speaker": "Matt Farrell",
"content": "Okay. Bill, I hope you make it to New York in January."
},
{
"speaker": "Bill Chappell",
"content": "I wouldn't miss it."
},
{
"speaker": "Matt Farrell",
"content": "Thanks, Bill."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Olivia Tong with Raymond James. Your line is now open."
},
{
"speaker": "Olivia Tong",
"content": "Great, thanks so much and congrats on retirement and promotion to you guys as well. My question is primarily around some of the more recent premium price innovation that you benefited from, particularly in laundry, with Deep Clean and the POWER SHEET segment and litter as well. So as we go into a potentially more - or we are in a more challenging backdrop, does your trade-up opportunity become more challenging relative to your peers, when macros get more challenging since your consumers, obviously skew a little bit more towards value to you, therefore, I would imagine that they are a bit more pressured relative to consumer average. So just wondering about your ability there. And then the mix implications, given that you obviously have been able to continue, to eke out a bit of mix benefit in the domestic business, despite obviously all the pricing lapping? Thank you."
},
{
"speaker": "Matt Farrell",
"content": "Okay. We got a lot in there. I think if I want to boil it down and you're wondering, because of our premium offerings of late, would that disadvantage us. And I would say, if you just take them one at a time for -- as Hardball goes, Hardball has been contributing to our share growth quarter-after-quarter. And we - last year, our share was like 4.5% of the category, the lightweight category. And that's grown quite a bit. We'll update everybody in January about what our share gain was on the entire year, but we think that's going to continue to grow. It's because of the performance of the product, which is it seizes up, close to, as hard as a rock. There's nothing in the category like it. POWER SHEETS it's laundry in a box. And I think given over time, maybe it's been a slower roll as far as the consumer willing to pay for sustainable products. But this one seems to be a winner for us. So we don't think that simply, because our category historically, our portfolio historically has been focused on value that because we now have products in laundry and litter, where our core products, our value. So the yellow box in litter, and the yellow bottle in laundry detergent, those are value products. But over time we offer premium products. And our consumer has traded up to them, and we've had other consumers and for other brands trade over to us. So again, in the end, I think for most consumer product companies, Innovation is always going to be the story in any environment, in any economy. So we feel very positive about those two innovations in particular."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And just an example, like for Deep Clean, it's mid-tier in the laundry category, that's still a value to the premium tier. So folks can still treat down to that. It's growing categories, though, because folks are trading down and trading up value in other areas. So net-net, we still think it's a positive in mostly economic environment."
},
{
"speaker": "Matt Farrell",
"content": "And what was your gross margin question, Olivia?"
},
{
"speaker": "Olivia Tong",
"content": "It was just around mix more importantly and the impact of mix as time progresses, but I think you answered that within the top line question."
},
{
"speaker": "Matt Farrell",
"content": "Okay. Thanks."
},
{
"speaker": "Olivia Tong",
"content": "Thanks so much. Really appreciate it. I'll pass it along."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Javier Escalante with Evercore. Your line is open."
},
{
"speaker": "Javier Escalante",
"content": "Hi, good morning everyone. I wonder whether you can expand on the international business in the context of the increase in reinvestment in Q4, if you can flag geographies or brands that you are seeing most traction, and also whether there is any measurable contribution of the business that you acquired in Japan? Or is it just too early? And then I have a follow-up?."
},
{
"speaker": "Matt Farrell",
"content": "Yes. I would say with respect to international, we're doing well like this, considering we have so many countries and so many brands, including region brands as the call goes out to our general managers in our subsidiaries. And so consequently, where we think we can spend to drive growth or position ourselves well for next year is where we're going to go. But I wouldn't say there's any one particular in international, one particular category or brand that, we would be over indexing on in Q4. It's just opportunistic spend."
},
{
"speaker": "Javier Escalante",
"content": "Understood."
},
{
"speaker": "Rick Dierker",
"content": "Another was Japan. It's probably too early to talk about that, Javier. I mean we're optimistic. It is a relatively small business, but we're excited about the opportunity to add a few, of our global brands into Japan to - it was a great team that is doing a great job at OXICLEAN. We think they can also do a great job, with a handful of other brands."
},
{
"speaker": "Javier Escalante",
"content": "And the follow-up is on the legacy, let's call it that way. The Detergent business, Deep Clean doing well. Do you try - this is kind of like the second iteration that you go into mid-tier. You need the OXICLEAN detergent, I believe, and didn't pan out. So what is driving this success time around? Do you feel it's a consumer something with the competition from our friends in Germany, is that the retailers are more susceptible to this mid-tier, anything that you can that you can contrast relative to the OXICLEAN extension in detergent that didn't pan out as well as Deep Clean, that would be very helpful? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, it's a fair question. I think it's a simple answer. OXICLEAN is brand, but it's an additive brand. And it was not a consumer - there was consumer confusion as we try to go into laundry, I just didn't make the connection. Here, ARM & HAMMER is well known for laundry, and just going up and down the tiers is a much easier proposition. That's why I think we're finding early success"
},
{
"speaker": "Javier Escalante",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Korinne Wolfmeyer with Piper Sandler. Your line is open."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Hi, good morning. Thanks for taking the question. As we think about some of your innovations next year and particularly around the VMS business, how should we be thinking about R&D spend and some of this extra innovation spend. Is there any risk to the SG&A, as we head into next year due to these investments? And then, anything else we should be considering? I think you called out some IT spend that, was a bit of a headwind. Anything else to consider for SG&A as we head into Q4 next year?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. We don't - I mean, over a long period of time, we spent around 2% of SG&A and R&D, and that's been a pretty good number for us. Next year, we're implementing an SAP project, redoing our - updating our ERP system just - the last time we did that was 2009, which is time for an upgrade. But I wouldn't really qualify or call anything at this point in time. We'll do that in January at our Analyst Day."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Great, thanks."
},
{
"speaker": "Operator",
"content": "And that was our last question. I will turn the call back over to Matt for any additional or closing remarks."
},
{
"speaker": "Matt Farrell",
"content": "No, I think that kind of wraps it up for today. We're looking forward to seeing everybody at our Analyst Day in New York City at the Exchange at the end of January and until then go on."
},
{
"speaker": "Operator",
"content": "This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful day."
}
] |
chd | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Church & Dwight's Second Quarter 2024 Earnings Conference Call. Before we begin, I've been asked to remind you that on this call, the company's management may make forward-looking statements regarding, among other things, the company's financial objectives and forecasts. These statements are subject to risks and uncertainties and other factors that are described in detail in the company's SEC filings. I would now like to introduce your host for today's call, Mr. Matt Farrell, Chairman, President and Chief Executive Officer of Church & Dwight. Please go ahead, sir."
},
{
"speaker": "Matt Farrell",
"content": "Good morning, everyone. Thanks for joining us today. I'll begin with a review of the Q2 results. And then I'll turn the call over to Rick Dierker, who's our CFO and Head of Business Operations. And when Rick is done, we'll open up the call for questions. So Q2 was another solid quarter for Church & Dwight. Reported sales growth was 3.9%, which beat our outlook of 3.5% and that was thanks to strong results across the board from domestic, international and Specialty Products. Organic sales grew 4.7%, which exceeded our 4% Q2 outlook with volume accounting for a very healthy 3.5% of our growth. Adjusted gross margin expanded 150 basis points. At the same time, we increased marketing spending, and we gained market share in the majority of our categories. Adjusted EPS was $0.93, which was $0.10 higher than our $0.83 outlook. That was a quality quarter, and Rick will take you through that later. The results were driven by higher than expected sales growth and gross margin expansion. And we continue to grow in the online class of trade with online sales as a percentage of global sales now reaching 21.2%. Now I'm going to turn my comments to each of the three businesses. First up is the U.S. consumer business with 3.8% organic sales growth. Volume growth was 3.3%, making this the fourth consecutive quarter of volume growth in the U.S. As you read in the release, Church & Dwight had the highest dollar consumption growth among our top 10 peers and five of our seven power brands gained market share in the quarter with a few hitting all-time highs. Now let's look at a few important categories in the U.S. Innovation is a big contributor to our success this year. And as I comment on the categories, I'll highlight the success of our new product launches. I'm going to start with laundry detergent. So ARM & HAMMER liquid laundry detergent consumption outpaced the 1.6% category growth and achieved an all-time high record share in the quarter of 14.8%, which is up 20 bps. ARM & HAMMER unit dose, ARM & HAMMER scent boosters and extra liquid laundry brand, all grew faster than their categories and also grew share in the quarter. Regarding new products, we have launched two new products into the detergent category, ARM & HAMMER Deep Clean and ARM & HAMMER Power Sheets. The first, ARM & HAMMER Deep Clean, is our most premium laundry detergent entering the mid-tier of liquid laundry. ARM & HAMMER Deep Clean accounted for 40% of ARM & HAMMER's liquid laundry detergent consumption growth in the quarter and is highly incremental to the ARM & HAMMER franchise. The second new product is ARM & HAMMER Power Sheets which is a laundry detergent. ARM & HAMMER was the first major brand to offer this new unit dose form in the U.S. the last year in August. Since expanding the launch of this product into bricks and mortar retailers this year, we have seen high consumer interest in the form. Our ARM & HAMMER Power Sheets has proven to be highly incremental to both the sheets category and the total laundry detergent category, and we are seeing repeat rates increase. We feel great about the future prospects for this product and form. Now I'm going to talk about litter. ARM & HAMMER litter grew consumption 6% in Q2, which was almost double the category growth. Our new lightweight ARM & HAMMER Hardball Clumping Litter is outperforming our expectations as our share of the lightweight category has grown from 4.5% in Q1 to 8.2% in Q2. This is important because lightweight accounts for 16% of the Clumping Litter category, and so we expect Hardball to continue to grow in the coming quarters. Turning to personal care. The gummy vitamins business continued to be a drag on the total company organic growth in Q2. The gummy vitamin category declined 1.9% in Q2, which is an improvement from the 5% category decline in the past two quarters. The bad news is our consumption was down even greater. We were down 10.9%. We continue to move forward with our plan to stabilize our gummy business through new packaging, upgraded formulas to improve the consumer experience, new forms like chewables and greater marketing investments that we've talked about with you in the past. However, the improvement is taking much longer than we anticipated. Next up is BATISTE. BATISTE continues to see strong consumption growth with consumption up 14.5% in Q2, growing share to 47%. BATISTE continues to be the global leader in dry shampoo and innovation is very important to the success of this brand. So listen to this. This year, we launched BATISTE Sweat Activated and BATISTE Touch Activated dry shampoos. These products are bringing new users to the category. And already, these two new products account for a 2% share of dry shampoo and Sweat Activated is the number 1 new product in the category. Over in mouthwash, THERABREATH continues to perform extremely well. THERABREATH is the number 1 alcohol-free mouthwash and the number 3 brand in total mouthwash with a 17% share. This year, THERABREATH entered the antiseptic segment of the category with the launch of THERABREATH Deep Clean Oral Rinse. It's important to note that antiseptics represents 30% of the $2 billion mouthwash category, and our launch into antiseptics accounted for 100 basis points of our 400 basis point year-over-year market share gain in total mouthwash. So that's a great indicator of the future of the antiseptic launch. HERO continues to drive the majority of growth in the acne category and has grown to become the number 1 brand in the acne category with a 20% share. HERO continues to launch innovative solutions and patches combined with adjacent consumer needs. An example would be the recently launched Dissolve Away Daily Cleansing Balm. Now a few comments about private label. Regarding private label, the good news is our weighted average private label exposure is relatively stable. We have seen notable private label share gains in gummy vitamins, where private label gained 2 share points, achieving a 16.7% share, which is back to pre-COVID historical highs. This has also contributed to our difficulties in that business. In the litter category, private label share has increased sequentially in the last few quarters from 13.1% in Q4, 13.3% in Q1 and 13.5% in Q2. So current levels are historical highs. The good news is that it's a different story for us as ARM & HAMMER Litter continues to gain share in spite of the private label strength. I'll close my comments on the U.S. by saying that although consumption has been strong through the first half of the year, we did experience a slowdown in June and July. And for context, and you read this in the release, our categories averaged 4.5% dollar consumption growth through May of this year. But since then, it has been closer to 2%. Now this is not entirely a surprise as we expected a deceleration as year-over-year pricing rolled off. However, unit consumption also saw a deceleration from the first five months to what we saw in June and July. So it appears that the consumer maybe getting extended and is making choices around spending habits. While we have only seen this trend for the last couple of months, we expect that categories are likely to grow at a slower pace than we experienced in the first half of the year. And as you know, our balanced portfolio of value and premium offerings performs, I should say, is well suited to changes in consumer buying patterns. Turning now to international and Specialty Products. Our international business delivered organic growth of 9.3% in Q2. This was driven by strong growth in the subsidiaries as well as our Global Markets Group. And just a few call outs. We had strong growth in Canada, Mexico, Germany and our Global Markets Group. And finally, Specialty Products. Organic sales increased 3.9% and that's two quarters of solid organic growth for this business. We're confident that this division will achieve a 5% organic sales growth this year, which would hit our evergreen growth target. I want to wrap up my comments by reiterating that the company is performing well, all three divisions delivering strong growth. I want to thank all the Church & Dwighters out there for doing such a great job each and every day. And now I'm going to turn it over to Rick to give you some more color around the quarter and full year outlook."
},
{
"speaker": "Rick Dierker",
"content": "Thank you, Matt, and good morning, everybody. We'll start with EPS. Second quarter adjusted EPS was $0.93, up 1.1% from the prior year. The $0.93 was better than our $0.83 outlook and is a high-quality beat, primarily driven from higher than expected sales growth and gross margin expansion. We'll walk through the details of the P&L. But this was a strong quarter with 8% growth of profit before tax versus the prior year, excluding the tariff benefit. Other important highlight for the quarter was the majority of our brands gained share. Reported revenue was up 3.9% and organic sales was up 4.7%. Organic sales was driven by volume of 3.5% and positive price mix of 1.2%. Volume was the primary driver of organic growth, and we expect volume growth to continue for the rest of the year. And as Matt mentioned earlier, this makes four consecutive quarters of volume growth. Our second quarter gross margin was 47.1%, a 320 basis point increase from a year ago, reflected a one-time benefit on a favorable ruling and rebate related to historical tariff payments. Excluding this impact, adjusted gross margin increased 150 basis points due to productivity, volume and mix, net of the impact of higher manufacturing costs. Let me walk you through the Q2 bridge. Gross margin components are as follows; positive 80 basis points impact from price, volume, mix and a positive 120 basis points from productivity. This was partially offset by a 10 basis point drag from currency and a 40 basis point drag from inflation. Moving to marketing. Marketing was up 20.2 million year-over-year. Marketing expense as a percent of net sales was 10.1% or 100 basis points higher than Q2 of last year and led to share gains. For SG&A, Q2 adjusted SG&A increased 20 basis points year-over-year, primarily due to international R&D and costs related to the Graphico acquisition. Other expense decreased by $7.8 million, primarily due to lower outstanding debt and higher interest income. For income tax, our effective rate for the quarter was 24% compared to 17.9% in 2023, which is significantly higher than a year ago due to a high level of stock options exercised in Q2 of '23. We continue to expect the full year rate to be approximately 23%. And now to cash. For the first six months of 2024, cash from operating activities was $499 million, almost $500 million, a decrease of 9 million with higher cash earnings offset by higher working capital. We now expect full year cash flow from operations to be approximately 1.80 billion. Capital expenditures for the first six months was 76.6 million, a 13.4 million increase from the prior year as capacity expansion projects proceeded as planned. We expect 2024 CapEx of approximately 180 million as we complete the majority of those investments that were initiated in 2023, and we continue to expect CapEx to return to historical levels of 2% of sales in 2025 and beyond. And now for the full year outlook, as Matt mentioned, strong financial performance in the first half of the year and strong categories and share gains. As we move into the second half, consumption growth has moderated in many categories as the consumer remains under pressure. Consequently, we are tightening our organic revenue outlook and now expect or getting sales growth to be approximately 4%, at the low end of our prior 4% to 5% range. Reported sales growth is expected to be approximately 3.5%, which also reflects a drag from currency and the impact from divestitures. We continue to expect full year adjusted EPS in the range of 8% to 9% growth, but now at the low end of the range. In round numbers, the sales call down would normally be offset by the gross margin raise at the EPS line. However, we have two other factors for the change. Number one, as you saw in the release, full year SG&A is now expected to increase as a result of higher spend for Graphico. That drag went from $0.01 to $0.02 as we make incremental investments. And then number two is dry powder in the event categories get more promotional in the second half. Turning to gross margin. We now expect expansion of approximately 100 to 110 basis points, up from our previous outlook of 75 basis points of expansion. We continue to expect an increase in manufacturing costs to be more than offset through productivity, mix and higher volume. We continue to expect marketing as a percentage of net sales to be approximately 11% as we continue to grow share across many of our brands. And with that, Matt and I would be happy to take any questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. We'll hear first today from Rupesh Parikh at Oppenheimer."
},
{
"speaker": "Rupesh Parikh",
"content": "Good morning and thanks for taking my question. So, Rick, I just want to, I guess, go back to your comments on the promotional backdrop. So, I would love to hear about what you guys are seeing right now on the promotional backdrop and then what your expectations are for the balance of the year?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. Let me give you a sense for what's going on promotionally, Rupesh. And as everybody knows, the household is former promotional than personal care. But if you look at liquid laundry detergent sold on deal from Q1 to Q2. It actually was down 190 basis points year-over-year and was down 200 basis points sequentially. And you might be scratch your head about why would that be, but you guys probably have this in your Circana data as well. But a large premium brand is actually down 900 basis points sequentially and 600 basis points year-over-year. Of course, that's not the whole story. Couponing is not tracked. It's not in the consumption numbers. But that would explain how you went from 33.5 sold on deal in Q1 to 31.6 in Q2. So it was largely driven by a large brand. If you look at litter, Q1 versus Q2, that's a different story. Q1 sold-on deal was about 15.5% and Q2 was a little over 18% -- like 18.3%. So it's up sequentially. But it's -- that was generally driven by one competitor. They're sold-on deal Q1 versus Q2, almost doubled. It's 24% for this other brand in Q2. So, I would say, as far as our brands go, we've -- as I said, we had an all-time high share in the quarter in liquid laundry and also very close to an all-time high share for litter in Q2. But that's to give you a little bit of color on promotions. Unit dose is, it's kind of the same story as well, Q1 to Q2, just round numbers went from 26% to 31% on that's year-over-year, I'm sorry. But sequentially, it was -- went from 26% to 36%. So, there's a lot of big changes happening in each of the categories. But I would say, if you're just looking at the second quarter, you wouldn't say it's any more promotional. It's just an anomaly with one brand in liquid laundry and one brand in litter swinging the numbers."
},
{
"speaker": "Rupesh Parikh",
"content": "Okay. Great. And then maybe just one follow-up question. Just going back to the slowdown in June and July. It sounds like it's across categories, but I don't know if there's any more color you can provide between your discretionary offerings and maybe some of your more essential categories."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, I can give you some color on that. We look at the commentary of food companies. And we see callouts like, hi, the consumers being price conscious, we've got value seekers out there. And then we look at fast food chains, and we see spending is less per trip. Then we look at our data, you look at staples and you see decelerating consumption in a lot of categories. I mean if you just look at the Circana and Nielsen data, you can see it. I guess the last thing here today is unemployment has ticked up a little bit. And as I said on the call, the expected -- the dollar growth year-over-year, we expected to peel back as a result of price increases lapping. But we're also looking at volume. It's a year-over-year volume growth is also decelerating in the categories. We're doing better than the categories as evidenced by our brand success. But we would say the consumer is likely a bit weary balancing the household budget, making choices to satisfy their needs. We have three things going for us. One is the strength of the brand. So, you saw in the release five out of seven brands grew share. If you went back to our old standard, 10 out of 14 of our major brands grew share in Q1 and in Q2. And so that's strength of the brands to be number one. Two is the innovation. You heard the proof points in my opening remarks. And number three, you know the split we have 60-40 between premium value. So therefore, we said, hey, given the category movement in June and July, we concluded 3% organic in the second half. It's probably a sensible outlook, but I can give you just some round numbers. So, if you look at the laundry detergent category, May, June and the first few weeks of July, May was around 2%, June flat and then July down close to one point, and that's just in dollars. And then again, the Litter category, round numbers, May was 3% up; June, flat; and then July, up slightly. And if you look at another category like non-alcohol mouthwash, who goes 14, 13, 11, May, June, July, you see how the categories are kind of trending down. And I can give you other examples, but that's where we come out and say, based on everything we're hearing from other industries, unemployment, what we've seen in the Circana and Nielsen data, it seems pretty obvious to us that 3% makes a lot of sense for the next 6 months."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And Rupesh, this is Rick. I would just, to tack on to that, it's not just one category. That's kind of what Matt is going through. If you take the weighted average and you look at every category individually, there is a slight deceleration in most."
},
{
"speaker": "Rupesh Parikh",
"content": "Great. Thank you. I’ll pass it along."
},
{
"speaker": "Matt Farrell",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "Our next question today comes from Chris Carey at Wells Fargo."
},
{
"speaker": "Matt Farrell",
"content": "Hi, Chris."
},
{
"speaker": "Chris Carey",
"content": "Hi, guys. Rick, you mentioned, potentially keeping some dry powder for additional spending. Is that additional spending now factored into the outlook for the year? Or are you saying that you're now guarding a bit more of that dry powder should you need to deploy it in certain categories. And then what are the categories that you have your eye on, specifically, I think the Litter category, well take in the step up in promotional spending. I think we heard enough last night to corroborate that. But can you just expand a bit on the dry powder piece and just what you're kind of preparing for?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. No worries. I would say, it's really the second in your example, it's dry powder is, if categories further decline, if the promotional environment heats up because volume growth gets harder to come by, we are just -- we're saying we're ready for it. We're prepared if that happens, we haven't deployed it yet, but if it happens, we will. And that's really primarily around our household businesses like laundry and litter. And then, of course, as the category is down for vitamins that would be applicable as well."
},
{
"speaker": "Matt Farrell",
"content": "Yes. And the other thing is you heard us talk about the success we're having in so many categories with our new products and that's where we've concentrated our promotions, displays, et cetera, not just in the household but also in our personal care products. And we got the marketing coming behind it, too. We've got a lot more marketing in the second half behind those brands. So we definitely like our chances regardless of the slowing categories."
},
{
"speaker": "Chris Carey",
"content": "Okay. Makes sense. One quick follow-up is just on the 3% and kind of thinking that's the right range for the next 6 months. Did I hear you correctly, it's a bit about category, which makes sense. You're gaining share. Where -- just given the trend line, where are you keeping a particular eye on regarding whether maybe by Q4, we're talking about 2% or something of the sort. I suppose your dry powder would help you counteract that. But any callouts on just the categories that you really have your eye on where things are developing a bit differently relative to your expectations? And then just connected to that, can you just frame the BMS business whether you're just seeing stabilization or whether there's any kind of sequential worsening. It's not really a BMS question, to be clear. But just given that's the business that feels less predictable, I just wanted to make sure I got a specific comment on that?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, we're in 16, 17 categories. If you just graft those categories and you just see pretty much across the board softening, so it's not just, hey, it's one or two big categories. We think it's really broad-based. So consequently they're all on the table for keep an eye on for the second half."
},
{
"speaker": "Rick Dierker",
"content": "Framing the bottom in business."
},
{
"speaker": "Chris Carey",
"content": "It was just on vitamin -- are you stable or is it faster than other businesses? Just maybe trying to ring- fence vitamins versus everything else where you're clearly -- you clearly had a lot of relative momentum for those categories?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, the category, I gave some numbers there before about May, June, July for a bunch of different categories. Vitamins if you do May, June, July category dollars down 1, down 2, down 1 at May, June, July. So it's more us than the category and we have not been able to renovate our portfolio as fast as we had hoped. And some of it is the retailers how much additional shelf-space will they change your shelf position et cetera. And some of it is also the speed at which we can renovate the portfolio. So I'd say it's more on us frankly than the external environment. We know we need to do and I think we think about how good we would be, if we could get that one turn around considering how all the other businesses are doing well, but yes it's more work to do there, Chris."
},
{
"speaker": "Chris Carey",
"content": "Okay. All right. Thanks so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Bonnie Herzog at Goldman Sachs."
},
{
"speaker": "Bonnie Herzog",
"content": "Thank you. Good morning. I had a question on your organic growth guidance. Matt, I believe you mentioned that your guidance assumes the underlying category growth remains pressured, but does your guidance also assume further slowdown from here? Just trying to understand potential downside risk? And then how do you see the balance of price mix and volumes playing out, especially in the context of the category slowdown?"
},
{
"speaker": "Matt Farrell",
"content": "Yes, well, look it’s the categories has slowed down. Some of them, for example, laundry and litter you get to July pretty much flattish. So when you have flat categories, the only way you're going to grow is you have to take share. And we -- obviously we like our chances because that's what we've been doing so far this year with -- especially driven by our new products. A lot of our share growth in litter was driven by Hardball our new launch there. So now we're not saying, hey, this is going to -- this graph if you're going to graph it is going to continue to go down the rest of the year. We're just saying it looks like a step change from the first 5 months of the year to where we are now and I think it's more likely than not that it will stay this way to the rest of the year."
},
{
"speaker": "Rick Dierker",
"content": "Yes. We still think categories are going to grow and we're going to take share. So that's how we get to our 3% for the back half. And then in terms of price volume mix it's kind of unchanged from what we've said before. We're primarily a volume-driven organic growth grower in the last four quarters and that will continue we think for the next two."
},
{
"speaker": "Matt Farrell",
"content": "Yes. So this might help you too. If you look at dry shampoo, the dry shampoo first 5 months of the year was double digits I assume May was 12%. And if you look at June, July it's more like 6%, 7%. So category is still growing just not growing as fast. So it looks like it's just kind of a notch down. And this is where innovation is really going to matter I think going forward."
},
{
"speaker": "Bonnie Herzog",
"content": "All right. That's helpful. And then my second question is on your marketing investment that you called out for Q3. I guess I'm curious to understand how much of that step-up that you expect in Q3? Is it essentially new incremental or is it really just a shift coming out of Q2 where your spend levels were a little bit below what we had anticipated. And then should we expect sustained spending levels into Q4? And I'm thinking about that in the context of some of your new launches?"
},
{
"speaker": "Rick Dierker",
"content": "Yes, I'll take that, Bonnie. So our Q2 marketing spend was right where we expected it to be. We were at 10.1%. If you take a big step back we spent quite a bit of marketing in Q4 in 2023. And we had one of our best new product years ever this year on par. And we're taking hundreds of basis points out of the marketing spending that would be naturally in Q4 if you kept it flat and putting that throughout the year. And so Q1 was up 150, Q2 was up 100, Q3 is going to be up significantly more like Q1 than Q2 and then Q4 will be down significantly because we just want to get that phasing correct to support new products."
},
{
"speaker": "Bonnie Herzog",
"content": "All right. Thank you for that."
},
{
"speaker": "Operator",
"content": "Next up, we'll hear from Peter Grom at UBS. Please go ahead. Your line is open."
},
{
"speaker": "Peter Grom",
"content": "Thanks, operator. Good morning, everyone. Hope you're doing well. Maybe just one quick housekeeping. I think the release mentioned the domestic consumption outpacing sales, primarily due to some retail inventory reductions. Can you maybe just talk about that? Where did you see the reductions, what categories specifically?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. So we said there were two reasons why Circana I would say 6% and domestic organic was 3.8%. So the 200 basis points of a disconnect it was one we had talked about before which was we had a HERO pipe in a year ago. And then the second one which actually was more of a surprise for us was retail inventory adjustment in the quarter. That was primarily on laundry, but I would tell you there's more noise in the system these days as categories start to move around from retailers on how they manage inventory. We are at good levels across the chain and we're set up for success."
},
{
"speaker": "Peter Grom",
"content": "That's helpful, Rick. And then kind of going back to the category discussion, but maybe shifting gears to kind of international. Can you just talk about what you're seeing from an international perspective both from an underlying category standpoint, but also when we think about the 3% implied back half growth on a total company basis, what do you expect to see from your international business?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. If you know our international business had a very strong first half. So we expect them to still punch above their weight for the full year. Our algorithm is international is going to grow 8% on an annual basis and they're tracking above that right now. Before I give you some remarks with respect to the U.S. consumer, we're still keeping an eye on the international consumer as well. So far things have been holding up pretty well. They've been more resilient at least in our markets and in our categories so far, but I think the commentary that I had before is more focused on the U.S. than international, but still it's something to keep an eye on, Peter. But right now, it's not a worry. ."
},
{
"speaker": "Rick Dierker",
"content": "And to just give you a little bit more granularity if our full year call for international is 8% we saw around 9% for the first half. So that would mean we think it's around 7% in the back half."
},
{
"speaker": "Peter Grom",
"content": "Great. Thanks so much. I'll pass it on."
},
{
"speaker": "Operator",
"content": "Steve Powers at Deutsche Bank, your line is open for our next question."
},
{
"speaker": "Steve Powers",
"content": "Okay. That was very enthusiastic. So the shipments versus consumption discussion that Peter just started, I guess just extend it, I guess I'm curious whether you have visibility any known timing differences favorable or unfavorable as we go into 3Q, 4Q?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. At this point in time we don't have any I mean there are different classes of trade always talk about store closures or rightsizing and so all that's kind of baked into our outlook. It's a little noisier than normal I'd say. We've got caught by surprise a little bit on the one in Q2, but the good thing is we still -- despite that we still met or beat our outlook on organic."
},
{
"speaker": "Matt Farrell",
"content": "Yes. So drug and dollar are the two classes of trade that a little bit turbulent I guess right way to say it, looking ahead, but we got a pretty good handle on what we have out there and how we think that will move around as a result of store closures."
},
{
"speaker": "Steve Powers",
"content": "Okay. Great. And this is, I guess, it's on the topic we've all been talking about in terms of the slowing in the kind of promotional environment. But I guess it's more just a philosophical question in this moment. So many companies as we've gone through the second quarter earnings season that are exiting the first half with higher gross margins than expected yourselves included. Does that from your perspective raise the risk even more that seemingly rational levels of competition and what have you evolved alongside the slowing. It just seems like we're in a pretty precarious moment where so many companies have been calling for volume improvement or volume sustainability where things have been good. Now things are slowing abruptly, but at the same time they're carrying more gross profit into that moment. And I'm just questioning whether you think that elevates the risk versus what you've seen historically that things do get more competitive more quickly."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, look I think if people look back through history and you say when do people start promoting? And yes you're right when you have slowing categories. So that's why Rick said, it's probably prudent to say, hey, you got to have a top line call and a bottom line call that kind of bakes that in and so you have some dry powder if that were to happen, but that's why we spent so much time this morning talking about innovation. And we had an innovation beyond the categories that we described. So I think that's going to be really important to share growth and consumption growth in the next 6 to 12 months."
},
{
"speaker": "Rick Dierker",
"content": "One thought to add to that. Normally, if you look back at history really hyper promotional environments happen when categories are negative or volumes are negative. Neither of those things are happening. In general, it's still positive growth from a dollar perspective and still positive growth from a volume perspective. So that's context. Private label shares are still relatively stable. All those things are still true, but we're just trying to give a heads up to say there is something going on."
},
{
"speaker": "Matt Farrell",
"content": "Yes. So Steve, that's sort of our MO. We were always palms up and we see what we're seeing. So that's what we're doing today."
},
{
"speaker": "Steve Powers",
"content": "Okay. I appreciate it. Thank you very much."
},
{
"speaker": "Operator",
"content": "Next, we'll hear from Dara Mohsenian at Morgan Stanley."
},
{
"speaker": "Dara Mohsenian",
"content": "Hi. Good morning, guys. So I just wanted to touch on a couple of pieces of your portfolio. THERABREATH, obviously, continues to post very strong growth. You could see that in the scanner data or your call commentary on market share. But it is a higher-priced product. So just hoping you could give us a bit more detail on the brand performance. And as we move through the quarter, the performance -- any signs of trade down there is the therapeutic benefit of the product really mitigating any impact from a weaker consumer and just your view on growth potential for that brand as you look out over the next few quarters, given the strong momentum recently. And then just on the VMS side, I understand all your points around the intervention in terms of packaging forms, marketing. Just any more detail on when the timing of some of those things may pay off and how you guys think about that given the progress hasn't been as strong as expected so far. Thanks"
},
{
"speaker": "Matt Farrell",
"content": "Yes, we'll look at here, THERABREATH is a big success story for the company. As you know, we have 17% share, we're number 3 in the category. Number 1 is Listerine at 38% and Crest at 18%. And we've been getting more facings from different retailers and different classes of trade and the launch into antiseptic is something that we think is going to be a source of growth for us for a good long time because when -- 30% of the category. And we now have a 4% share of the non-alcohol, so we've got a long way to go there. So I would say, we feel really good about THERABREATH and yes, it's more highly priced, but that's not something new. We don't promote the product. I think one interesting proof point is, if you look at what happened on Prime Day, THERABREATH, actually, was the number 3 brand an unpromoted and we had a really good Prime Day for THERABREATH. So there's lots of indicators to say this brand has a lot of staying power even as a premium brand in this environment. And then with respect to vitamins. Yes, I think then that's probably going to be over the next 6 to 12 months. We do not expect we're going to be able to stabilize that as we had planned to when we started the year. We thought that in the first half, we'd be down and then by midyear, things start to turn around, so we would be exiting the year with a stable business, no loss of share. I don't see that happening right now. But we got lots of different irons in the fire here and some are working, some aren't. We just need a little more time."
},
{
"speaker": "Dara Mohsenian",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Lauren Lieberman at Barclays, please go ahead. Your line is open."
},
{
"speaker": "Lauren Lieberman",
"content": "Thanks. Good morning. So sticking with THERABREATH and also layering in HERO, if I may, both brands continue to have very, very strong growth, but they have decelerated. And we were looking at it more than anything else is kind of law of large numbers. But I was curious, if you could comment on what you're seeing in the spaces in which those brands compete in terms of those category growth rates changing? And as we look forward, this law of large numbers, like do we think they keep migrating down to earth so that growth, isn't 30%, but it's like 20% as we move forward and how to frame that because I think it's important in terms of the big picture, the aggregate outlook for the company is the growth rate of those 2 brands actually matters a lot."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, look, I'll give you some category data, like the acne category May, June, July is steady, up 8% May, June and July. So no worries there. And we've got the number 1 brand in the category, not only in the category but also in patches, subcategory at 54% share. So it's -- that's not a worry for us right now, either one of those brands. Of course, with the passage of time, you're not going to have 30% growth rates. This is just math as you think ahead to 2025. But we're still expecting that we're going to have really strong years next year."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And just to add to that, you're right, I think 30% or 40% growth. And as that comes down, it's because we're really lapping distribution in general, but consumption is just still extremely, extremely strong. And I would say, we're not going to point to a growth rate in the future, but we still have to be double digit, strong double-digit growth as we look out over the horizon."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay, great. And then if I can ask a second question on market share trends. So we are still on Nielsen. So I know that there are some pretty significant differences lately between Nielsen and Circana and coverage matters a lot. So take that as preamble. But as we see it, market shares for Church in aggregate were softer in June and July. So along with the categories slowing that some of the share performance wobbled a bit, particularly if you take out here on Thera. Just if you could comment on that, again, that might be completely different than what you're seeing in your data. So I would like to know if that's the case. And if not, what is it do you think that -- why if in fact shares have been more sluggish why that is?"
},
{
"speaker": "Rick Dierker",
"content": "Yes. Thanks, Lauren. I would just say that's not what we're seeing. In Q1, I think we were 10 out of 14. If you go back to our old vernacular of all of our power brands because this question a little bit more detail, so 10 out of 14, I think Q2 was 10 to 14. I think July -- June, July -- or July was 9 of 14. So no real change."
},
{
"speaker": "Lauren Lieberman",
"content": "And what about the pace of that growth, though, not just like is it up, but is it up less?"
},
{
"speaker": "Matt Farrell",
"content": "Well, I think it's reflected in our second half call, right? We said we grew 5% organic in the first half, 3% in the second half. So I think that's all baked in the numbers but we wouldn't give like mid-quarter."
},
{
"speaker": "Rick Dierker",
"content": "It's more of a -- that's more of a category. We still feel really good about the share. We expect share gains in the second half, and we're positioned to do that."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Kaumil Gajrawala at Jefferies. Go ahead. Your line is open."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Hi. If I could ask a little more on VMS, which is not that long ago, you were increasing capacity for the space. I'm curious if anything has changed, maybe there's some product changes you need to make or innovations you need to catch up on. But has your view generally about that segment changed?"
},
{
"speaker": "Matt Farrell",
"content": "Well, look, it's a very competitive category. They're well over 60 competitors. There aren't a lot of barriers to entry simply because you could find commands to make your product. So if you get an idea and catchy brand name, you can pretty much enter. So that's really what we've been experiencing. And of course, we've definitely struggled in the bricks and mortar. We do have some bright lights here on the online class of trade. So we're doing extremely well on Amazon, we've got a lot of growth there, but then that's a smaller piece of the pie. We've mentioned before renovating the category, meaning that we're -- this year, we've been changing the formulas to improve the consumer experience, meaning that taste and bite, we're launching into chewables, different forms. But all those have gone slower than expected. And then we haven't got a lot of help from the retailers."
},
{
"speaker": "Rick Dierker",
"content": "Yes. And remember for context, right, this category grew through COVID on a rocket ship pace, it grew probably over 50% over four or five years. And so everyone's rush in to put the capacity in to accommodate that and the category itself is still finding its feet as it comes off of those highs. That's why we keep seeing negative growth. And then there's other forms now. It's just not hard pill and gummy. There's liquid. There's powder. There's other forms. And so that's a category story, and we're being impacted by that as well. But as Matt said, we think innovation is super important. We're trying to move the speed of light to get the right innovation out there as fast as possible."
},
{
"speaker": "Matt Farrell",
"content": "Yes. We call it out because there has been a struggle for us. ."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Yes, essentially, you're sort of -- when you first started talking about the category it sounds quite different from how you like to be positioned or how do you like a category to be positioned. Does it still make -- we just saw Clorox divested their VMS. I recognize it's different but does it still make sense to own?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, that's -- we evaluate all of our businesses, all of our categories annually. So obviously, we put a lot of investment into this but I can't go any further than that."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Yes. Thank you."
},
{
"speaker": "Operator",
"content": "Andrea Teixeira at JPMorgan. Please go ahead with your question."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you. Good morning. I was just hoping to see if you can call I mean, shift a little bit of the conversation into M&A. And I know you've been looking at your Analyst Day, you had said you had looked at back last year around 4 potential acquisitions. None of those kind of future profile or enough to be attractive. So I was hoping to see what has changed anything that we should be thinking of? Is that more the targets are not willing or the private equity funds not coming up with some interesting ones for you? What is preventing you to growing organically, which is something that you historically have done? And then also just a housekeeping on WATERPIK. I think that's the only brand that we really didn't talk about and WATERPIK in dry shampoo just thinking of like how, I mean, you quoted in the first quarter there was a 1% headwind from WATERPIK and gummies each. So it's hoping to see what was the headwind in the second quarter, if any, assuming there's still headwinds there? And what is embedded in the second half?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. As far as M&A, you're correct in that last year, we looked at 4 or 5 different brands and we didn't pull the trigger on any of them. But what I can tell you is that we're as busy as ever right now. We're always looking at opportunities and they are out there and we just kind of stick to our criteria. But we do realize it's been 18 months since we made an acquisition. We have cash building up on the balance sheet as you'll see when we file the Q. But yes, we're very busy and the market is active."
},
{
"speaker": "Rick Dierker",
"content": "And then on WATERPIK the good news on WATERPIK is consumption is up high single, low double digits. So we really work through that retail inventory issue that we talked about last quarter. I would say WATERPIK flattish for this quarter. We think it's slightly down for the full year largely based on what happened in Q1 from a sales perspective. So not ignoring WATERPIK but I'd tell you that consumption looks good for WATERPIK."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Next, we'll hear from Filippo Falorni at Citi."
},
{
"speaker": "Filippo Falorni",
"content": "Hi. Good morning, everyone. I wanted to ask about the gross margin outlook for the second half. What have you embedded from a pricing standpoint that you're kind of comment on dry powder on promotional activities? And then from a commodity standpoint, are you seeing some modest inflation? What is the commodity outlook for the second half? Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, sure. I would say inflation is maybe a little bit higher than when we talked about it 3 months ago. Pulp and paper are up. HDPE is up a little bit ethylene's up a little bit. But no change from a net perspective as productivity has come out a little bit better as well. Yes, we do have some trade and couponing and promotional spending assumed in the back half. Again, it's dry powder, not necessarily that we are going to do it. And we also want to spend behind our new products in terms of displays and support and whatnot. So that's kind of our assumption."
},
{
"speaker": "Filippo Falorni",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Kevin Grundy at BNP Paribas. Please go ahead."
},
{
"speaker": "Kevin Grundy",
"content": "Great. Thanks. Good morning, everyone. We covered a lot of ground most of the portfolio. I wanted to kind of take it a different direction, I guess. And maybe if you could comment at all on Barry's departure because it's an area we've got a lot of questions from recently. Obviously key executive with the company is CMO and President of your Domestic Business and probably one of a handful points of interface with the investment community. So Matt, maybe just comment on how high a priority it is to refill that role maybe skill set you might be looking for? I know you see this with the company through early October and whether the search is going to include both internal and external candidates. So thanks for that. Okay, I'll leave it there. Thank you."
},
{
"speaker": "Matt Farrell",
"content": "All right, Kevin, that's a multipart question many of which I can't respond to. What I can say is that Barry has been here 11 years, had an eight-year stint international, three in the U.S., a big part of our success and sad to see him go here through early October. It's business as usual here. So we have some time to figure out how we're going to fill the position. But I think that's as detailed as we go into on a call like this."
},
{
"speaker": "Kevin Grundy",
"content": "Okay, I'll leave it there. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Olivia Tong at Raymond James."
},
{
"speaker": "Olivia Tong",
"content": "Great, thanks. My question is primarily around gross margin and trying to understand the upside in Q2. And then in terms of the deceleration in second half it sounds like that 100 basis points or so was primarily around the dry powder but wanted to see if there are other factors that are driving that expectation for a deceleration in the second half."
},
{
"speaker": "Rick Dierker",
"content": "Yes, deceleration for gross margin?"
},
{
"speaker": "Olivia Tong",
"content": "Yes, exactly."
},
{
"speaker": "Rick Dierker",
"content": "Yes. Okay. Well, in the quarter, we had favorability really because of mix. Within our personal care portfolio, we had higher-margin product sell even more than we expected and some of the lower-margin personal care products not sell as much. So that was kind of a tailwind from -- in the price volume mix line. That's what happened for the quarter. For the back half of the year, it's a couple of things. There's a little bit more inflation. It's not as favorable year-over-year personal care mix as those categories come in a little bit. But the dry powder we're talking about in terms of trading coupons in the back half as well. So those are probably the 2 or 3 things I'd point to in the back half."
},
{
"speaker": "Olivia Tong",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Anna Lizzul at Bank of America. You have our next question."
},
{
"speaker": "Jon Keypour",
"content": "Thank you. This is Jon Keypour on the line for Anna. I also just want to say I'm glad Steve Powers is here because he opened the way for the question I have, which is. I guess, on pricing is there any risk that the promo environment gets to such a place that we see negative price in the back half. And then a follow-up to that in terms of the innovation pipeline and like route to market and kind of time to market given where the categories are stabilizing at this lower kind of growth rate and the idea that maybe this becomes a '25 issue as well. Are you guys able to pivot your innovation pipeline and have new products in market by next year that cater more towards, I guess, the mid or low end consumer more than potentially what you had in the pipeline last year or expected to have in the pipeline for next year? Thank you."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, there's two types of innovation. One is innovation where we're identifying a pain point or a need for the consumer. Another is when it comes to pack size which I think is what you're getting at. So yes, we're pretty good at pivoting quickly to create different price points in various categories in order to satisfy the consumer in a changing environment like this."
},
{
"speaker": "Rick Dierker",
"content": "And then on your first question about volume and price mix as we look forward, we do not expect to have negative price in the back half of the year."
},
{
"speaker": "Jon Keypour",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from Javier Escalante at Evercore."
},
{
"speaker": "Javier Escalante",
"content": "Hi. Good morning, everyone. I have a couple of clarifications on the detergent side. One is it that whether you have enough, you mentioned that Deep Clean was 40% incremental. Do you have enough data to know whether this is people trading up ARM & HAMMER? Or you're gaining share -- you're gaining users from other brands? The other -- I mean we both used to can and shows personal prices down. Do you think that that is promotional activity or that is a price correction?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. On the first question, we fully anticipated when we launched the Deep Clean that you would have some ARM & HAMMER consumers' trade up. So Deep Clean is part of our good, better, best strategy. So good would be the basic ARM & HAMMER detergent and ARM & HAMMER with OxiClean is the better and Deep Clean is the best. So yes, we do have some data that as we have people trading up. And we also have consumers that are leaving other brands and migrating over to Deep Clean. And that's why we think, long term, Deep Clean is going to be a source of growth for the company."
},
{
"speaker": "Rick Dierker",
"content": "Yes. We probably wouldn't comment much on looking at kind of data about Henkel or Persil or any of those things. We would just say we continue to gain share in laundry. And as the category is slowing a bit, we continue to gain share and do better in the market."
},
{
"speaker": "Javier Escalante",
"content": "Understood. Fair. The other is curious about how fast this so-called dry powder can be deployed vis-a-vis retailers? And to what extent this is also contingent to supply chain, the strength of the supply chain because one of your competitors continue having issues with it. Thank you."
},
{
"speaker": "Rick Dierker",
"content": "Yes, Javier. It's a fair question. Typically, as you're putting in incremental promotions, that maybe is a longer lead time. But if you want to heat up a promotion, that can be done relatively easier and you go after incremental volume that way as well or couponing. But again, it's dry powder is the key message."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Robert Moskow at TD Cowen."
},
{
"speaker": "Robert Moskow",
"content": "You have a lot of analysts covering your stock. That's glad to be."
},
{
"speaker": "Matt Farrell",
"content": "Yes. We're not doing an alphabetical order either."
},
{
"speaker": "Robert Moskow",
"content": "But glad to participate. This year, it just -- as a newcomer, it looked like your new product pipeline was extraordinarily good. Like you have a lot of like really resonant products in a lot of different categories, all at once. As you think about it for next year, do you expect it to be as strong as it is this year? And in light of a slowing category growth and maybe some more value-seeking, is there anything you need to tweak in terms of the mix of premium versus more value-oriented products."
},
{
"speaker": "Matt Farrell",
"content": "Yes. Well, one thing I want to keep in mind about new products is, we're having a great year with all these new product ideas we came out with. But remember, we're going to have Year 2 of these next year. So you only have a partial year, only building distribution this year, in many cases, building awareness. We think the products that some of the ones I talked about and others will be big drivers next year. And on top of that, we have new product ideas coming as well. So like I said, I do think that in any environment, but particularly this one, new products are going to make the difference. And then your other question was tweaking the portfolio between premium and value. I've been with the company for 18 years, and the 60-40 split, it's now 63-37 premium value has been sustained over a couple of decades. So unlikely that's going to change in the near term. And that's why we always like our chances when you have periods with change in consumer-buying habits."
},
{
"speaker": "Robert Moskow",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "And our final audience question today comes from the line of Mark Astrachan at Stifel."
},
{
"speaker": "Mark Astrachan",
"content": "Yes, thanks. Good morning and thanks for squeezing me in here. Two quick ones. One, just asset prices on potential M&A, are you seeing it come down similarly to the market? And then on vitamins, just again, if you go back to when you bought the business, it was partly about adoption of the form factor of gummies there's more press out there not saying that I agree or don't agree with the efficacy of a gummy versus some other forms. Is that partly what's impacting the consumer in your business in gummies in general? Is there an opportunity to educate the consumer? Or is there opportunity and tech to make the product more effective? If not, how quickly can you pivot to some of the other stuff that you talked about in terms of chewables and potentially powders and whatnot within the brands you have?"
},
{
"speaker": "Matt Farrell",
"content": "Yes. As far as vitamins goes, yes, there's been quite a change over time. I think we bought the business in 2013, the gummies represented 3% of the market, and now it's in the 20s. So it's changed quite a bit. I would say as far as your comment about efficacy, I think it's more that people are moving to powders and chewables and other forms. The larger vitamin category has pulled back. But remember, it's falling back from COVID. You had several years of growth in just a couple of years. So I think household penetration is greater as a result of COVID and that's kind of plateaued and started to pull back. But no, I wouldn't say that our issues are related to the fact that there's an issue with efficacy. It's more around the -- our own issues in-house."
},
{
"speaker": "Rick Dierker",
"content": "Yes. The other area that folks are moving away from gummies at times are from a sugar perspective. They want to go towards sugar free. So we're rapidly going after the sugar-free part of the portfolio. We're rapidly going after improving our taste profile. So that gap widens again versus competition."
},
{
"speaker": "Matt Farrell",
"content": "Yes. So one of our disadvantages is we don't have as what brought a portfolio of sugar-free as some of our competitors. And again, that's one of the areas when I talk about renovating the portfolio. That's one of the areas we're focused on. All right, operator, I think we are at the end of the line."
},
{
"speaker": "Operator",
"content": "Correct. No further questions from our audience today."
},
{
"speaker": "Matt Farrell",
"content": "Okay. Thanks everybody for joining us. We had a kind of a great first half. We're looking forward to a strong second half, and we'll talk to you all at the end of the third quarter."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this does conclude our conference call. We thank you all for your participation. You may now disconnect your lines."
}
] |
chd | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Church & Dwight's First Quarter 2024 Earnings Conference Call. Before we begin, I've been asked to remind you that on this call, the company's management may make forward-looking statements regarding, among other things, the company's financial objectives and forecasts. These statements are subject to risks and uncertainties and other factors are described in detail in the company's SEC filings."
},
{
"speaker": "",
"content": "I would now like to introduce your host for today's call, Mr. Matt Farrell, Chairman, President and Chief Executive Officer of Church & Dwight. Please go ahead, sir."
},
{
"speaker": "Matthew Farrell",
"content": "Good morning, everyone. Thanks for joining us today. I'll begin with a review of the Q1 results. And then I'll turn the call over to Rick Dierker, our CFO. And when Rick is done, we'll open the call up for questions."
},
{
"speaker": "",
"content": "Q1 was another solid quarter for Church & Dwight. Reported sales growth was 5.1%, beating our outlook of 4%, thanks to stronger results across the board from domestic, international and specialty products. Organic sales grew 5.2%, which exceeded our 4% Q1 outlook with volume accounting for a very healthy 70% of our growth."
},
{
"speaker": "",
"content": "Gross margin expanded 220 basis points. At the same time, we increased marketing spending in the quarter and gained market share in the majority of our categories. Adjusted EPS was $0.96, which was $0.11 higher than our $0.85 outlook. The results were driven by higher-than-expected sales growth, gross margin expansion and a lower tax rate."
},
{
"speaker": "",
"content": "We continue to grow in the online class of trade with online sales as a percentage of global sales now reaching 20.5%. In March, we signed a definitive agreement to acquire GRAPHICO, our Japanese distributor for approximately $35 million. We expect the acquisition to close later this year. GRAPHICO's annual sales are approximately $38 million. The business is based in Tokyo and has 59 employees."
},
{
"speaker": "",
"content": "Since 2008, GRAPHICO has partnered with Church & Dwight and driven OXICLEAN to be the #1 powder prewash additive in Japan. The acquisition is expected to contribute to greater expansion of our business in Japan and the greater APAC region. We intend to leverage the capabilities of the GRAPHICO team to bring additional Church & Dwight brands to Japanese consumers."
},
{
"speaker": "",
"content": "Now I'm going to turn my comments to each of the 3 businesses. First up is the U.S. The U.S. consumer business had 4.3% organic sales growth, 3.3% that was volume driven, making this the third consecutive quarter of U.S. volume growth. 5 of our 7 power brands gained market share in the quarter and private label market share in our categories remained relatively stable."
},
{
"speaker": "",
"content": "Now let's look at a few important categories in the U.S., starting with laundry. ARM & HAMMER liquid laundry detergent consumption was flat while the category grew 2%. Many of you may recall, we had pulled back on promotional activity in Q4, and that continued into early Q1. As our promotional activity normalized, ARM & HAMMER liquid laundry saw share gains late in the quarter and the brand has continued to perform well in April. Now elsewhere in laundry, ARM & HAMMER unit dose and ARM & HAMMER scent boosters both grew faster than their categories and grew share in the quarter. Our XTRA liquid laundry brand, which is our extreme value offering grew consumption 6.3% and increased market share to 3.8%."
},
{
"speaker": "",
"content": "Regarding new products, we have launched 2 new products into the detergent category, ARM & HAMMER Deep Clean and ARM & HAMMER Power Sheets. The first ARM & HAMMER Deep Clean is our most premium ARM & HAMMER laundry detergent entering the mid-tier of liquid laundry and delivering a superior clean at a price consumers can afford."
},
{
"speaker": "",
"content": "The second new product is ARM & HAMMER Power Sheets laundry detergent, which is launched -- which was launched online in August of 2023. ARM & HAMMER was the first major brand to offer this new unit dose form in the U.S. Now due to its online success, Power Sheets is now available in select brick-and-mortar retailers. Power Sheets continues to grow online. It now has 9,000 reviews with a 4.5 rating, and both Deep Clean and Power Sheets are off to a great start in 2024, and we're excited about the early results we are seeing."
},
{
"speaker": "",
"content": "Now over in Litter. ARM & HAMMER Litter grew consumption 5% in Q1, which was in line with category growth. Our new lightweight ARM & HAMMER Hardball Clumping Litter is now expanding nationally after a successful in-market test in 2023. We expect this new litter to help ARM & HAMMER capture a greater share of the lightweight litter category."
},
{
"speaker": "",
"content": "To give you a couple of facts here, lightweight litter today accounts for 16% of the clumping litter category. Our share of lightweight clumping litter has grown from 4% to 6% since year-end 2023, but that compares to our 29% share in regular weight litter. So still a long way to go."
},
{
"speaker": "",
"content": "Turning to Personal Care, BATISTE continues to see strong consumption growth with consumption up 19% in Q1, growing share to 47.5%. BATISTE continues to be the global leader in dry shampoo. We are meeting consumers' desire for long-lasting results with the launch of BATISTE Sweat Activated and BATISTE Touch Activated dry shampoos. And so far, consumers are posting excellent reviews for both of these new innovations."
},
{
"speaker": "",
"content": "Now our mouthwash. THERABREATH mouthwash and HERO continue to perform extremely well. THERABREATH is the #1 alcohol-free mouthwash brand and is now the #3 brand in total mouthwash with a 16% share. THERABREATH recently entered the antiseptic segment of the category with the launch of TheraBreath Deep Clean Oral Rinse, which represents 30% of the category."
},
{
"speaker": "",
"content": "HERO continues to drive the majority of growth in the acne category and has grown to become the #1 brand in the larger acne category with 19% share. HERO continues to launch innovative solutions in patches combined with adjacent consumer needs, such as recently launched Dissolve Away Daily Cleansing Balm."
},
{
"speaker": "",
"content": "Now there are 2 businesses, Gummy Vitamins and WATERPIK that created a drag on total company organic growth in Q1. First, WATERPIK. The good news for WATERPIK is consumption for our water flosser business is healthy. However, flosser shipments were affected by retailer inventory adjustments in the first quarter. This, combined with lower shower head consumption accounted for a 1% negative drag on organic revenue growth but we expect this to be transient."
},
{
"speaker": "",
"content": "The second is gummies, which also created a 1% drag. The Gummy Vitamin category declined 5% in Q1, which was actually worse than our expectations for the category and our consumption was down even greater, down 12%. We continue to move forward with our plans to stabilize our vitamin business through changes, through packaging, messaging and greater marketing investments that we've talked about with you in the past."
},
{
"speaker": "",
"content": "I will close my comments on the U.S. by saying that overcoming the drag from these businesses still -- and still posting a 5% organic sales growth for total company, just illuminates the strength of our portfolio."
},
{
"speaker": "",
"content": "Turning now to international and Specialty Products. Our international business delivered organic growth of 8.8% in Q1. This was driven by strong growth in the subsidiaries, just a few callouts, especially Mexico, Germany, U.K. and France. And also had growth from our Global Markets Group. And finally, Specialty Products. Specialty Products organic sales increased 7.2% primarily due to record sales in our [ Eurasia ] business as SPD continues to expand globally."
},
{
"speaker": "",
"content": "I want to wrap up my remarks by reiterating that the company is performing well with all 3 divisions delivering strong growth. And I want to thank our global employees for their great efforts each and every day. Now we rarely raise our full year outlook after only one quarter. But given our fast start, we raised our outlook for gross margin and EPS growth, and we have confidence in our new full year forecast."
},
{
"speaker": "",
"content": "And now I'm going to turn it over to Rick to give you some more color around the quarter."
},
{
"speaker": "Richard Dierker",
"content": "Thank you, Matt, and good morning, everybody. We'll start with EPS. First quarter adjusted EPS was $0.96, up 12.9% from the prior year. The $0.96 was better than our $0.85 outlook, primarily driven from higher-than-expected sales growth, gross margin expansion and a lower tax rate. Reported revenue was up 5.1%, and organic sales were up 5.2%. Organic sales were driven by volume of 3.7% and positive product mix and pricing of 1.5%. 70% of our organic growth was volume driven. And as Matt mentioned earlier, this makes 3 consecutive quarters of U.S. volume growth."
},
{
"speaker": "Our first quarter gross margin was 45.7%, a 220 basis point increase from a year ago, primarily due to productivity, volume, mix and pricing, net of the impact of higher manufacturing costs. Let me walk you through the Q1 bridge. Gross margin was made up of the following",
"content": "positive [ 130 ] basis points impact from price volume mix and a positive [ 130 ] basis points from productivity. This was partially offset by 10 basis points from currency and 30 basis points from inflation."
},
{
"speaker": "",
"content": "Moving to marketing. Marketing was up $29.7 million year-over-year. Marketing expense as a percentage of net sales was 10.1% or 150 basis points higher than Q1 of last year and led to share gains. For SG&A, Q1 adjusted SG&A increased 80 basis points year-over-year. Other expense all-in was $20.9 million, a $2.2 million decrease primarily due to lower outstanding debt and higher interest income. We now expect other expense for 2024 to be approximately $80 million."
},
{
"speaker": "",
"content": "For income tax, our effective rate for the quarter was 19.9% compared to 24.4% in 2023, a decrease of 450 basis points due to a high level of stock option exercise in Q1 of 2024. We continue to expect the full year rate to be approximately 23%."
},
{
"speaker": "",
"content": "And now to cash. For the first 3 months of 2024, cash from operating activities increased to $263 million, a decrease of $10.1 million with higher cash earnings, offset by higher working capital. We now expect full year cash flow from operations to be approximately $1.050 billion, up slightly from our previous $1 billion outlook."
},
{
"speaker": "",
"content": "Capital expenditures for the first 3 months were $46.3 million, a $21 million increase from the prior year as capacity expansion projects proceed as planned. We expect 2024 CapEx of approximately $180 million as we complete the major capacity investments that were initiated in 2023, and we expect capital spending to return to historical levels of 2% of sales in 2025."
},
{
"speaker": "",
"content": "And now for the full year outlook. We continue to expect the full year 2024 reported an organic sales growth to be approximately 4% to 5%. We now expect full year EPS in the range of 8% to 9% growth. This is up from our previous 7% to 9%. And is inclusive of costs related to the exit of the MEGALAC business as well as GRAPHICO transaction costs. We now expect full year gross margin to expand approximately 75 basis points, up from previous range of 50 to 75 basis points. Given our outstanding Q1 margin expansion of 220 bps, this outlook implies moderate gross margin expansion for the remainder of the year."
},
{
"speaker": "",
"content": "We continue to expect an increase in manufacturing costs to be more than offset through productivity, mix, higher volume and carryover pricing. We continue to expect marketing as a percentage of net sales to be approximately 11%."
},
{
"speaker": "",
"content": "SG&A is now expected to be flat as a percentage of net sales compared to 2023, reflecting the investments we are making in our international, e-commerce, infrastructure and costs related to the GRAPHICO acquisition Matt discussed earlier."
},
{
"speaker": "",
"content": "For Q2, we have a strong outlook and expect reported sales growth of approximately 3.5%. Organic sales growth of approximately 4%. We had a really strong April from a consumption perspective. So some might be expecting a higher organic growth outlook. Our 4% outlook reflects higher coupons and trade promotion in support of new products. We're fully lapping 2023 price increases and we're lapping a year ago distribution gains for HERO."
},
{
"speaker": "",
"content": "Moving on to the rest of the P&L. We expect moderate gross margin expansion in the quarter in Q2 as we have less of an impact from carryover pricing. Increased marketing spending to support our innovation pipeline, higher SG&A expense and a significantly higher tax rate of 24% compared to the prior year of 17.9%, which benefited from a high level of stock option exercises. This represents a roughly $0.07 drag on EPS. As a result, we expect adjusted EPS of $0.83 per share, down 10% versus last year adjusted Q2 EPS."
},
{
"speaker": "",
"content": "And with that, Matt and I would be happy to take any questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] We'll take our first question today from Chris Carey with Wells Fargo Securities."
},
{
"speaker": "Christopher Carey",
"content": "Just regarding the Q4 outlook for organic sales to be below the run rate that we're seeing in the scanner trends, Rick, you mentioned trade promotion lapping of HERO -- or excuse me, I think the THERABREATH or HERO distribution gains, if you could confirm that? How would you contextualize the drivers of those 2 items for the organic sales outlook in Q2 being below what we can see in the consumption trends? And then got you a follow-up."
},
{
"speaker": "Richard Dierker",
"content": "Yes. Thanks for the question, Chris. You're right. April was around 6.5% consumption growth, really, really strong. And we said 3 things really driving a lower organic outlook of around 4%, which is probably in the grand scheme, HERO, lapping year ago distribution gains as we went national for HERO. It was probably the biggest one."
},
{
"speaker": "",
"content": "And then number two, not getting any contribution from pricing, we've fully lapped 2023 pricing actions by -- as we enter into Q2. And then the third one would be higher coupons for -- and trade for supporting our new products because this is one of our best years of innovation."
},
{
"speaker": "Christopher Carey",
"content": "Okay. That's helpful. The second thing would just be we're seeing an improvement sequentially in laundry volumes. Obviously, there's been some noise in this category with compaction with stepped-up promotional activity in the year ago base. How would you characterize your expectation for laundry sequentially from here?"
},
{
"speaker": "",
"content": "Clearly, we're seeing the improvement as those lapse normalize, would you expect to continue to see that improvement going forward? And do you just have any expectation for how volumes might shape up in laundry specifically over the next couple of quarters?"
},
{
"speaker": "",
"content": "And if I could sneak in, are you starting to see any competitive activity in your litter business, which is what we're hearing from one of your competitors?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. You got a lot of questions there Chris."
},
{
"speaker": "",
"content": "Yes. So if you look at laundry category, you got -- there's a lot going on there. You've got liquid laundry, you got unit dose and you got scent booster. So if you look at the categories, the last 3 quarters for each of those, liquid laundry sort of decelerated year-over-year growth, Q3, Q4, Q1, it's like up 5%, [ up 2, up 2 ]."
},
{
"speaker": "",
"content": "And so it has decelerated. The reason we feel good about where we stand right now is we know we lost some share in the -- early in the quarter, then we normalized the trade spend. And then we're going to have even more couponing and trade going forward. Why? Because of we got Deep Clean that we've launched nationally. So -- and we think that -- we make that stick in high mid-tier and that could provide years of growth for us. So I think the horse to ride this year and laundry is going to be Deep Clean."
},
{
"speaker": "",
"content": "As far as unit dose and scent boosters go, unit dose, that's decelerated as well the last 3 quarters, [ 8, 5, 3 ]. But we -- our unit dose grew 34% in the quarter. So we had a lot of success, a lot of trade down going on there."
},
{
"speaker": "",
"content": "And then scent boosters, which is a very discretionary category, the last 3 quarters is [ 2, 1, 1 ] as far as the year-over-year growth. And we grew 7% because we're a value in that category. So we're in a good position, both in unit dose and at scent boosters. So then when you talk about the promotional things are right now."
},
{
"speaker": "",
"content": "Look, liquid laundry, if you went to Q4 versus Q1, it's up a bit, like up 70 bps. So just as in measured channels, of course. And of course, you can't see coupons as well. I feel good IRI and Nielsen. But if you look at the sold-on deal, it went from 33.2 to 33.9 sequentially. So you wouldn't say, well, that's not that big a move. But year-over-year, Q1 to Q1, it's up 180 bps."
},
{
"speaker": "",
"content": "So we would still say that if you go back to pre-COVID times, if you went back to, say, 2018, it's about a 40% sold on deal. So we're a long way from being where we used to be. But I'd say trend-wise, you do a trend line, you'd said it is inching up over the last 6 to 8 quarters."
},
{
"speaker": "",
"content": "You mentioned litter as well. Litter is same sold on deal in Q1, Q4 it's 15.3%, but still up year-over-year 40 bps, but a long way from where it was."
},
{
"speaker": "",
"content": "If you went back years ago, we would more around 20%. So -- but it is -- obviously, we had one competitor that was out of stock for a while, so they'll need to -- I suspect, be promoting to win back -- win back share. But as I said, we've -- the horse we're riding there is a Hardball. We've got a lot of opportunity in the lightweight litter category. So that's -- you had a long question, so it's kind of a long answer, did I hit most of the points, Chris?"
},
{
"speaker": "Christopher Carey",
"content": "That's perfect."
},
{
"speaker": "Operator",
"content": "Our next question will come from Rupesh Parikh with Oppenheimer."
},
{
"speaker": "Rupesh Parikh",
"content": "Also congrats on the nice quarter. So just going back to the vitamin category. Just curious what continues to weigh in the category? And then how should we think about expectations for the balance of the year versus, I guess, the double-digit consumption decline we just saw in Q1?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Well, if you look at the category, Q4 and Q1 just round numbers are both down 5%, down 5%, down 5%. And normally, you would expect New Year's resolutions and people wanting to get healthy, that would be a boost to the category. We didn't see it in Q1. So it was 2 things. It still is probably the tail from post COVID."
},
{
"speaker": "",
"content": "But also, you could also argue that for many people, it's discretionary. So the third thing though is that people moving from gummies to other forms, and that is powders and also things like chewables. And we're launching a chewable this year. So we could see some of that shift to other forms. But I would say those are the dynamics that we're looking at."
},
{
"speaker": "",
"content": "Now as far as our performance, yes, we've had double-digit decline in Q4 and Q1. So obviously, not happy about that. Takes a while to turn that around. You probably are starting to see new packaging in in-store. Not only new packaging but higher marketing spend as well."
},
{
"speaker": "",
"content": "We are seeing signs of retailer support with respect to shelf placement and facings pre and post resets. So we hope that this is the year we're going to stabilize. We're really hoping that in the second half of this year that this business will inflect and start to grow. But we've been down Q4 and Q1, as I said."
},
{
"speaker": "Rupesh Parikh",
"content": "Great. And then maybe just one quick follow-up for Rick. So you guys raised the bottom line guidance, but still kept the same top line guide even with the Q1, and it sounds like strong momentum in April. So just curious in terms of -- is it just conservatism for reaffirming the guide? Or is it still just early in the year?"
},
{
"speaker": "Richard Dierker",
"content": "Yes. I think Matt's comment was spot on in his prepared remarks. Usually, after Q1, we don't touch the outlook. Gross margin was so strong in Q1, we felt like we had to reflect that. And as a result, earnings was very strong as well."
},
{
"speaker": "",
"content": "So that's why we adjusted it. And 4 to 5, I think it's a great guide. I know we said 4.5 pretty much throughout the year. So I would expect us to talk more about the outlook in July."
},
{
"speaker": "Operator",
"content": "Our next question will come from Dara Mohsenian with Morgan Stanley."
},
{
"speaker": "Dara Mohsenian",
"content": "So first, just a clarification on WATERPIK. The 100 basis point issue you mentioned in Q1, is that something that fully comes back in the balance of the year? Is that embedded in the Q2 guidance? Is it more spread out in the balance of the year? And was that just a shipment issue? Or is there some form of retail sales weakness also?"
},
{
"speaker": "",
"content": "And then maybe just broader, Matt, on the U.S. business, you're obviously excited about innovation this year. You mentioned the couponing in Q2. Can you talk about the level of contribution you're expecting from innovation this year? And maybe on some of the key early ones, the reception you're seeing so far from a trade and consumer standpoint?"
},
{
"speaker": "Matthew Farrell",
"content": "Okay. A multi-parter. Well let's pick WATERPIK first. I'll make a few comments about that, and Rick can build on that, and we'll come back to what we're expecting for the U.S. ."
},
{
"speaker": "",
"content": "As far as WATERPIK goes, yes, it was down in the first quarter, but we still expect on a full year basis, this business to be up and to hit its plan. So I wouldn't be completely alarmed about the WATERPIK activity in Q1. The fact that the flosser consumption is healthy, is real positive for us. That's a really strong way to start the year."
},
{
"speaker": "Richard Dierker",
"content": "Yes. I mean consumption for WATERPIK is high -- up high single digit, low double digits. So consumption is great. We had to work through some inventory that was higher than I guess, at retail, and that's been worked through now. So we feel like it's in a good spot as we move forward."
},
{
"speaker": "Matthew Farrell",
"content": "Yes. And as far as our expectations for the year, we called the 4% to 5% organic growth for the year. And we expect just ballpark, about 2% of that driven from new product launches, which is a big number."
},
{
"speaker": "",
"content": "And -- but if you kind of roll through, we've got Deep Clean launching in laundry. And ARM & HAMMER, we're going national with -- ARM & HAMMER Litter, we're going national hwith HardBall. Those are our 2 big businesses on the household side of the house. And then when you get into personal care, THERABREATH, launching with the -- antiseptic being 30% of the category, that's gigantic. So we're only just getting started there."
},
{
"speaker": "",
"content": "And the BATISTE, I mentioned, we're the #1 dry shampoo in the world. You got BATISTE Touch, BATISTE Sweat. If you're getting really high ratings and early days of velocities for virtually everything that we've launched are meeting or exceeding expectations. So that would suggest we feel good about at least after 1 quarter, that we're going to hit that 2% number for organic sales growth in 2024. And that will probably be one of our biggest years ever for as contribution of organic sales from new products."
},
{
"speaker": "Operator",
"content": "Our next question will come from Andrea Teixeira with JPMorgan."
},
{
"speaker": "Andrea Teixeira",
"content": "So I was hoping if you can talk about like the dynamics as you set up shelves. If there is anything you would call out in terms of the -- of any pull forward in shipments and consumption? I understand that obviously, you had a very strong quarter, but you're guiding more conservatively into the second quarter."
},
{
"speaker": "",
"content": "Just trying to understand the puts and takes or anything that you see the lapse, and I appreciate when you gave us the lapse on some of the components last year. But also, if you're seeing your competitors being more I would say, more aggressive in litter or things like that, that some of them had suffered from, obviously, the cyber attack and all of that. How are the dynamics in terms of market share as we think into the second quarter and the balance of the year?"
},
{
"speaker": "Richard Dierker",
"content": "Andrea, it's Rick. I'll give you a couple of comments, and if Matt wants to add. So first of all, for the Q2 call, I went through a little bit of the details. But really, it's new product couponing and trade promotion is kind of a little bit of a step down or step up in Q2, so that's impacting net sales."
},
{
"speaker": "",
"content": "We had year ago HERO gains as we went national, that's what I said before. And then we're lapping some of the price increases, right? Almost all of our volume -- all of our organic growth from here forward is almost 100% volume driven. Okay? So we had 70% in Q1, but as we move forward, it's closer to 100%."
},
{
"speaker": "",
"content": "And then as for litter, Matt went to the amounts sold on deal, it has ticked up a little bit. Private label is up a little bit more, spending is up a little bit, but by and by our shares are strong in litter."
},
{
"speaker": "Matthew Farrell",
"content": "Yes. And as far as you mentioned, supply difficulties of other competitors. Yes, sure. Obviously, we and other brands in the category can benefit and have benefited from that difficulty. And when you have a repeat purchases over and over again. Oftentimes, so changes stick."
},
{
"speaker": "",
"content": "So naturally, that's our expectation that, yes, we're going to hang on to some of those new consumers that moved our way, but some will be tempted back by promotions."
},
{
"speaker": "Operator",
"content": "Our next question comes from Nick Modi with RBC Capital Markets."
},
{
"speaker": "Nik Modi",
"content": "Just 2 quick questions. Rick, maybe on just the marketing guidance. I guess based on our math, the rest of the year would imply kind of reduced marketing, of course, off of very big increases from a year ago. But just wanted to get kind of philosophically, do you kind of saw the upside, would you have a bias to reinvest more given the consumer environment or -- would it be more flowing through to the bottom line?"
},
{
"speaker": "",
"content": "And then the second question is really around reinflation, right? We're starting to see some commodities across the energy complex reinflate. And I would just be curious on kind of how you think about managing that against this consumer backdrop in terms of pricing?"
},
{
"speaker": "Richard Dierker",
"content": "Yes. Thanks for the question, Nick. For marketing, we were up 150 basis points in Q1. We expect to be up in Q2. And then Q3 and Q4, but Q3 up probably, and then Q4 down. And why is that? We spent a lot of marketing in Q4 a year ago. We wanted to move and shift part of that to the front half as we supported our new product. So we did that in a meaningful way. Feel really good about that."
},
{
"speaker": "",
"content": "On an absolute basis, marketing in Q4 would still be a high number. So we feel like we're supporting, the brand is great. To the extent that we overdeliver and have the momentum. We typically look to reinvest in marketing because it drive share. It drives organic growth, and it's a virtual cycle."
},
{
"speaker": "",
"content": "On inflation, I would say for us, it's largely unchanged. Inflation expectations aren't moving much at all. Ethylene is down a little bit HDPE is up a little bit. But net-net, we're right where we were when we talked 3 months ago."
},
{
"speaker": "",
"content": "So we don't have -- if there's a theoretical question, if there's inflation, what do we do? I would tell you, our productivity program is very strong right now, and we think that's going to be evergreen as well."
},
{
"speaker": "Matthew Farrell",
"content": "Yes. And just to add to that, Nick, as you know, we got a portfolio value brand. So to the extent that interest rates stay where they are, we have some defense against that. We have found that HERO and THERABREATH are really high [ ranks ], but we've really been unaffected by any decline in consumer sentiment over the past few quarters. So they seem to be somewhat resilient, and those are some of our bigger growers right now. So we still think we're pretty well positioned at least for the remainder of 2024."
},
{
"speaker": "Operator",
"content": "Our next question will come from Peter Grom with UBS."
},
{
"speaker": "Peter Grom",
"content": "I was hoping to just follow up on the 2Q organic sales outlook, Rick, you mentioned fully lapping pricing. You touched on the couponing many times throughout this call. So within that 4%, can you maybe unpack what we should expect from a price versus volume perspective?"
},
{
"speaker": "",
"content": "And then kind of the same question for the full year. I think previously, the expectation was that volumes would be kind of 2/3 of the full year organic sales growth. Has that changed? Or is that still the right expectation?"
},
{
"speaker": "Richard Dierker",
"content": "Thanks, Peter. In Q1, it was 70% volume and 30% price. And I just made the comment that on a go-forward basis, Q2, Q3, Q4 they'll likely be closer to 100% volume and minimal price, if anything."
},
{
"speaker": "",
"content": "And if you rewind the clock, pre-COVID, you go back 10 years ago, and that was our track record, 100% volume-driven growth. And actually, sometimes in the past, it was maybe 110% volume-driven growth and a little bit more trade as we went national for some of our brands."
},
{
"speaker": "",
"content": "So that's the expectation as we look forward. And so for the full year, I probably wouldn't change the outlook we gave you on the mix."
},
{
"speaker": "Peter Grom",
"content": "Great. And then maybe just a quick follow-up on Dara's question. Just kind of on WATERPIK and the fact that you expect it to kind of reverse and grow for the year, a pretty nice rebound. So just maybe thinking about the sales benefit from a brand perspective? Just in that you overdelivered versus the full year outlook despite that drag?"
},
{
"speaker": "",
"content": "What really gets worse from here? Is it simply just cycling the tough comps and moderating growth of HERO and THERABREATH or are there other brands where you're kind of expecting things to slow sequentially?"
},
{
"speaker": "Richard Dierker",
"content": "No. Look, we think the -- not much changed from our original outlook. And we beat the quarter on organic sales growth and despite some of these things that were dragging us down. It's just early in the year to call any incremental upside, and we typically don't do that."
},
{
"speaker": "",
"content": "So let's see how consumption goes, and we continue to do well on a share perspective. And I think we're very optimistic about the year and the top line."
},
{
"speaker": "Operator",
"content": "Our next question will come from Anna Lizzul with Bank of America."
},
{
"speaker": "Anna Lizzul",
"content": "What's the solid volume growth that you saw in Q1? I was wondering if you're seeing a more significant benefit from trade down. I think you mentioned some in laundry in response to Chris' question, but wondering if you're seeing this elsewhere as well?"
},
{
"speaker": "",
"content": "And then we've been hearing from some companies, earnings season that the lower-income consumer appears to be more challenged. I was wondering how you're thinking about sort of the broad health of the consumer across your different income tiers in relation to your categories and volume growth?"
},
{
"speaker": "Matthew Farrell",
"content": "Well, with respect to the consumer, you've probably heard us say on other calls that our big barometer is always unemployment. And unemployment has been consistently low. Yes, the interest rates have risen, but they've been high now for a while. So we don't see any change other than maybe people are disappointed that they're not coming down as fast."
},
{
"speaker": "",
"content": "So yes, and there's -- we all know that student loans started to restart as well. So there's other pressures on the consumer. The credit card debt is rising, delinquencies are rising. We're all looking at the same data, but that's going to be translating down into consumption for our products. You've seen the first 4 months of the year."
},
{
"speaker": "",
"content": "I think that's probably because of -- it's got -- you have to go category by category and brand by brand. So like I said earlier, I do think we're well positioned for the remainder of the year. Yes, what was the first part of your question?"
},
{
"speaker": "Anna Lizzul",
"content": "Just wondering if you're seeing broad trade down. You mentioned some in laundry, any other categories?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Well, look, the predominant portion of our portfolio that is valued is laundry and litter. And in laundry, we have -- obviously, we have ARM & HAMMER, but we also have XTRA, an XTRA group in the first quarter, it was in my prepared remarks. So we feel real good about that. And that may be an indication of more pressure on the consumer when you see the deep value brand growing."
},
{
"speaker": "",
"content": "And then over in litter, yes, we have both a high-priced litter, meaning premium litters, we call it the black box. And we have the orange box, which is value. So we keep people in the category. So-- people may trade down, but they'll trade down within ARM & HAMMER, which actually supports our top line."
},
{
"speaker": "",
"content": "So like I said before, we have some good dynamics in those 2 big categories that we think are going to help us for the remainder of the year."
},
{
"speaker": "Operator",
"content": "Our next question will come from Bonnie Herzog with Goldman Sachs."
},
{
"speaker": "Bonnie Herzog",
"content": "All right. I had a quick follow-up on Laundry. Curious to hear how you guys think about managing the balance between driving share and profitability? I guess I'm thinking about it as you step up trade spend and also as you -- especially as you look at it in the context of curtailing some of the ineffective promos you mentioned earlier."
},
{
"speaker": "Richard Dierker",
"content": "Bonnie, it's Rick. I just want to be really, really clear. In Q4 of last year, we didn't repeat some bad promotions. And that carried over a little bit into January, and then we were pretty [ palms up ] about that."
},
{
"speaker": "",
"content": "We have a great balance between what we think the right trade spending is and the right growth. And we're just getting back to what we would say was normal before we kind of called some of those bad promotions. So it's not like we're hiking up trade spend to the above category levels or anything like that. We are just pumping it back from an artificial low."
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Our practice generally is we're generally below the category average and liquid laundry from a sold on deal perspective."
},
{
"speaker": "Bonnie Herzog",
"content": "Okay. That's helpful. And then I just had another question on international business. Your sales growth in the quarter was quite strong at nearly 9%, and the growth really seems pretty broad-based and balanced. So just curious to hear, how much of the volume growth was driven by distribution expansion versus just maybe strengthen your existing markets?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. I think one of the things to point to in international and you're right that all 6 subsidiaries grew as well as the GMG. So clearly ran the table. But what we're seeing the benefit of is that we're being very selective about what brands we're going to support and what retailers we want to grow with."
},
{
"speaker": "",
"content": "And we're leveraging revenue growth management far more than we had historically. And that's true in the last [ 18 ] months, and it's really showing up in the first quarter. In the past, you may have heard us talk about Global Markets Group, it's grown 15% annually for a lot of years as well. And they -- there was a Global Markets Group that generally would be driving the international number. Well, that's not true in Q1."
},
{
"speaker": "",
"content": "Q1, it's subsidiaries that are driving it. And it's for those 3 reasons that I gave being selective with respect to brand, with respect to retailer, and using all the tools of revenue growth management."
},
{
"speaker": "Richard Dierker",
"content": "Yes. The second thing that's helping international is a couple of these new brands, HERO and THERABREATH. And typically, it takes us 2 to 3 years to get new brands, new acquisitions out internationally, and we're doing it rapidly, and there's been a great response to many countries and many distributors for those brands."
},
{
"speaker": "Matthew Farrell",
"content": "Yes. We think that will build throughout the rest of the year. But that's a nice tailwind on top of what I said in my earlier remarks."
},
{
"speaker": "Operator",
"content": "Our next question will come from Olivia Tong with Raymond James."
},
{
"speaker": "Olivia Tong Cheang",
"content": "I wanted to ask you about the GRAPHICO acquisition and what drew you to that? Is there other markets that have distributor relationships? And does that seem like an area where you may be interested in more deals? And then just on thoughts on your -- on the M&A environment overall, particularly in goods, what you're seeing and interest there?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Well, if you go back a few years, the way we got established in Germany was, we had a very small distributor that had introduced BATISTE into Germany. And that while, that being the basis for starting a very small subsidiary in Germany, which has grown over time. This one is different in that, GRAPHICO is a public company in Japan, obviously, a micro cap."
},
{
"speaker": "",
"content": "But they have been working with OXICLEAN for 25 years, even before that Church & Dwight bought the business back in 2008. And they have a very capable team that's driven the brand to be number one, prewash, additive, and powder and Japan. And so we benefit them from getting just [ buying ] a critical mass of talent in Japan and now we can introduce our other products into Japan."
},
{
"speaker": "",
"content": "Keep in mind is when you're -- oftentimes, we have multiple distributors in a country because some distributors are households, some are personal care, they're experts in different areas. And this enables us to concentrate our brands through one subsidiary."
},
{
"speaker": "",
"content": "Will there be other distributors in Japan? Yes, there could be a couple of others, but this is one where we can have a base of operation. We should have a -- this should be a really big business for us given the size of the economy and the population of Japan, but also its a really nice beachhead for us in Southeast Asia from which to grow. So we're really enthusiastic about it. We've got a great team that we're -- that's coming on board as a result of this acquisition."
},
{
"speaker": "Olivia Tong Cheang",
"content": "And then just thinking through about the M&A environment overall?"
},
{
"speaker": "Matthew Farrell",
"content": "Well, look, you know we're always on a hunt. Its the highest and best use of cash for the company, where we have a disproportionate amount of our cash that goes towards acquisitions. And there's always something for sale, but that's about as far as I can go right now."
},
{
"speaker": "Olivia Tong Cheang",
"content": "Great. And then just one on -- following up on Bonnie's question around promotion. You talked about it continuing to creep up, but still obviously well below pre-COVID norms. Is your expectation that it does get back there or just continue to show creep through the year? And then on the couponing, still point of clarification, is this more than normal or more a function of the timing of new products and the trial building couponing that goes with that to support the launch?"
},
{
"speaker": "Richard Dierker",
"content": "Yes. That's really more on your second question, it's more of your second explanation. It's incremental couponing to support higher and more new products is the short story. On the -- on your first question on amount of promotion and really trade spend. I think it's -- same that we told Bonnie. It's -- the forward look for promotion for laundry is always dependent upon how category growth is doing. And if category growth is stable, then normally, promotion stays in line. And right now, category growth is great."
},
{
"speaker": "Matthew Farrell",
"content": "Yes, one thing to keep in mind, [ Bonnie ], is -- all its price increases that went through the last couple of years, they were really unusual for all CPG and food companies. So yes, that does obviously make it more expensive for the product, but didn't necessarily expand gross margins for people."
},
{
"speaker": "",
"content": "So yes, I don't -- like Rick said, we have to react to what's going on in the category. So you can't really predict or we're certainly not going to telegraph what we might be -- our plans might be for the remainder of the year."
},
{
"speaker": "Operator",
"content": "Our next question will come from Lauren Lieberman with Barclays."
},
{
"speaker": "Lauren Lieberman",
"content": "I was curious in thinking about the gross margin progression from here and for the rest of the year. One of the things you called out with regard to sales slowing down, particularly starting next quarter, was that lapping on distribution gains from HERO? So I was just -- what we can see in Nielsen, which I know isn't representative of the full distribution of the brand. Is that like, let's call it, same-store sales still really, really strong?"
},
{
"speaker": "",
"content": "But is some of the slowing down that's implied in HERO also impacting that gross margin forecast going forward? Because I imagine and we know it's super accretive. And so I just want to think about -- talk about how to think about the contribution of HERO to that gross margin build as we move from here and start to lap the distribution?"
},
{
"speaker": "Richard Dierker",
"content": "Yes. No problem, Lauren, this is Rick. That isn't really in our thinking as we move forward. The 2 things that are driving gross margin to maybe not grow as fast would be less carryover pricing, and I know what I talked about from the organic revenue side, too. So we're fully through all the carryover pricing."
},
{
"speaker": "",
"content": "And then number two, we talked about it during our Analyst Day in January, we're adding more fixed cost to the system for capacity reasons, like new distribution centers, those are coming online as we move through the year. So those are the 2 things."
},
{
"speaker": "Operator",
"content": "Our next question comes from Javier Escalante with Evercore ISI."
},
{
"speaker": "Javier Escalante Manzo",
"content": "I do have a follow-up on the gap between retail sales that we see and the reported domestic number. You flagged WATERPIK as a point of impact. But we use [Ocana] and I believe that you guys do too. And the retail takeaway is more about 7%, 8%. And so there is a little bit of still kind of like a 2-point gap. Do you think that it's related to a slow retailer reorders as your competitor in laundry mentioned earlier in the season? And I have a follow-up."
},
{
"speaker": "Richard Dierker",
"content": "Yes. Are you comparing Q1 when you're -- for your question, Javier?"
},
{
"speaker": "Javier Escalante Manzo",
"content": "Correct. Yes. Correct. Exactly. Correct. Just trying to understand whether is this something of the accounting of the couponing or something weird that basically we are overstating your retail sales growth and therefore, your shipment growth?"
},
{
"speaker": "Richard Dierker",
"content": "Yes, I got it. No. It's interesting. I know we all have similar databases. Our -- internally, our shipment number, of course, is [ organic sales ] is 4.3%. And then IRI, our number is around 6%. So our gap is closer to 1.5%. Part of that is the couponing. Part of that is the water pit consumption that we've talked about working through retail inventory. And yes, I mean, those are the 2 biggest pieces."
},
{
"speaker": "Javier Escalante Manzo",
"content": "And when it comes to the gross margin getting better than expected, and I know that price mix was an issue -- was the driver. Is it more kind of like the change in the portfolio, meaning richer sales from HERO and THERABREATH, what was the driver of the better gross margin are there for the earnings bit?"
},
{
"speaker": "Richard Dierker",
"content": "Yes. That's a good question. I think it was really the 2 things. It was -- mix was a little bit more helpful and volume was helpful. I mean price came in as expected. Manufacturing costs came in as expected, productivity was in line. So it was really higher volumes, which help with throughput and efficiencies and then a little bit favorable mix."
},
{
"speaker": "Operator",
"content": "Our next question will come from Filippo Falorni with Citi."
},
{
"speaker": "Filippo Falorni",
"content": "I want to follow up to your point of the cycling of the distribution gain for HERO and maybe extend it to THERABREATH as well. Can you comment like how much incremental shelf space are you getting this year compared to last year in the U.S? And then I think at CAGNY, you talked about more international opportunities for those brands. So maybe can you give us some sense of the potential contribution from international?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Okay. When you think about THERABREATH and HERO, THERABREATH, we bought that business in 2021. And HERO in 2022. So for THERABREATH, resets this year, we're getting more doors. But I would expect that the distribution gains from a number of doors perspective is going to plateau for THERABREATH this year, and that we're going to be getting -- the way to look for distribution gains in the future are going to be more facings."
},
{
"speaker": "",
"content": "And we are seeing that already from some existing retailers where we already have good distribution, but maybe not the amount of facings -- we deserve. And then innovation, which will, so I think more facings and innovation are going to drive future growth for THERABREATH once we plateau with respect to the number of doors. For HERO, since we've owned that a little bit less a year less than THERABREATH, there's still some distribution gains to come with some decent-sized retailers."
},
{
"speaker": "",
"content": "But we expect this the same thing to happen. But with respect to HERO, what we'll be starting to do is start to move from just patches and acne into adjacent consumer needs, such as skin care, pre and post acne. And you mentioned international. So international is an area where we're running to launch HERO and THERABREATH. HERO, we're planning on launching in 40 countries in 2024, and that will happen throughout the year."
},
{
"speaker": "",
"content": "And then, of course, the sales growth will start to build in future years. But I think the other thing that's probably worth pointing out is that both HERO and THERABREATH are high rank products. And so if you're a retailer, you really like a high rank product which is a growing brand. And consequently, you do want to give that brand more facings and listen to innovation. So we think the dynamics for each of those brands are going to bode well for growth not only in 2024, but in 2025."
},
{
"speaker": "Operator",
"content": "Our last question will come from Brett Cooper with Consumer Edge Research."
},
{
"speaker": "Brett Cooper",
"content": "I was hoping to dig more into the HERO business in the U.S. So distribution is up significantly, making sort of the underlying read of demand a bit difficult. So I was hoping you could click one level below and say, and talk about what we're seeing with respect to existing consumer demand, new users, trial and repeat and other drivers?"
},
{
"speaker": "Matthew Farrell",
"content": "Yes. Could you -- I didn't hear the first part of your question, I'm sorry."
},
{
"speaker": "Brett Cooper",
"content": "Just -- it's the HERO business in the U.S., right? So huge distribution gains, right? So you see significant sales growth. So just trying to understand, I guess, one level below, kind of what you see from consumers that have been in the business for a while and then what you're seeing with respect to new users, trial and repeat and any other drivers on the sales growth?"
},
{
"speaker": "Matthew Farrell",
"content": "Look, the volumes for this business continue to grow. So it's not a price-driven business. And the awareness in household penetration is still ahead of us for this brand. You may remember that when the -- back in -- before patches hit the scene, it was really ointments and lotions et cetera, that people were using to address acne."
},
{
"speaker": "",
"content": "It's patches now that are driving the category. And our ability to grow is going to be going into adjacencies."
},
{
"speaker": "Richard Dierker",
"content": "And I would probably say in all channels, we are growing and have positive growth even in channels that are declining because of some maybe macro or secular trends. So that bodes well for this brand."
},
{
"speaker": "Operator",
"content": "That will conclude today's question-and-answer session. I will now turn the conference over to Mr. Farrell for any additional closing remarks."
},
{
"speaker": "Matthew Farrell",
"content": "Well, thanks for joining us today. We had a great quarter. So let's see everybody in July."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference call. Thank you for your participation. You may now disconnect."
}
] |
chrw | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good afternoon, ladies and gentlemen, and welcome to the C.H. Robinson Fourth Quarter 2024 Conference Call. At this time, all participants are in a listen-only mode. Following the company's prepared remarks, we will open the line for a live question-and-answer session. [Operator Instructions]. As a reminder, this conference is being recorded, Wednesday, January 29, 2025. I would now like to turn the conference over to Chuck Ives, Senior Director of Investor Relations."
},
{
"speaker": "Chuck Ives",
"content": "Thank you, Shamali, and good afternoon, everyone. On the call with me today is Dave Bozeman, our President and Chief Executive Officer; Michael Castagnetto, our President of North American Surface Transportation; Arun Rajan, our Chief Strategy and Innovation Officer; and Damon Lee, our Chief Financial Officer. I'd like to remind you that our remarks today may contain forward-looking statements. Slide 2 in today's presentation risk factors that could cause our actual results to differ from management's expectations. Our earnings presentation slides are supplemental to our earnings release and can be found in the Investors section of our website at investor.chrobinson.com. Our prepared comments are not intended to follow the slides. If we do refer to specific information on the slides, we'll let you know which slide we're referencing. Today's remarks also contain certain non-GAAP measures, and reconciliations of those measures to GAAP measures are included in the presentation. And with that, I'll turn the call over to Dave."
},
{
"speaker": "Dave Bozeman",
"content": "Thank you, Chuck. Good afternoon, everyone, and thank you for joining us today. I'd first like to acknowledge the challenges that many people are facing due to the severe weather and natural disasters in certain regions of the country, including the recent wildfires that damaged and destroyed many homes and businesses in the Los Angeles area. Our thoughts are with everyone who has been impacted, and we extend our gratitude to the first responders who worked tirelessly to keep people safe. I'm proud of the support that our company and our employees provided to help those in need as well as our customers. Turning to our fourth quarter. We've talked extensively over the past year about our new Robinson operating model and the disciplined execution that the model is enabling as well as how we're leveraging our industry-leading talent and technology to raise the bar in logistics. The benefits of these efforts were never more evident than in the significant year-over-year improvement in our Q4 financial results. In what continues to be a historically prolonged freight recession with market growth in 2024 that did not materialize as had been projected, the difference in our execution versus last year is stark. Our people are embracing the discipline needed to generate higher highs and higher lows across market cycles, resulting in a higher quality of volume, greater productivity and expansion of our gross profit and operating profit margins. In a trucking environment, where the cost of purchase transportation increased in Q4 due to a decline in industry capacity, our dynamic costing and pricing tools, our revenue management practices and our cost of higher advantage enabled us to provide greater value to our customers and at the same time, improve our NAST gross margin both year-over-year and sequentially. In our Global Forwarding business, the team has debunked the thesis that Robinson couldn't continue to improve productivity when volumes are growing. Throughout 2024, I've been impressed with and highly appreciative of the team as they continue to be nimble and highly engaged with our customers to help them navigate various market disruptions and to provide differentiated service and solutions. As a result, our ocean and air shipments grew each quarter on a year-over-year basis and each grew more than 5% for the full year. Through improvements in process standardization and automation and embracing the rigor of our operating model, the forwarding team decoupled headcount growth from volume growth, reduced their average headcount for the year more than 10% and achieved productivity improvement of greater than 15% for the full year. Over the two-year period of '23 and '24, we delivered compounded productivity growth of 30% or more in both Global Forwarding and NAST. And as we said at our Investor Day in December, we view our productivity as evergreen improvements that we do not expect to give back. Enabled by the operating model disciplines and tools that are being applied across our company, we expect to further advance our productivity as we grow our businesses, including both NAST and Global Forwarding. The productivity improvements have lowered our cost to serve and increased our operating leverage. Combined with our expanded gross margins, this resulted in a 79% year-over-year increase in our enterprise's Q4 adjusted income from operations. I want to thank our people, one of our greatest competitive advantages for their relentless efforts to embrace our new operating model and execute in a fit, fast and focused way as we keep pushing the bar higher on exceptional service to our customers and carriers, and on financial performance across market cycles. Our new operating model has changed how we discover and expect root cause issues and quickly implement countermeasures to improve the level of our operational execution. The reliability of our operating reviews continues to increase as we leverage our data-rich environment to inform our decision-making and enhance our competitive differentiation. This is showing up in improvements such as more disciplined pricing and better decisions on the volume that we're seeking. We are still early in our journey. But the operating model is helping us execute a solid strategy even better, and we expect further improvement as the accountability that the operating model demands is embraced deeper in the organization. I'm confident in the team's ability to drive a higher and more consistent level of discipline in our operational execution. As freight markets continue to fluctuate due to seasonal cyclical and geopolitical factors, we continue to remain focused on what we can control, including deploying our operating model and lean principles across the company, providing best-in-class service to our customers and carriers, gaining profitable share in targeted market segments and leveraging game-changing Generative AI to improve our service, workflows and cost at scale, not in theory. We also continue to focus on ensuring that we'll be ready for the eventual freight market rebound with a disciplined operating model that responsibly grows market share, further decouples headcount growth from volume growth, drives additional operating leverage and generates incremental operating income. I'll turn it over to Michael now to provide more details on our NAST results."
},
{
"speaker": "Michael Castagnetto",
"content": "Thanks, Dave, and good afternoon, everyone. In Q4, we delivered further optimization of our NAST volume, our gross profit margin and our adjusted gross profit per shipment resulting in a 40% year-over-year increase in our adjusted operating income. From a volume standpoint, the market continues to be in a prolonged freight recession, as Dave mentioned. The Cass Freight Shipment Index in Q4 was down 3.2% year-over-year and down 4.8% sequentially, and it was the lowest Q4 reading the industry has seen in the last 15 years. At the same time, the truckload linehaul cost per mile, excluding fuel surcharges, increased due to a decline in industry capacity. Our resilient team of freight experts responded to the challenging freight environment by improving the quality of our volume with pricing discipline and a cost of higher advantage delivered by our procurement teams and the growing usage of our digital brokerage capabilities. All of this led to an improvement in the AGP yield within both our transactional and our contractual truckload business and 170 basis point year-over-year improvement in our NAST gross margin. Supported by our operating model and armed with innovative tools, our team also delivered a sequential improvement in NAST gross margin and truckload AGP dollars per shipment, despite the rising cost of purchase transportation. From a volume perspective, our total NAST volume declined approximately 1% year-over-year, outpacing the index for the seventh consecutive quarter. This included a 2.5% increase in LTL volume and a 6.5% decrease in truckload volume. Our team is continuously testing the best combination of volume and margin to improve our earnings. We know we have the optionality to increase our volume when the conditions are right, and we are ready to pivot when it makes sense to do so, but we're going to maintain our discipline. From a market balance perspective, we continue to be in a drawn-out stage of capacity oversupply, although carrier attrition is occurring and moving toward better balance each quarter. Due to a seasonal decline in capacity, the dry van load-to-truck ratio and spot rates experienced some upward pressure during the holiday season and the subsequent winter storm similar to last year. But the load-to-truck ratio and spot rates are expected to return to preholiday levels once the storms abate. What stands out is that our execution is markedly different than last December and January as we're making better decisions on the optimal freight for us and making better use of our proprietary digital capabilities. In our LTL business, the 2.5% year-over-year increase in our Q4 shipments was driven by strength across several of our LTL services. By leveraging our vast access to capacity, our broad range of LTL services and solutions and our high level of customer service, our LTL team continues to onboard a solid pipeline of new business and build on our existing LTL business that exceeds $3 billion in annual revenue. Looking ahead to Q1, it is typically a seasonally weaker quarter compared to Q4, with the 10-year average of the Cass Freight Shipment Index, reflecting a 2.5% sequential volume decline from Q4 to Q1. As Dave said, regardless of market conditions, we remain focused on what we can control. Our people and their unmatched expertise enable us to deliver exceptional service and greater value to our customers and carriers. In line with the disciplined and focused approach to capture growth opportunities in targeted customer segments, such as small and medium businesses, we have invested in our sales organization, and we will continue to deliver industry-leading solutions to customers and carriers. As recently announced, one of those solutions is the introduction of C.H. Robinson Financial, an innovative digital payment solution for carriers that is aimed at setting a new standard of speed and efficiency unmatched by any other freight provider. It marks a significant leap forward in fostering financial stability and streamlining operations for carriers. As Dave called out earlier, I also want to take a moment to thank the NAST team for their incredible work in 2024. Our performance and improvements throughout the year reflect their commitment to our customers, carriers and each other. Through their continued engagement with the C.H. Robinson operating model, our people are delivering improved results in a very difficult marketplace, and I am proud to lead this team. I'll turn it over to Arun now to provide an update on the innovation we're delivering to strengthen our customer and carrier experience and improve our AGP yield and operating leverage."
},
{
"speaker": "Arun Rajan",
"content": "Thanks, Michael, and good afternoon, everyone. As I mentioned at our Investor Day in December, C.H. Robinson is in prime position to disrupt from within to lead the industry forward in a way that others cannot match. The innovations that we bring to the industry and our customer supply chains, such as automation powered by Gen AI have a market-wide impact due to our size and scale. And we are not just talking about doing this. We are already doing it for thousands of global customers. As an example, with our proprietary technology that reads, classifies and response to incoming e-mails, we've been able to automate more than 10,000 transactions per day. This automation across the quote-to-cash life cycle of an order, whether it be quoting, order entry, low tenders, appointment scheduling, other manual tasks, enables us to reduce our response times and provide a better and more uniform experience for our customers and carriers. It also creates business model scalability, thereby enabling us to decouple headcount growth from volume growth and to create greater operating leverage. In the fourth quarter, as throughout 2024, we continue to scale our process innovations and our use of Gen AI. After utilizing Gen AI to automate orders that are tendered via e-mail, the automation of our order tenders increased 1,150 basis points compared to Q4 of last year and 440 basis points sequentially. And while the automation of this process has now reached nearly 90%, the other points in the order life cycle have more runway for improvement. The increased automation in our order entry process and other points in the order life cycle enabled us to increase our NAST and Global Forwarding shipments per person per day by more than 30% over the two-year period of 2023 and 2024. And although our productivity improvements will continue to compound at these levels, we expect to continue increasing our productivity in 2025 and beyond to create further operating leverage. We also continue to increase the rigor and discipline in our pricing and procurement efforts, resulting in improved AGP yields across our portfolio. With continued innovation in our digital brokerage and dynamic pricing and costing, we're responding surgically and faster than ever to dynamic market conditions by performing more frequent price discovery and enhancing the quality of the pricing that we deliver. Along with our operating model, this was a major contributor for the year-over-year improvement that we achieved during the seasonal market tightness and throughout 2024. But as I also said at our Investor Day, a digital-only approach has proven to be ineffective in the logistics industry due to the level of complexity and variation in freight characteristics that necessitate human expertise. The active role that our people play from a human-in-the-loop perspective leverages their deep domain expertise and drive feedback to our algorithms on a regular basis in the form of export market adjustments. And through our revenue management discipline, our teams are armed with intelligence on targeted countermeasures that they can take to implement a disciplined pricing strategy based on individual customer value propositions. Ultimately, we are innovating and disrupting from within to deliver on 3 items that are key to our strategy, transforming the customer and carrier experience to drive growth, delivering business model scalability and driving gross margin and operating margin expansion. With that, I'll turn the call over to Damon for a review of our fourth quarter results."
},
{
"speaker": "Damon Lee",
"content": "Thanks, Arun, and good afternoon, everyone. As covered by Dave and the team, we delivered significant year-over-year improvement in operating income in Q4, driven by an increase in AGP while reducing cost through our operational discipline and productivity initiatives and thereby driving higher operating leverage. In the face of continued soft market volume and rising spot costs due to declining capacity, disciplined procurement of capacity and revenue management improved the quality of our volume and our AGP, which was up $66 million or 10.7% year-over-year, driven by a 25.6% increase in Global Forwarding and a 6.2% increase in NAST. On a monthly basis, compared to Q4 of last year, our total company AGP per business day was up 9% in October, up 6% in November and up 12% in December. From an expense standpoint, our total operating expenses, excluding restructuring charges, declined $15.3 million year-over-year. Q4 personnel expenses were $354.4 million, including $3.7 million of restructuring charges related to workforce reductions. Excluding restructuring charges in the current and prior year, our Q4 personnel expenses were $350.6 million, down $12.5 million due to our continued productivity and cost optimization efforts and despite an increase in incentive compensation related to our improved financial results. Our average Q4 headcount was down 9.5% compared to Q4 of last year. Moving to SG&A. Q4 expenses were $146.4 million, including a $12.6 million decrease in the loss related to the planned divestiture of our European Surface Transportation business and $9.5 million of other restructuring charges, primarily related to reducing our facilities footprint. Excluding these, SG&A expenses were $149.6 million, down $2.7 million year-over-year with the expense reduction across several expense categories. Turning to our 2025 annual operating expense guidance, we expect our personnel expenses to be $1.375 billion to $1.475 billion. This includes some headcount decline including those related to the planned divestiture of our Europe Surface Transportation business and driven by continued productivity improvements, partially offset by investments in our team as we reward the talented people that fuel our progress. We expect 2025 SG&A expenses to be $575 million to $625 million, including depreciation and amortization of $95 million to $105 million. Although most of our SG&A expenses are subject to inflation, we expect continued cost improvements to partially offset the inflationary impact. Shifting back to Q4. Our effective tax rate for the quarter, excluding the tax impact of restructuring charges, was 12.4%, resulting in a full year tax rate of 18.7%. We expect our 2025 full year effective tax rate to be in the range of 18% to 20%. Our capital expenditures in Q4 were $15.2 million, bringing our 2024 total to $74.3 million. For 2025, we expect capital expenditures to be $75 million to $85 million. From a balance sheet perspective, we ended Q4 with approximately $1.2 billion of liquidity comprised of $1.04 billion of committed funding under our credit facilities and a cash balance of $146 million. Our financial strength continues to be a key differentiator in our industry as it enables us to continue investing and improving our capabilities. Our debt balance at the end of Q4 was $1.38 billion, and our net debt to EBITDA leverage at the end of Q4 was 1.61x, down from 2.08x at the end of Q3. This was primarily driven by the improved performance of the business, and the resulting increase in our trailing 12-month EBITDA as well as a decrease in our net debt balance. Overall, Our Q4 financial results are a testament to our disciplined execution and our focus on profitable growth, and I am optimistic about our runway for further improvement. With that, I'll turn the call back to Dave for his final comments."
},
{
"speaker": "Dave Bozeman",
"content": "Thanks, Damon. As I reflect on the noteworthy progress that we made in 2024, I'd like to thank the Robinson team for all the work they've put in to get to this point. I don't take their efforts and dedication for granted, and I commend them for helping us get more fit, fast and focused and for embracing the discipline that the new operating model demands. Our improved execution at the bottom of the freight cycle is delivering improved financial performance. We're making better and faster decisions on capturing the right freight at the right price to deliver a higher quality of volume. I believe the disciplines and practices that we have implemented at Robinson can endure through a prolonged freight recession through a market inflection and through any part of the freight cycle. As I've mentioned during the past year and at our Investor Day in December, all the changes we're making are aimed at our North Star of generating incremental operating income by focusing on growing market share and expanding our gross and operating margins. We expect to continue growing market share by reclaiming share in targeted segments and by leveraging our robust capabilities to power value-added services and solutions for our customers and carriers that drive new volume to our 4 core modes and expand our addressable market. We are optimizing our gross profit by monitoring key input metrics and responding faster to error states and changing market conditions with counter measures and innovative technology that improves our execution such as our dynamic costing and pricing tools and our digital brokerage capabilities. And we're improving our operating leverage and operating income margins by embedding lean practices, removing waste and expanding our digital capabilities, such as leading the logistics industry on implementation of the game-changing capabilities of Gen AI. We are arming our people with better tools and moving with greater clock speed and urgency to seize opportunities and solve problems in order to win now and to be ready for the eventual freight market rebound. On my first earnings call in August of 2023, I said that I look forward to leading this great company to new heights and sharing our progress with all of you along our journey. While there's still more grass to cut, I believe we're on the right path, and I'm pleased with the progress we've made on evolving our strategy and improving our execution by instilling discipline with our new operating model. This concludes our prepared remarks. I'll turn it back to the operator now for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions]. Our first question comes from the line of Chris Wetherbee with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Chris Wetherbee",
"content": "Yes, hi, great. Thanks. Good afternoon, guys. I guess I wanted to kind of just make sure that I understood the approach that you're taking to the market as it stands today. So at the Investor Day, you outlined gross margin opportunities, also some productivity opportunities on operating margin expansion. And I think while you outperformed the market from a volume standpoint in NAST, I guess, TL was down in that 6.5% range. So I guess I just want to make sure I get some clarity on how do you think about those separate opportunities of the gross profit margins and then ultimately, the operating margins as we're in this type of market. So I guess, how should we expect you to try to balance those priorities, particularly as we turn over into 1Q and 2Q where maybe we're seeing some recovery, maybe we're not? It's still a little bit unclear."
},
{
"speaker": "Dave Bozeman",
"content": "Yes. Hi, Chris. This is Dave. Good to hear from you, and good to see you at Investor Day. A number of things in what you said there, is certainly still is a very tough market out there for us, which is why I'm really proud of the team in how they're really navigating the waters here within NAST. I'm going to have Michael go a little bit deeper into the team and where you're getting at. And then we can also circle back to it as well when he's done it. We don't double quick enough on it. But Michael, let's go a little bit further on that one."
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. Thanks, Chris. I think you called out really what we're trying to make sure we accomplish, which is the quality of volume that we manage and execute for our customers and carriers. And Q4 continued to be a very competitive marketplace where demand is just not where the market needs it to be. And with that in mind, we're prioritizing, making sure that we hold the right freight that we deliver a very high level of service. And through the tools that we've implemented we were able to expand our gross margins in a rising cost market, which was a challenge we really set out for ourselves during some of the work you saw us talk about at Investor Day. And so really, to Dave's point, proud of the work the team did. Certainly, as we head into Q1 and Q2, we would want to share the same sentiment that you have that, hopefully, those shoots of volumes start to come forward. But even then, we're going to still maintain that discipline that we price things correctly, we haul the right freight, we meet our customer service expectations and we deliver strong bottom line numbers as a result."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Chris. And then again, just to put a period on that, it's really about that flexibility with our model and where we're going. If we start seeing this thing inflect, Michael and team and the rest of the team across Robinson, as we said in Investor Day, we are prepared with the flexibility for when this market starts to come back, and again, driving that higher lows, if it's steadier throughout the year, we're prepared to continue to deliver what you're seeing here. So thanks for the question."
},
{
"speaker": "Chris Wetherbee",
"content": "Appreciate it. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Bascome Majors with Susquehanna International Group. Please proceed with your question."
},
{
"speaker": "Bascome Majors",
"content": "Thanks for taking my question. We're a couple of months removed from when you put the plan together to share with us in December. Just curious if you could walk through some of the cyclical puts and takes on the path to '26 as you feel today? And if there's any other leanings in either direction on any of your businesses compared to what we heard in early December? Thank you."
},
{
"speaker": "Damon Lee",
"content": "Hi, Bascome. This is Damon. Look, certainly, Investor Day was a good event for us. I think our message came across loud and clear. We feel good about the targets we laid out in Investor Day and the mix of those targets between businesses and initiatives. So I would say there's not been any pivot or change from our position on how we laid out Investor Day in December and what we see today. So again, we feel good about the targets we laid out. We feel good about the path, in which we will deliver those targets. And you're touching on an exact reason on why we gave a range for the market, right? No one knows what the market is going to be between now and 2026. But we're going to control what we can control and keep the discipline. And as Michael mentioned, the focus on the quality of volume. And I think all of that will certainly line up to delivering those 2026 goals, the way we laid them out in December."
},
{
"speaker": "Bascome Majors",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ariel Rosa with Citigroup. Please proceed with your question."
},
{
"speaker": "Ben Mohr",
"content": "Hi, yes, this is Ben Mohr on for Ari. Thanks so much for taking our call. Great to see you guys at the Investor Day. On your two key areas for revenue growth, you mentioned enterprise versus SMB markets. What would you say you're in, in terms of inning for both of those? Is it more like seventh inning for enterprise, but a whole lot more like third inning for SMB? And then on your cross-selling opportunity as your second area, you noted 20% of Global Forwarding AGP growth comes from relationships that began at NAST and there could be more runway. How much opportunity is left from this cross-selling across your segments, would you say you're in the third inning there. I'd like to hear your thoughts on both these areas of growth?"
},
{
"speaker": "Michael Castagnetto",
"content": "Yes, Ben, this is Michael. Thanks for the question. I think the broad answer to everyone…"
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, it seems like we may have technical difficulties. Please stand by. [Technical Difficulty] Ladies and gentlemen, we do have the speakers back in. We will now proceed with the Q&A session."
},
{
"speaker": "Michael Castagnetto",
"content": "Ben, I think we'll re-answer. I think we cut off after your question. Your question was really what inning are we in our -- we gave some examples of verticals, you asked about SMB and then you also asked about the cross-selling opportunity. And overall, I'd say we're in early innings in all aspects of that business. We believe while we've done business in certain verticals for a long time and SMB is something that is core to our history and something we've done for a long time that we have a lot of runway in front of us in those areas to grow, but also to move up the value stack and deliver more and more capabilities and services to our customers. As you think about then that next stage of cross-selling, whether it's NAST to GF, GF back to NAST or the example we gave with our RMS announcement right before Investor Day of bringing those two teams together. We have a tremendous opportunity in front of us to maximize the value of one Robinson. And certainly, while we've seen the benefits of that, there's no way we could say that we've maximized that opportunity. And so we feel really good about what we presented back in December and feel really aligned to those opportunities. And more importantly, we're going to hold ourselves accountable to maximize the impact of the different aspects of our divisions and make sure we bring the full scale and capabilities of Robinson to all of our customers."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Ben, and sorry for that interruption there. The only period I put on that on what Michael said, I just came off the road, I'm talking to the teams and they are really fired up on this. This certainly is early innings of this game. But from an SMB perspective, these guys are going out and getting it. We feel really good to Damon's question and answer to Bascome earlier, we feel really good about what we've laid out on this growth trajectory and the team is really aligned and Michael and team are doing a nice job on driving that accountability. So thanks for the question. And again, I apologize to everyone for the disruption."
},
{
"speaker": "Ben Mohr",
"content": "Great. Thanks so much for the color."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Brian Ossenbeck with JPMorgan. Please proceed with your question."
},
{
"speaker": "Brian Ossenbeck",
"content": "Good afternoon. Thanks for taking the question. So I guess maybe for Michael, can you just give us some color if you can about maybe demand or indications of demand across any particular verticals and customers that you're speaking with? And then also along with those lines where you think we're sort of starting off the year within the bid season as things start to get ramped up here?"
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. Thanks, Brian. I think what we saw in Q4 was a continuation of a marketplace that had very high adherence to route guides, a very, very competitive transactional space. And the team did a really nice job of really weaving through that for the best results we could deliver. An example of that is we feel really good about the health of our contractual business, our wins as we're going into those RFPs, saw -- we beat the Cash Shipment Index in our contractual space in Q4. So really lining up to that concept of the optionality we discussed earlier of making sure that when we're engaging customers directly on their business where we can bring the value proposition of Robinson to the table, we're winning. And then we're being really smart about the transactional business, we're winning on a day-to-day basis where incumbency has less value. And we aren't going to see the long-term benefits of getting super aggressive in that space based on the current market. You asked about kind of moving into Q1. Q1 is a traditionally heavy RFP space. And I'll just keep saying what I said about Q4 is we feel good about the strategy we have from a how we're engaging customers, our pricing strategy for that space. But we're not -- I wouldn't say we're seeing uptick yet in the overall demand in those RFPs. It continues to be a marketplace that's -- we're seeing impact of carrier exits, but we're not seeing impact of demand increases at this point."
},
{
"speaker": "Brian Ossenbeck",
"content": "Okay. Appreciate that Mike. Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Tom Wadewitz with UBS. Please proceed with your question."
},
{
"speaker": "Tom Wadewitz",
"content": "Yes, great. Good afternoon. I wanted to see if you could offer some thoughts about -- and I apologize if I missed this earlier, but how do you think about truckload volume growth in '25? Do you think that's something that you transition to in second half? I guess you have to have under -- maybe your underlying view on how the market progresses. But do you think we should be optimistic that you get into that? And then I guess another component of that would be, you did have some weakness in truckload volume in 4Q focused on kind of the right loads and everything. When the market starts to tighten, do you think you get a bigger swing, a significant swing in the truckload volumes or do you think that's going to tend to be gradual?"
},
{
"speaker": "Michael Castagnetto",
"content": "Yes, Tom, thanks for the question. I think we want to make sure we continue to reiterate the optionality that we feel we have in truckload volume right now. We're taking a very disciplined approach for what volume is the right volume for us in the current marketplace. I don't think anyone on this call would give you a crystal ball of what we think is going to happen in 2025 from a volume perspective. I think everybody in our industry has been trying to predict that for the last 36 months. And it keeps extending. But I feel really good that when the market inflects, we will have the tools and the talent to maximize the impact of that inflection. We saw it seasonally in Q4 and then with the storms that happened again this January. And we said it in our prepared comments that our performance was markedly different and that I just couldn't be more proud of the team in how they managed a situation where seasonal cost increases, storm-related events and we're handling that in a much more disciplined and effective manner."
},
{
"speaker": "Tom Wadewitz",
"content": "What about when you see the swing? Do you think that the way you're set up, you might have kind of a big step-up in volume or do you think it ends up being just more gradual?"
},
{
"speaker": "Michael Castagnetto",
"content": "I think, Tom, it would depend on the type of swing. And that's the part we're -- listen, we do mockups, we do testing of what we think will happen and we're prepared for it. But I think we all have to make sure we do the right thing depending on how that inflection happens and whether it's a gradual inflection or a very quick turnaround. Where I am confident is regardless of what it is, I think we have the tools and talent to execute against it."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay, great. Makes sense. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ken Hoexter with Bank of America. Please proceed with your question."
},
{
"speaker": "Ken Hoexter",
"content": "Hi, great. Good afternoon. Maybe just a little bit on the forwarding side. Can you talk about given how far, I guess, maybe the squeeze we've already seen on rates and then what, I guess, could happen as maybe shipping starts to return to some normal shipping patterns, how that impacts the forwarding side? And then any side thoughts on headcount as well?"
},
{
"speaker": "Damon Lee",
"content": "Hi, Ken. Thanks for the question. So as we laid out in Investor Day, as part of our 2026 OY [ph], Walker or Bridge, we did have an item in there related to rate normalization. And that was both rate normalization for truckload and rate normalization for global forwarding. So as the forwarding market returns to call it more normalized levels of rates, we have taken that into consideration as we've built our path forward for 2026. So I'd reference you as far as the net impact of that for the enterprise, I would reference you back to the net $10 million headwind that we showed by 2026 for rate normalization for the enterprise. And certainly, you've got tailwind coming from truckload in that $10 million and then you've got headwind coming from ocean rate normalization from our forwarding business. Specifically to your question around head count, as Dave mentioned in his opening comments, the Global Forwarding team did a fantastic job in 2024, debunking the thesis that we can't separate headcount from volume growth. In fact, it's no longer a theory, in our Global Forwarding business, it's actually a fact. And in 2024, that business demonstrated decoupling headcount from growth throughout the year. And certainly, those lessons we've learned, those tools and skills that we've honed to execute that in 2024, we'll forward into 2025 to whatever market we see from a forwarding perspective."
},
{
"speaker": "Tom Wadewitz",
"content": "So, just to clarify your comment on the rates going back to normalization on Investor Day, I totally remember the slides. But do you think that's kind of where we're settling out as things get back to normal historical? Or do you think given the amount of capacity added on, we start seeing maybe additional pressure on those -- on the shipping rates?"
},
{
"speaker": "Damon Lee",
"content": "Yes. So our view hasn't changed and consistent with what we laid out in Investor Day. We see the ocean rates normalizing back to the levels we saw in the second half of 2023. So that's the math that supported our ROI bridge and market normalization assumptions at Investor Day, and we stick to that viewpoint as of today."
},
{
"speaker": "Tom Wadewitz",
"content": "Sounds good, appreciate the time, thanks."
},
{
"speaker": "Damon Lee",
"content": "Thanks, Tom."
},
{
"speaker": "Operator",
"content": "Thank you. 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 afternoon. I know we touched on a lot here, but just kind of a bigger picture question, thinking about the path forward. You're obviously very focused on profitability thresholds that you want to hit. You've done a great job on the cost side. At a certain point, the market will come back and you're going to want to get your share or better at volume. So how do you think about balancing this desire to win back the Robinson share or, again better while still keeping some of these profitability threshold that you set for yourself over the last year?"
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Jon, good to hear from you. A couple of things on that question. One, it's everything we've been really discussing and that we laid out in Investor Day as well, we have put together our operating model discipline that sets us up for the basis of that question. And that's with our people being at the forefront of that strategy and technology giving them the tools to drive that technology. That's going to allow us to really drive growth that we've talked about in the verticals. It's going to allow us to drive and take share in our small and medium business segment. And on top of that, when the market inflects, we have a history that will drive the transactional space as well. So we have optionality built into our model, and we feel really good about that. So the key point is be it a slow burn or be it an aggressive turn, we've set ourselves up to really be ready for either one. And our team is really attacking what we can control and the cards that are dealt with us, but we are prepared for either scenario. We can double click a little bit more with that one."
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. I think the question you're asking is a good one. But where we feel comfortable is that each marketplace creates different scenarios in the current marketplace, pricing is low. Our advantage is really through our pricing and costing engines that we've been able to implement with our team and really as we've said, increase the quality of our volume and making sure that we're getting that right combination of volume and margin. In a different marketplace where costing is moving and pricing is moving, we think we still have the best tools in the industry to then provide us the opportunity to pick up freight and win share. We need to be able to do both and our expectation of ourselves as we will do both. And we've consistently been able to do that throughout 2024. And I have confidence in the team that we'll do that when the market in flex and continuing into 2025."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Jon, and hopefully, at Investor Day, we laid out those physicals to show you why we feel confident about that. But thanks."
},
{
"speaker": "Jon Chappell",
"content": "Absolutely, Dave. Thanks. Bye."
},
{
"speaker": "Dave Bozeman",
"content": "Operator, next question, please."
},
{
"speaker": "Chuck Ives",
"content": "Apologies, everyone. We seem to have lost our operator. So given that we can't get the operator back on the line, I think we're going to have to end the call. Apologies. Please feel free to reach out to me afterwards with follow-up questions, and we'll answer those questions for you. Thank you."
},
{
"speaker": "Dave Bozeman",
"content": "We may have our operator back. We'll hang on a second."
},
{
"speaker": "Operator",
"content": "I'm sorry, we had some technical difficulties. If we're ready to proceed, we do. Our next question will be from David Hicks with Raymond James. Please proceed."
},
{
"speaker": "David Hicks",
"content": "Hi, guys. Thanks for taking the question. I also just wanted to kind of hit back on the Global Forwarding segment kind of just given the development in the Middle East. What are you hearing from the ocean liners on a return to the Red Sea/Suez Canal route? And how does that kind of change the pace or timing of AGP per shipment and forwarding coming back to those second half '23 bubbles that you mentioned?"
},
{
"speaker": "Dave Bozeman",
"content": "David, this is Dave Bozeman. And thanks for the question. When it comes to the ship lines, certainly, the situation of Red Sea is a situation that's still ongoing. I mean it takes time for the ship lines to really adjust back into normal operations. I think what we see from them is they are evaluating the situation. We don't see a full out sailings through the Suez Canal. They're still on their normal sailings around the horn. And so we're monitoring that closely. But at this point, it's still a situation of monitor. We don't know exactly the timing of when that will shift. When it does, we'll certainly be front and center there. Damon, anything on…"
},
{
"speaker": "Damon Lee",
"content": "Yes, David, I would just add that, look, our viewpoint is that carriers won't immediately return to the Red Sea. I mean we're seeing some activity there. But we believe for it to return to levels of normalcy that it will take time for that to happen. So nothing happens quickly overnight in the shipping world. And so as Dave mentioned, we're monitoring it. We're controlling what we control, and we'll certainly service our customers based on what the market yields."
},
{
"speaker": "David Hicks",
"content": "Great, appreciate it. Thanks, guys."
},
{
"speaker": "Chuck Ives",
"content": "Operator, are you still connected to put the next question through please? Apologies, everyone. We seem to have lost our operator again. So this is the conclusion of our call. Have a great evening, and we look forward to talking to you again. Thank you."
}
] |
chrw | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good afternoon, ladies and gentlemen, and welcome to the C.H. Robinson Third Quarter 2024 Conference Call. At this time, all participants are in a listen-only mode. Following the company’s prepared remarks, we will open the line for a live question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded, Wednesday, October 30, 2024. I would now like to turn the conference over to Chuck Ives, Director of Investor Relations."
},
{
"speaker": "Chuck Ives",
"content": "Thank you, Donna, and good afternoon, everyone. On the call with me today is Dave Bozeman, our President and Chief Executive Officer; Arun Rajan, our Chief Strategy and Innovation Officer; Michael Castagnetto, our President of North American Surface Transportation; and Damon Lee, our Chief Financial Officer. I’d like to remind you that our remarks today may contain forward-looking statements. Slide 2 in today’s presentation list factors that could cause our actual results to differ from management’s expectations. Our earnings presentation slides are supplemental to our earnings release and can be found in the Investors section of our website at investor.chrobinson.com. Our prepared comments are not intended to follow the slides. If we do refer to specific information on the slides, we’ll let you know which slide we’re referencing. Today’s remarks also contains certain non-GAAP measures and reconciliations of those measures to GAAP measures are included in the presentation. And with that, I’ll turn the call over to Dave."
},
{
"speaker": "Dave Bozeman",
"content": "Thank you, Chuck. Good afternoon, everyone, and thank you for joining us today. I’d first like to acknowledge the challenges that many communities are facing after the recent hurricanes to hit the Southeastern U.S. Many of our employees were impacted, and I’m proud of the incredible support that our company and our employees provided to help those in need and our customers. The commitment and compassion are truly inspiring and it makes me extremely proud to be part of this team. Turning to the quarter. I’m pleased with our third quarter results that reflect continued improvement in our execution as we continue to deploy our new operating model. We are raising the bar even in a historically prolonged freight recession with strong execution and disciplined volume growth across divisions, while delivering exceptional service for our customers and carriers. I want to thank our people, one of our greatest competitive advantages for their relentless efforts to embrace our new operating model and execute in a fit, fast and focused way so we can keep pushing that bar higher. Due to a focus on constantly testing market conditions and optimizing yield, we improved the quality of our volume in Q3 and continue to expand our NAST gross profit margin. We also continue to push our efficiency to higher levels in both NAST and Global Forwarding, and we remain on track to deliver greater than 30% compound growth in productivity over the two-year period from the end of 2022 to the end of 2024. Michael will cover the NAST results in a little bit, but I’d like to give our Global Forwarding team some recognition as well. In Q3, the team continued to be nimble and highly engaged with our customers to help them navigate various market disruptions and to provide excellent service. This resulted in a 7% year-over-year increase in our ocean shipments and a 20% increase our air tonnage. At the same time, they’ve embraced the rigor and the discipline driven by our operating model, and they’ve decoupled headcount growth from volume growth, reduced their headcount by more than 10% year-over-year and lowered their cost to serve. This improved operating leverage, combined with elevated ocean rates resulted in a 230% year-over-year increase in Global Forwarding’s Q3 adjusted income from operations. This combined with our improvements in NAST gross margin, productivity and operating leverage resulted in a 75% increase in our enterprise Q3 adjusted income from operations. Our new operating model has changed how we discover and inspect root cause issues and quickly implement countermeasures to improve the level of our operational execution. The reliability of our operating reviews continues to increase as we leverage our data-rich environment to inform our decision-making and enhance our competitive differentiation. At an organizational level, we continue to cascade the operating model deeper into the organization and build operational muscle at various levels of the enterprise to deliver on our strategic roadmap. As part of this effort, an evolving tool kit is being used by our employees in the form of problem resolution, balanced scorecard reviews, daily management and value stream mapping to name a few. Empowering our people with the Robinson operated model is creating a flywheel of performance, talent development and accountability that is evolving our culture to be driven by progress, execution and proactive problem identification and resolution. This has shown up in improvements such as more disciplined pricing and better decisions on the volume that we’re seeking. We are still early in our journey, but the operating model is helping us execute a solid strategy even better, and we expect further improvement as our team continues to embrace this new way of operating. As I’ve said before, I know from my past experiences of implementing lean operating models that improvement isn’t always linear, but I’m confident in the team’s willingness and ability to drive a higher and more consistent level of discipline in our operational execution. As freight markets continue to fluctuate due to seasonal, cyclical and geopolitical factors, we remain focused on what we can control, including deploying our new operating model, providing best-in-class service to our customers and carriers gaining profitable share in targeted market segments, streamlining our processes, applying lean principles and leveraging generative AI to drive out waste and optimize our cost. We also continue to focus on ensuring that we’ll be ready for the eventual freight market rebound with a disciplined operating model that responsibly grows market share, decouples headcount growth from volume growth and drives operating leverage. I’ll turn it over to Michael now to provide more details on our NAST results."
},
{
"speaker": "Michael Castagnetto",
"content": "Thanks, Dave, and good afternoon, everyone. Supported by our new operating model and armed with innovative tools, our team of freight experts is responding to the challenging freight environment, and we are acting more quickly and more effectively to provide solutions to our customers and carriers and to improve the quality of our volume. In Q3, we delivered further optimization of our adjusted gross profit per truckload, which increased 21% year-over-year and 5% sequentially. Compared to a year ago, the improvement is being driven by better pricing discipline in new management process that we’ve stood up and a cost of higher advantage delivered by our procurement teams and the growing usage of our digital brokerage capabilities. All of this led to significant improvement in the AGP yield within our transactional truckload business and a 180 basis point improvement in our NAST gross margin. From a volume standpoint, we continue to be in a prolonged freight recession, as Dave mentioned. The cash freight shipment index was down 2.8% year-over-year in Q3, and except for the pandemic year of 2020, the Q3 index is the lowest Q3 reading the industry has seen since 2010. In this environment, our total NAST volume increase [indiscernible] 2.5% increase in LTL volume and a 3.5% decrease in truckload volume. Our team is continuously testing the best combination of volume and margin to deliver the quality of earnings that we’re targeting. We know we have the optionality to increase our volume when the conditions are right. But right now, our tests are showing us that pursuing volume beyond what we delivered wouldn’t result in sufficient profit. We are ready to pivot when it makes sense to do so, but we’re going to maintain our discipline. From a market balance perspective – continue to be in a drawn out stage of capacity oversupply. Although carrier attrition is occurring, it remains at a slower pace and not enough to materially impact the overall market. After experiencing some upward pressure during produce season, load-to-truck ratios retreated to 4:1 or lower for most of Q3. Looking ahead, Q4 is typically a seasonally weaker quarter compared to Q3. The 10-year average of the cash freight shipment index, excluding the pandemic impacted year of 2020 and reflects a 3.3% sequential decline from Q3 to Q4. As Dave said, we remain focused on what we can control. Our people and their unmatched expertise enable us to deliver exceptional service and greater value to our customers. In line with the disciplined and focused approach to capture growth opportunities in targeted customer segments, we have invested in our sales organization, and we will continue to support our people with industry-leading tech and solutions to enhance their capabilities. As we recently announced, one of those solutions is our growing drop trailer offering, which is nearly a $1 billion business for us. The breadth of our carrier network and the associated trailer pool provides us with the flexibility to customize a drop trailer program for our customers and to best meet their needs and we’re now the fourth largest drop trailer provider in North America. We’ll continue to lean into this offering and our other capabilities to responsibly capture market share growth. I’ll turn it over to Arun now to provide an update on the innovation we’re delivering to strengthen our customer and carrier experience, increase AGP yield and improve operating leverage."
},
{
"speaker": "Arun Rajan",
"content": "Thanks, Michael, and good afternoon, everyone. In the third quarter, we continued to make progress on a number of important fronts, including scaling our process innovations and our use of generative AI. From a process standpoint, we continue to increase the rigor and discipline in our pricing and procurement efforts, resulting in improved AGP yields across our portfolio. With continued innovation in our digital brokerage and dynamic pricing and costing we’re responding surgically and faster than ever of the dynamic market conditions. On an annual basis, we’re now generating over 215 million algorithm-driven spot rates across truckload and LTL, enabling digital connectivity for our customers. And by way of continuous experimentation, we're performing more frequent price discovery and enhancing the quality of the pricing that we deliver. The continuous learning of our algorithms is not just through experimentation, but also from the active role that our people play from a human-in-the-loop perspective to drive continuous feedback to our algorithms on a regular basis in the form of expert market adjustments. Our revenue management discipline and tools are also contributing to our improved yield management. As we focus on optimizing yield, our teams are armed with intelligence and surgical countermeasures that can be taken to implement a disciplined, pricing strategy based on individual customer value propositions. We also continue to scale our use of GenAI across the lifecycle of an order. Whether being used to automate customer quoting, order entry, load tenders, appointment scheduling or other manual tasks, our GenAI tools and capabilities are enabling us to respond faster than ever to customers and carriers and to dynamic market conditions. The reduction of manual touches by the growing use of our GenAI tools is freeing up time that our customer and carrier facing employees can devote to relationship building, exception management and value added solutioning. In addition to improving the customer and carrier experience, GenAI is contributing to our productivity gains and will enable us to effectively scale our operations when the market returns to growth. Our productivity is on track to our 2024 goals which will enable us to increase our NAST and Global Forwarding shipments per person per day by more than 30% over the two-year period of 2023 and 2024. Our productivity improvements won't end in 2024 and they serve as critical inputs into our plan to create further operating leverage. This is a core part of our enterprise strategy along with responsibly growing market share and expanding gross margin to greater operational discipline and innovative technology that improves our execution. I look forward to our upcoming Investor Day where we'll go deeper on these strategies. With that, I'll turn the call over to Damon for a review of our third quarter results."
},
{
"speaker": "Damon Lee",
"content": "Thanks Arun and good afternoon everyone. This quarter we delivered significant year-over-year improvement in operating income driven by an increase in adjusted gross profit or AGP, while controlling cost through our productivity initiatives and thereby driving higher operating leverage. Disciplined revenue management and procurement of capacity in the face of continued soft freight market conditions improved the quality of our volume and benefited our AGP, which was up a $100 million or 15.8% year-over-year. On a monthly basis compared to Q3 of last year our total company AGP per business day was up 13% in July, up 18% in August and up 11% in September. Within our two largest businesses of NAST and Global Forwarding, AGP, operating income and adjusted operating margin all improved on both a year-over-year and a sequential basis. And while elevated ocean rates are benefiting our forwarding business, the continued discipline that our people are showing as they embrace our operating model has enabled both businesses to be more fit, fast and focused and to grow operating margins. As we look forward Q4 is typically a seasonally weaker quarter from a volume and gross profit perspective. Michael mentioned the typical sequential volume decline that the trucking market experiences in the fourth quarter. From a Global Forwarding perspective, there are several indications that customers pulled forward some of their peak season ocean freight due to the ongoing concerns about geopolitical issues and capacity disruptions, including the Red Sea conflict and the potential for labor disruptions at the east coast and gulf coast ports of the U.S. this could dampen ocean demand in Q4. Additionally, ocean rates have steadily declined since early July. Given the mix of contractual and transactional volume in our ocean business, the impact of changing market rates generally takes one to two months to flow through to our average profit per shipment. Consequently, we began to see the negative impact from declining rates in our profit per shipment in September and we expect this to continue in Q4. From an expense standpoint, our total operating expenses excluding a loss on the planned sale of our European surface transportation business and other restructuring charges were down $3.2 million year-over-year. Q3 personnel expenses were $361.6 million, including $2.9 million of restructuring charges related to workforce reductions. Excluding restructuring charges in the current and prior year, our Q3 personnel expenses were $358.6 million, up $18 million or 5.3%. This was driven by an increase in incentive compensation related to improved financial results and was partially offset by our continued productivity and cost optimization efforts. Our average Q3 headcount was down 9.6% compared to Q3 last year. We continue to expect our 2024 personnel expenses excluding restructuring to be below the midpoint of a $1.4 billion to $1.5 billion range. This includes an expectation that headcount will be relatively flat in Q4 compared to the end of Q3. Moving to SG&A, Q3 expenses were $193.6 million, including a $57 million loss on the planned sale of our European Surface Transportation business or EST and $1.5 million of other restructuring charges. Excluding these SG&A expenses were $135 million, down $21.3 million or 13.6% year-over-year. The expense reduction was across several expense categories as we continued to eliminate non-value added spending. We now expect SG&A expenses for the full year excluding the planned sale of EST and restructuring charges to be toward the low-end of the guidance range of $575 million to $625 million. SG&A expenses include depreciation and amortization, which we still expect to be $90 million to $100 million in 2024. Our effective tax rate in Q3 excluding the planned sale of EST and restructuring charges was 24.2%. This results in a year-to-date tax rate of 20.8% and we now expect our 2024 full year effective tax rate to be in the range of 18% to 20%. Our capital expenditures in Q3 were $17.3 million, bringing our year-to-date total to $59.1 million. We now expect 2024 capital expenditures to be $75 million to $85 million compared to the previously provided guidance of toward the lower-end of $85 million to $95 million. From a balance sheet perspective, we ended Q3 with approximately $1 billion of liquidity comprised of $860 million of committed funding under our credit facilities and a cash balance of $132 million. Our financial strength continues to be a key differentiator in our industry as it enables us to continue investing and improving our capabilities even through a prolonged freight recession. As a result, we expect to emerge stronger when the market tightens. Our debt balance at the end of Q3 was $1.56 billion and our net debt-to-EBITDA leverage at the end of Q3 was 2.08 times down from 2.4 times at the end of Q2. This was primarily driven by the performance of the business and the resulting increase in our trailing 12-month EBITDA as well as a decrease in our net debt balance. Overall our Q3 financial results are a testament to our execution with a focus on margin expansion and discipline on how we run the company. I'm optimistic about where we're going and I look forward to meeting many of you at our upcoming Investor Day. With that, I'll turn the call back to Dave for his final comments."
},
{
"speaker": "Dave Bozeman",
"content": "Thanks, Damon. As we strive to get more fit, fast and focus and deliver higher highs and higher lows over the course of market cycles. I'm pleased with our improving execution at the bottom of the free cycle. I want to commend our people for continuing to learn and embrace the changes that the new operating model is driving. We're making better and faster decisions on capturing the right freight at the right price to deliver a higher quality of volume and financial results. As I've mentioned before, all the changes we're making are aimed at our North Star of generating incremental operating income. We will do this by focusing on growing market share and expanding our gross and operating margins. We'll continue to grow market share by reclaiming share in targeted segments by leveraging our robust capabilities to power customer-centric solutions and by expanding our addressable market, through value-added services and solutions for our customers and carriers to drive new volume to our four core modes. We'll also be more intentional with our go-to-market strategy to drive additional synergies and cross-selling across our portfolio. We'll optimize our gross profit by monitoring key input metrics and responding faster to error states and changing market conditions with countermeasures and innovative technology that improves our execution. And we'll expand our operating income margins by embedding lean practices, removing waste and expanding our digital capabilities. This will enable us to strengthen our productivity and optimize our organization structure to be the most efficient operator in addition to the highest value provider. While there's a lot more work to do, I'm pleased with the progress we've made on evolving our strategy and improving our execution by instilling discipline with our new operating model. We're arming our people with better tools and moving with greatest clock speed and urgency to seize opportunities and solve problems in order to win now and to be ready for the eventual freight market rebound. We'll share more about our strategy, how we'll execute that strategy and the resulting financial targets at our upcoming 2024 Investor Day on December 12. This concludes our prepared remarks. I'll turn it back to Donna now for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Today's first question is coming from Tom Wadewitz of UBS. Please go ahead."
},
{
"speaker": "Tom Wadewitz",
"content": "Hi. Yes. Good afternoon. Let's see, and nice to see the strong results. I wanted to see if you could give a little more comment on maybe how we might think about the NAST operating margin and gross margin in 4Q. I think there were – you said maybe stable headcount sequentially and talked about cash freight shipments index, the normal sequential decline. But I just wanted to see if you could give any thoughts on kind of improvement or deterioration sequentially? And then another, I guess, related to those, how do we think about key drivers in 2025 for those two metrics for NAST gross margin and operating margin? Does it become more market-driven or is there still a lot left for C.H. Robinson to do that's truly company-specific? Thank you."
},
{
"speaker": "Michael Castagnetto",
"content": "Hey Tom, this is Michael. Thank you very much for the question. I think as we said earlier, we're really proud of the work the team has done to be really disciplined in how we've managed a pretty tough part of this cycle. We continue to believe that our industry-leading costing and pricing engines gives us an opportunity to keep doing the work we're doing and keep that measurement moving forward. As we look in terms of our expectations of operating margin and leverage, really we're going to continue to control what we can control in terms of the marketplace. And from an internal perspective, we have a lot of confidence in the productivity initiatives that we've implemented and really have enacted more of an evergreen mentality that we're going to continue to work and drive for constant improvement. We've set some pretty lofty goals for the last two years in terms of a combined 30% improvement of productivity, and we feel we're on path for that throughout the rest of 2024. And beyond that, certainly, we expect those numbers to slow a bit. You just can't maintain that high level of a drive, but we have expectations of ourselves to get better, whether it's each quarter or into 2025."
},
{
"speaker": "Dave Bozeman",
"content": "Yes. Tom, this is Dave. Just to add on to that, continue to – I like the muscle that we're building and that we're seeing. We're team is getting smarter every day and wiser every day as we continue to deploy the model, problem solving is going throughout the organization. This will help as we continue to prepare ourselves for the rebound. And as Michael said, our mentality is continuous improvement every day and certainly every year, and so it's a never stopped game for us at this point in the cycle, which is a really, really tough cycle. So I'm super proud of the team and how they're standing up on the higher highs, higher lows and certainly the higher lows right now."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Jon Chappell of Evercore ISI. Please go ahead."
},
{
"speaker": "Jon Chappell",
"content": "Thank you. Good afternoon. Dave, you said before, the processes are never ending, but you've also mentioned a couple of times that they're non-linear either a point as we get we're looking at SG&A at the low-end of your range with the personnel expenses at the low-end of the range you set out earlier this year. Is there a point where it just becomes more difficult to garner any more productivity and margin expansion without getting some help from a broader market volume tailwind?"
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Jon, good to hear from you. No, you're right. This thing continues to go. What we said before is – and again, I can't tell you how proud I am of the team with the 15% last year and exceeding that and then in another 15% from a NAST perspective this year and continue to drive that. But the way we look at it is, even as you go into the out years, there will always be continuous improvement. Now certainly, Jon, we want that market rebound to happen. But the mentality that we have is control which you can control and that's just continuous improvement on processes and things that we do every day. So even in a rebound market, you should still always continually improve with the model that we have and that's some of the tech that we've leaned into. So I'll have Arun jump in here as well, but it's a good question, and it's a different question on how we looked at it yesterday versus how we look today on our mentality of continuous improvement."
},
{
"speaker": "Arun Rajan",
"content": "Yes. Yes, Jon, to Dave's point, this notion of evergreen improvements, whether it be productivity, gross margin expansion or volume growth. We have a number of strategic initiatives that power all of them. And there's always new technology or new capabilities that power them. So as an example on productivity yes, we made a ton of progress already. However, there's still opportunity with Gen AI and new technologies that come out. So I think that's the way to think about it. Each of these things have additional strategic initiatives and momentum going to 2025 and forward."
},
{
"speaker": "Jon Chappell",
"content": "Great. Thanks Arun. Thanks Dave."
},
{
"speaker": "Dave Bozeman",
"content": "Yes. You got it."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Brian Ossenbeck of JPMorgan. Please go ahead."
},
{
"speaker": "Brian Ossenbeck",
"content": "Good afternoon. Thanks for taking the question. Maybe this one is for Michael, when you look at the market, obviously it was a bit tight in July and then has come back in to really be sub-seasonal and still kind of soft when you look at the broader truckload market. So what are you looking at in terms of conditions and what do we need here to see the market turn? We saw price above cost per mile on a year-over-year basis. I mean in the past, that's meant sort of different things, but as we look forward to an improvement in inflection. What are you looking for? And what's sort of your best guess when we might start to see that? Thank you."
},
{
"speaker": "Michael Castagnetto",
"content": "Hey Brian thanks for the question. And I think you're asking the question we're all trying to figure out exactly when that's going to happen. You described the quarter pretty accurately, right? We had some tightness in the market in July. It definitely softened and gave ground throughout the rest of the quarter. And we are continuing to see capacity exit. But as we said earlier, it's not exiting at the rate that's creating an inflection in the marketplace. And if you look back at traditional cycles, and we're not in what I'd call a traditional cycle at this point is far into the low-end of the cycle for this long. You need a demand inflection to truly get the market to repair. I think continued capacity exits will help the market stabilize. And we've been bouncing along the bottom for a while here, but we're still not to a point where I'd say it's stable. Really, for us to see a true market inflection, we're going to need to see more demand – really more reaction from that customer base of longer-term consistent demand increases. And we see small pockets, we feel really good about how we're positioning ourselves with our customers to be ready for that. How we're positioning ourselves with our carriers to be ready for that. And to Dave's point, we think our team has done a really good job managing through this extended freight recession, but we're not seeing right now a whole lot of customer activity that would say this has a shorter end. And so we're really planning to do what David said, which is we're going to deliver higher lows during this part of the cycle, and we think we're in a really good spot to react when that inflection does happen."
},
{
"speaker": "Brian Ossenbeck",
"content": "All right. Thanks Michael. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Jeff Kauffman of Vertical Research Partners. Please go ahead."
},
{
"speaker": "Jeff Kauffman",
"content": "Thank you very much and congratulations. I know you talked a little bit about the pull forward, but I'd just like to dig a little deeper into that. In that of the revenue growth a pretty extreme revenue growth in 3Q, what's your best guess at how much of that improvement would have represented pull forward? And if we were to try to think about is the market normalizing in the fourth quarter or through the first quarter of the year, what kind of pullback do you think we could see outside the normal season now?"
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Jeff, thanks for the question here. Jeff, it's something that we've been examining and talking through. What I would tell you is that the pull through and because, obviously, we have Global Forwarding and NAST, you have to kind of break this down a bit. Number one, we don't – I'm going to tell you, it's not material from a pull-forward perspective. Now the two businesses are a bit different. Like from Global Forwarding, you could say that there was some pull forward that we would have saw in that business. We don't necessarily see that in truckload per se. So it's two different businesses that we look at here. So I'm kind of calling it like nonmaterial and truckload and a bit because of how shippers were looking at it on Global Forwarding, that we had to manage. So you can understand the complexities there, but that's how I would say it. I don't know if, Michael, you would add on to that, but..."
},
{
"speaker": "Damon Lee",
"content": "No. I would just add, Jeff, this is Damon that Q4 for both businesses is typically a seasonally weaker quarter. And so you'll certainly have that dynamic factor in as well from a sequential basis."
},
{
"speaker": "Jeff Kauffman",
"content": "So I guess where I'm going is there was a $300 million sequential revenue pickup on a gross revenue basis, give or take. Could we be looking at the fourth quarter, it looks a lot more like the second quarter. I was just looking for a little guidance in terms of how material of that $300 million jump, what do you think is normalization?"
},
{
"speaker": "Dave Bozeman",
"content": "Yes. I don't know that I'd go that far, Jeff and see that. I mean, if you look at, again rates for Global Forwarding, they're going to start slowing down and following into seasonality, as Damon said. So again, we're looking at this every day, and I understand how you're trying to look at modeling it as well. It's just the market that we're in, and we're dealing with that market that we're in and executing to what we can control there. So I wouldn't say, though, that it would follow kind of a 2Q thing."
},
{
"speaker": "Damon Lee",
"content": "I agree."
},
{
"speaker": "Jeff Kauffman",
"content": "Thank you."
},
{
"speaker": "Dave Bozeman",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Ken Hoexter of Bank of America. Please go ahead."
},
{
"speaker": "Ken Hoexter",
"content": "Hey good afternoon and great job in benefiting from the ocean and forwarding rate inflection. I guess my question would be on if we get inflection in spot, not when we get, but when I guess, when it approaches, how do you think that impacts the business in the new operating model? Does it make you more fluid? Should we expect your ability to fluctuate with spot rates to be a bit quicker – and then I guess to follow on that, are you seeing any of those signs in the firming between the rates and costs at this point or not yet?"
},
{
"speaker": "Michael Castagnetto",
"content": "Hey Ken, thank you for the question. This is Michael. I think the first – I'll break it down into both sides. So on the first side, I think the new operating model will do all the things you asked, which is, will it give us better capabilities, information and speed in which we act 100%, right? And that's really what we're working with the team on is how do we take our industry-leading data and information set and get it into their hands faster and more effectively. And I think we're doing that better than we ever have. That's positioning us to be ready for that market inflection and more importantly, to be having those conversations with our customers, in advance of the market inflection around how we want to handle that. We do scenario planning both on the capacity and customer side throughout to understand the best way to handle what an inflection could look like, whether it's a quick spike or more of a long drawn-out increase, and we feel we're really ready for either scenario. In terms of the second question, are we seeing signs of that? The short answer is no. We're seeing good activity from our teams; building good relationships; feel we're winning in the contractual space, picking up wallet share. But the truth is route guides are performing incredibly well. There's not a lot of freight that's flowing out of that into the transactional spot market. And in that spot market, it's incredibly competitive. And I think we're doing the right job to be disciplined in that space to win the right freight for us and for our customers that we service it correctly, really proud of our NPS scores are the highest we've seen in years, and I think that's a reflection of the team's work and making sure that we – the freight we do land, we execute, we deliver when and how our customers want to. But the truth is, is that there's not been a whole lot of market activity that would say there's a whole lot of inflection and certainly not in Q3 and really we're not expecting much in Q4."
},
{
"speaker": "Ken Hoexter",
"content": "And you've given a, oh go ahead, sorry, Dave, yes."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Ken, I wanted to pile on a little bit there what Michael said. But really going back to the beginning of your question, I just want to – and I don't – I'm sure you meant it this way as well. I mean, one, the – we did benefit from rates in Global Forwarding because that's the market. But it's really important to understand and break that apart. Super proud of that team because this operating model isn't just a NAST operating model or a particular division, it's a company operating model. And so the work that's going on in our business within Global Forwarding, just like NAST, is one where we're working to decouple headcount growth and volume growth. So there is a level of discipline that I would say that's there today that we benefited from and grown from and how we run that business, that's efficiency in evergreen that – and I'm sure you've seen that. I just want to call that out. And then secondly, for the NAST team, these guys were extremely hard in a super, super tough market. And the discipline that Michael was talking about and the operating model principles that these guys are running on daily from speed of decision to daily execution and discipline of what they take really does speak of forward-looking and that discipline won't go away when the market starts to inflect as well. So hats off to both operating divisions just from a disciplined perspective. I just wanted to make that clear that is just not maybe all rate in GF and is certainly discipline in execution in NAST that sets us up for where this market decides to go."
},
{
"speaker": "Ken Hoexter",
"content": "Thank you Dave. Appreciate it. Thanks guys."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Scott Group of Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hey. Thanks. Good afternoon. So when I look at your – the chart with truckload pricing and cost, right, pricing has turned a little positive year-over-year, cost still a little negative. And if I think back on prior cycles, I feel like it's usually where the cost goes positive first and you get squeezed a little bit and then eventually catch up. So I guess I'm wondering; why do you think it's a little different this time? And does this mean in your mind, when we get that eventual inflection, we won't get squeezed. And so if you’re right, that costs are up, spot costs up 9% next year, do you think you would outpace that with price?"
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Scott, thanks for the question. I think on the short term, minor moves in our overall costing are driven by a lot of factors, but I do think we’re making good decisions on how we price freight both in the contractual and spot markets that we’re pricing it more intelligently, more specifically to the characteristics of the customer, the characteristics of the load. And I think it’s more reflective of a better and more intelligent pricing process. As we think about going forward, listen, any change in the market will still feel a squeeze. The key for us is to do it better and get through it faster than we have in the past. And so we’re anticipating that when that change happens. And certainly, we’re hoping it happens as much as anybody, right? The idea, though, is that our team is better planned better situated to have intelligent conversations with our customers and really plan out what is a solution that gets them to where they need to be to manage their supply chains. This is obviously an extremely long elongated freight recession. And so it makes those conversations a bit more unique. We’re now into our second and sometimes third contractual pricing period in this low end of the cycle, which is usually not the case. And so that changes those conversations with customers. And we feel really good that the team is having intelligent conversations. But as we mentioned before, we have the optionality to handle this in a couple of different ways. And we’re constantly testing how to do that, both in the current market and where the market will go. And I’ve been here almost 27 years. And I can tell you, I think we’re putting the best information in our people’s hands than we ever have. And I think they’re in the best position they’ve ever been so that when this market inflects, sure, we’re going to feel it like anybody would. But I think we’re going to get through those conversations more intelligently and quicker than we have in the past."
},
{
"speaker": "Scott Group",
"content": "Makes sense. Thank you guys."
},
{
"speaker": "Dave Bozeman",
"content": "You're welcome. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Daniel Imbro of Stephens Inc. Please go ahead."
},
{
"speaker": "Daniel Imbro",
"content": "Good evening, guys. Thanks for taking our questions. Dave, maybe one on the personnel cost side. I think on the quarter, head count was down 1% sequentially, but adjusted personnel costs were still up about 2% sequentially and then back to growing year-over-year. I guess the question is this a new model where it’s fewer heads, but it’s higher comp per head. And so we’re past the period of personnel cost declining – and should we expect total personnel exit to continue increasing in the coming quarters, especially if we do any market tightness and you have to add back people? Thanks."
},
{
"speaker": "Dave Bozeman",
"content": "Thanks for the question, Daniel. So certainly, we’re not in a situation where cost per head is going up versus historical trends. The dynamic you’re seeing in Q3 is related to variable compensation. So as our financial results improve, the variable compensation goes along with that. So the trend that we’ve illustrated and talked about around evergreen productivity and decoupling headcount from volume is still very much in place. And the volatility you saw in Q3 is purely related to variable compensation."
},
{
"speaker": "Daniel Imbro",
"content": "Is variable compensation per broker out there that are going to continue? So if we have periods of strong profitability, there will always be a higher incentive compensation, so total comp per head still goes up?"
},
{
"speaker": "Dave Bozeman",
"content": "I think it’s relative to the sequential comps and I think it’s relative to our own expectation of performance."
},
{
"speaker": "Daniel Imbro",
"content": "Got it. Excellent."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Chris Wetherbee of Wells Fargo. Please go ahead."
},
{
"speaker": "Chris Wetherbee",
"content": "Hey, thanks. Good afternoon, guys. I wanted to ask on NAST head specifically. So I think we’ve seen kind of eight or nine quarters in a row of sequential declines there. And maybe the guidance is kind of flattening out for the fourth quarter. I guess as we think about it, conceptually, are we getting to the point where you now feel like with the technology, you’ve enabled the productivity initiatives? We’re at the right kind of equilibrium between the freight market and where you sit from a resource perspective. I don’t know if that’s too presumptions. But want to get a sense of kind of how you think about it? Or can there be incremental legs lower in terms of maybe broadly resources if the freight market doesn’t kind of respond positively as we move into 2025?"
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. Thank you, Chris. This is Michael. I think what you’re seeing with us is the continued work we’ve had as we’ve enacted the productivity work. We’ve implemented technology improvements and system improvements, whether it’s a combination of Gen AI or just process improvement through our teams getting better at what they do. I think we’re past maybe the historical headcount declines because of the market declines. We’re in headcount workforce planning because we’re getting better at what we’re doing. And the operating model is allowing us to really look at our business differently. And so I would say we have an expectation that we are going to decouple headcount from volume growth as we go forward. And as the market continues or changes, we expect ourselves to drive continuous productivity improvements. And certainly, I don’t think that’s linear. I think as we’ve seen with technology, Gen AI, as an example for us this year has really been an unlock that a year ago when we were planning this year, we weren’t – we probably weren’t counting on at the level that it’s impacted us. And so I think the team is going to continue to identify opportunities, attack those opportunities that bring the biggest return. And so we’ll see – I think we’ll see continuous improvement in our productivity, and I’ll probably let headcount be what it needs in terms of how we’re handling the volume of the current part of the cycle. And so – but I wouldn’t say that we’ve hit a floor, but I’d also say we’re going to continue to make sure we do it under the eye of smart discipline within our operating model and doing it with an eye on a continuous improvement mentality within productivity."
},
{
"speaker": "Dave Bozeman",
"content": "Yes. Chris, this is Dave. Just to add on there, Michael and team are doing a nice job at continuing to grow the model. I mean this is what happens as we continue to scale our model throughout our organization and scaling left and right and down. And it really allows the teams to discover, inspect and it allows our people to really start to do what we’re known for, and that’s spending that time with the customer solving problems, right? And taking away those medial tasks – and so the point here is from the conversation earlier, there’s going to always be improvement in discovery and productivity in our mindset and in our culture now. And how we manage headcount is just like Michael said. So what you’re hearing is a change in the way that we operate the company. And that’s why it’s so important to understand the model and how we operate that every day. So I just wanted to jump in there."
},
{
"speaker": "Chris Wetherbee",
"content": "Got it. Appreciate the time. Thanks very much."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Ari Rosa of Citi. Please go ahead."
},
{
"speaker": "Ari Rosa",
"content": "Hi, good evening. I was hoping you guys could address some of the changing competitive dynamics in your industry. We’ve seen, obviously, this quarter brought a merger or an acquisition, if you will, between two top 10 brokers, I wanted to get your thoughts on how that might impact the industry? And then also, we’ve heard some of the truckload carriers talk about a shift in business away from brokers and towards asset-based carriers. I’m curious if you’re seeing that, if you could corroborate that and just your thoughts on if that continues and what that looks like if the freight cycle tightens? Thank you."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Ari, good. Thanks for the question. I think we’ll break this down a little bit. Obviously, what you’re seeing in the market and some of the moves you’re probably talking about with – RXO and Coyote, listen, that’s something that’s going to happen within the market. I think as you – as we continue to go in this market, there’s going to be puts and takes, and you’ve seen that here in the last several months. For us, it’s about making sure we’re controlling what we can control in that marketplace. And I feel like we’re on the right path to do that. Driving the fit, fast focus for Robinson at our scale still being in the pole position within the industry. I think we’re taking the right path on doing that. But I think as we look forward, I’m going to have Michael jump in on the second part of your question because we do need to kind of break that down, hopefully, so."
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. Thanks, Ari. The second part in terms of are we seeing a shift towards asset versus broker for hire in the for-hire space. Traditionally, you see movement in the low end of the cycle towards the asset. But we feel really good about how we’re competing in the marketplace. We feel really strong about the wallet share gains we’re making in the contractual space. I think we’ve been pretty honest about how we’re attacking the transactional space and being disciplined and making sure that we serve our customers by hauling the right freight that fits for them and our carriers. And so while I think that’s a normal part of the cycle, we’re not seeing that, that is a competitive disadvantage right now. As I mentioned earlier, our drop program, which is something we’ve been talking about more is almost $1 billion and something we believe allows us to behave as an asset in an asset-light manner but in a space that’s traditionally an asset space, and we feel really good about our ability to keep bringing those solutions to customers. We’re also really confident that supply chains are not getting less complex. They’re getting more complex. And so customers are looking for companies that can flex, can move, can react and really meet them where they need to be met. And I feel really good about our team being able to deliver that every day. And that will be in the form of whatever it takes, whether it’s truckload, LTL, drop, you name it. And so good question, but I feel – this is not an abnormal thing in this part of the cycle, but we feel really good about our ability to compete in this space."
},
{
"speaker": "Chuck Ives",
"content": "Yes. Ari, just to put a period on that when we look at our four walls, I mean, there’s just a number of ROI, high ROI opportunities that we can go attack and that’s what we’re doing. And I think that’s really where you have to focus before tackle the organic before you really have to get the inorganic there. So that’s how we’re looking at it. We feel pretty good about it."
},
{
"speaker": "Ari Rosa",
"content": "Wonderful. Thank you for the color."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Jason Seidl of Cowen. Please go ahead."
},
{
"speaker": "Jason Seidl",
"content": "Thank you, operator. Dave, Michael, team, congrats on the good quarter. Wanted to go back to your comments about algorithmic pricing, and it sounds like you guys are using it selectively. I wanted to get a sense of what we should expect going forward? And how does the freight through that algorithmic pricing look from AGP margin perspective compared to your legacy business?"
},
{
"speaker": "Arun Rajan",
"content": "Yes. So good question, Jason. Our algorithmic pricing, everything we do, whether it’s algorithmic pricing or not anchors back to our revenue management goals and our overall strategy. So we have a certain gross margin percentage of strategy across our different modes and channels, it doesn’t really matter. Ultimately, we’re kind of optimizing to our overall strategic goals. Having said that, there’s obviously greater opportunity on the algorithmic side on both things like price discovery and cost discovery and more real-time signals and supply and demand. So there’s greater opportunity there in terms of sort of market pricing and so on. However, everything still kind of ties back to a disciplined approach anchored on our operating model to our revenue management strategy."
},
{
"speaker": "Dave Bozeman",
"content": "Jason, the only thing I’d probably add from my perspective is that the nature of the industry requires us to have a pricing engine to meet customers because so much of our pricing is digitally connected, and it’s not possible for humans to react in the right amount of time to make sure we’re getting as many quotes out to customers as we need. But all of our pricing, even our algorithmic pricing really feeds into that human in the loop mentality that we’ve built in. And so pricing the load is the first step – and then it really flows into our teams, our systems, our operating model, our ability to serve customers. And so I think it gives us a really good starting point for how we began a transaction with the customer, but then it really becomes a tool for our team to deliver industry-leading service and capabilities. And so – but you can’t operate in today’s scaled freight environment without a pricing engine that is driven by hopefully the best algorithms in the industry, and we feel pretty good about what we have."
},
{
"speaker": "Jason Seidl",
"content": "Fair enough. Appreciate the time, guys."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, thanks."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Stephanie Moore of Jefferies. Please go ahead."
},
{
"speaker": "Stephanie Moore",
"content": "Hi, good afternoon. Thank you. I wanted to – I actually think you brought up a good point earlier, your color around needing to see a demand inflection for the freight market to truly repair and maybe just a lack of underlying momentum in the market is actually a really fair assessment. So – if this is what continues and we don’t, in fact, see this demand inflection next year or for a lot of next year – what is your playbook? What are the next steps or levers that can be pulled to continue the current momentum and then drive growth? Thanks."
},
{
"speaker": "Michael Castagnetto",
"content": "Yes. Thanks, Stephanie. I’ll speak for the NAST part of it, and then maybe Dave wants to speak for the enterprise overall. I think the playbook is pretty simple, which is we’re going to control we can control. We’re going to run our operating model. We’ve got really good pricing discipline – like I’ve mentioned a couple of times, we’re putting those tools and capabilities into the best people in the industry. And we feel we can deliver results in this market or in a different type market. We have growth opportunities ahead of us. We believe we can continue to take share and outperform the market. And whether or not that comes from continued elongation of the current situation or a market inflection. I’m not lowering the expectation of what our team accomplishes we continue to expect ourselves to move up the value stack with our customers. We’re going to recapture business in the transactional space and really continue to win business in key verticals. And so I feel what I think myself, the team and probably everybody here want a market inflection just because I think it’s a lot more energetic market to do business in, sure. But we feel pretty good about our ability to deliver results. And as Dave has mentioned, continue to deliver higher lows in a tough market and get ready for higher highs in the future."
},
{
"speaker": "Dave Bozeman",
"content": "Yes, Stephanie, just I don’t know we’re at time. I’ll just put period on that. And that is, listen, this is why Robinson is in the pole position. I think with our balance sheet and the ability to invest in a tough market and continue to invest like we’ve done. It gives us the strength. We’ve got the biggest data set and a number of things that if this is a prolonged market. We’re going to continue to improve with our operating discipline. We’re going to continue to have a positive balance sheet that allows us to invest and then get ourselves set for when this thing starts to inflect. So thanks for the question. And again, we feel really good about where we are."
},
{
"speaker": "Chuck Ives",
"content": "All right. That does conclude today’s earnings call. Thank you for joining us today, and we look forward to talking to you again. Have a great evening."
},
{
"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."
}
] |
chrw | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good afternoon, ladies and gentlemen, and welcome to the C.H. Robinson Second Quarter 2024 Conference Call. At this time, all participants are in a listen-only mode. Following the company's prepared remarks, we will open the line for a live question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded, Wednesday, July 31, 2024. I would now like to turn the conference over to Chuck Ives, Director of Investor Relations."
},
{
"speaker": "Chuck Ives",
"content": "Thank you, Donna, and good afternoon, everyone. On the call with me today is Dave Bozeman, our President and Chief Executive Officer; Arun Rajan, our Chief Strategy and Innovation Officer; Michael Castagnetto, our President of North American Surface Transportation; Mike Zechmeister, our Chief Financial Officer; and Damon Lee, our Incoming Chief Financial Officer. I'd like to remind you that our remarks today may contain forward-looking statements. Slide two in today's presentation lists factors that could cause our actual results to differ from management's expectations. Our earnings presentation slides are supplemental to our earnings release and can be found in the Investors section of our website at investor.chrobinson.com. Our prepared comments are not intended to follow the slides. If we do refer to specific information on the slides, we'll let you know which slide we're referencing. Today's remarks also contain certain non-GAAP measures and reconciliations of those measures to GAAP measures are included in the presentation. And with that, I'll turn the call over to Dave."
},
{
"speaker": "David Bozeman",
"content": "Thank you, Chuck. Good afternoon, everyone, and thank you for joining us today. Having been in this seat for a little over a year now, I'm pleased with the progress we've made on evolving our strategy, improving our execution, and evaluating and enhancing the company's four P's, people, products, processes and portfolio. We've brought in some new leaders, and we're arming our people with better tools to execute on our profitable growth strategies. We're delivering innovative products to provide greater value to our customers and carriers. We're streamlining our processes, applying lean principles and leveraging generative AI to drive out waste and optimize our cost. And we're making changes to drive focus on the four core modes in our portfolio. All of these changes are aimed at our North Star of generating incremental operating income and delivering higher highs and higher lows over the course of freight market cycles. Our second quarter results reflect a higher quality of execution and performance as we continue to implement the new Robinson operating model. And although we continue to fight through an elongated freight recession, we are winning and executing better at this point in the cycle. Our people are delivering exceptional service and enhanced digital experience and differentiated value for our customers and carriers, and I thank the team for their efforts. Our truckload business grew market share for the fourth consecutive quarter and we took share the right way with margin improvement in mind, and our adjusted income from operations increased 32% year-over-year for the full enterprise. On our first quarter earnings call, I discussed that we had begun deploying a new operating model that is rooted in lean methodology to improve the level and consistency of our operational execution. Today, I would like to share more about how the Robinson operating model is coming to life, which would hopefully help investors understand how things are evolving. The Robinson operating model starts with an enterprise strategy map that lays out the key strategies that we need to execute on to drive profitable growth and improve the operating income of the business. Growth and operating income will come from margin expansion by improving our cost structure and operating leverage, and for market share gains by igniting profitable growth in targeted market segments and industry verticals. Our enterprise strategy map converts to a balanced scorecard for the enterprise and cascades down to strategy maps and scorecards for each division and for the functional support areas. These scorecards include the key metrics that each area of the business needs to deliver on and be accountable to. As examples, these metrics may be related to driving growth, meeting customer expectations, optimizing AGP, optimizing cost, managing our talent, or improving our cash conversion cycle. Through a regular cadence of operating reviews, on at least a monthly basis, but in some cases, weekly or even daily, scorecard metrics are reviewed and there's a binary view of whether they are on track. The metrics are green if they're on track and red if they're not on track. There is no yellow. We're coaching our people to embrace and attack the red with countermeasures or action plans to solve problems faster, which is driving improvements in execution. This may show up in improvements such as more disciplined pricing, better decisions on the volume that we're seeking, or how we're servicing our customers and carriers. These operating reviews prosecute the problem and not the person, as we want our people to embrace the red as an opportunity for improvement. Since we began implementing the new operating model in Q1, we're getting better at being vocally self-critical and driving transparency and accountability, and we've been able to shine a light on some error states that negatively contributed to our results. We're also getting better at making decisions faster and taking quick action on countermeasures to correct those error states and improve our performance. We are still early in our journey, but the operating model is helping us execute a solid strategy even better, and we expect further improvement as we continue to cascade the new operating model deeper into the organization and as our team continues to embrace it and build operational muscle. I know from my past experiences of implementing lean operating models that improvement isn't always linear, and we still have a lot of grass to cut. I'm confident in the team's willingness and ability to drive a higher level of discipline in our operational execution. As the global and North American freight markets fluctuate due to seasonal, cyclical and geopolitical factors, we remain focused on what we can control, including deploying our new operating model, providing best-in-class service to our customers and carriers, gaining profitable share in targeted market segments, and delivering tools that enable our customer and carrier facing employees to allocate their time to relationship building and value added solutioning. Our continued focus on productivity improvements is one part of our plan to address and optimize our enterprise-wide structural costs. We continue to eliminate or automate certain tasks to enable our teams to handle more volume. In 2024, we expect these initiatives will help drive a 15% increase in shipments per person per day in NAST and a 10% increase in Global Forwarding, both of which would result in compounded productivity improvements of 32% or better over '23 and '24 combined. We also took an important step yesterday on our journey to get fit, fast and focused when we announced that we've reached an agreement to sell our European Surface Transportation business. This move is consistent with our strategy to drive focus on profitable growth in our four core modes of North American truckload and LTL and global ocean and air. Growth needs to be highly scalable within our model to create the most value for our stakeholders. As such, our Global Forwarding and managed services businesses in Europe will continue to execute on the breadth of global services that we provide to customers and that feed our core modes. With ongoing efforts to improve the customer experience and our cost to serve, we continue to focus on ensuring that we'll be ready for the eventual freight market rebound, with a disciplined operating model that decouples headcount growth from volume growth and drives operating leverage. I'm also excited about the changes that we've made on my senior leadership team. Being able to attract Damon Lee as our new CFO is a big win for Robinson, with his proven track record of financial discipline while delivering results as an operational leader and a strategist with a lean and continuous improvement mindset. I look forward to Damon's contributions to our strategy and execution. I'm also greatly appreciative that Mike Zechmeister graciously agreed to extend his time with us to facilitate a seamless transition for C.H. Robinson and for Damon. I thank Mike for his five years service and dedication to Robinson and wish him the best in his upcoming retirement. We also recently announced that Arun Rajan transitioned from the role of COO to a new role of Chief Strategy and Innovation Officer. This change enables Arun and his team to focus their continued efforts on building our digital and operational capabilities and uphold tight alignment between our business teams and our digital investments. We're at a pivotal point as a company and with a single threaded leader at the helm of strategy and innovation, we can accelerate efforts already underway to bring industry leading products, technology, solutions and ways of working to our company and the global logistics marketplace. Working closely with the senior leadership team, Arun will oversee our enterprise strategy and innovation process from creation to implementation, and measure our performance against our strategic goals. I have high expectations for how this new role will benefit Robinson and all our stakeholders as we continue our transformation. And finally, it's been great to have Michael Castagnetto leading and driving further improvement in our NAST business. He has a proven record of building strong relationships with our people and our customers, driving operational excellence and delivering exceptional results. Michael has joined us on today's call and I'll turn it over to him now to provide more details on our NAST results."
},
{
"speaker": "Michael Castagnetto",
"content": "Thanks, Dave and good afternoon, everyone. It has been extremely energizing to be leading the NAST organization and working with our talented and dedicated team members who are committed to delivering the best solutions and service to our customers and carriers every day. While we're still in the early stages of implementing and adopting the new Robinson operating model, I am convinced that this approach is just what we need. Our discipline, execution and accountability has improved more than any other time in my previous 26 years at Robinson and two years in NAST. If it feels different, that's because it is, and it's showing up in our results. Supported by our new operating model, with our product and tech teams delivering new innovative tools like our recently announced digital matching product, our resilient team of freight experts is responding to the challenging freight environment, and we are reacting quicker and more effectively to provide solutions to our customers and carriers. As a result, our Q2 NAST truckload volume increased approximately 1.5% sequentially and year-over-year, which outpaced the market indices for the fourth quarter in a row. Within Q2, we saw some seasonal volume strength in June, primarily related to produce season, but overall seasonality was muted in Q2, as shown in the Cass Freight Shipment Index increasing only 0.2% sequentially versus the 10-year average of a 6.1% sequential increase excluding the pandemic year of 2020. Looking ahead to Q3, the 10-year average of the Cass Freight Shipment Index, excluding the pandemic impacted year of 2020, is a 0.4% sequential decline from Q2 to Q3. At this point, it's hard to say whether the muted seasonality that we saw in Q2 will continue into Q3. From a market balance perspective, we continue to be in a drawn out stage of capacity oversupply. Although carrier attrition is occurring, it remains at a slower pace and not enough to materially impact the overall market. Load to truck ratios did increase in June and put upward pressure on spot rates, but it was largely regional and related to produce volumes in the southern half of the US. In July. However, drive and load to truck ratios have retreated to the level seen in April and May. In Q2, we delivered further optimization of volume and adjusted gross profit per truckload, which increased 6.5% sequentially and year-over-year. The improvement compared to Q2 of last year was driven by improved pricing discipline and revenue management, that led to better AGP yield within our transactional truckload business, as our procurement teams, combined with the intentional usage of digital brokerage capabilities, delivered a cost of higher advantage versus the market average. These practices are part of our operating structures that are integrated into our operating model and ladder up to the NAST divisional scorecard and ultimately into the enterprise scorecard. In our LTL business, Q1 shipments were also up 1.5% on a year-over-year basis and 3.5% sequentially, driven primarily by strength in our retail consolidation service offering. By leveraging our vast access to capacity, broad range of services and our high level of service, our LTL team continues to onboard a solid pipeline of new business and build on our existing $3 billion LTL business. The strength and unmatched expertise of our people enables us to deliver exceptional service and greater value to our customers. We are investing in our sales organization to maximize our growth opportunities. As an example of the operating model at work, we took actions recently to streamline our sales process and reorganize our sales teams, and the result has been a more effective and quicker engagement with our customers and a greater opportunity for our more experienced salespeople to engage with the right customers. We've made net additions to and are actively growing our sales team in line with a disciplined and focused approach to capture growth opportunities in targeted customer segments. Our people are the single greatest differentiator for us versus the competition, and we are going to continue to lean into this. We may have gotten the balance of people versus tech wrong at certain points in our past, but we've learned and we are getting it right now. We will keep evaluating our results and adjust accordingly going forward. From upskilling our people to providing upward mobility and new opportunities, we will continue to lead with our people first. We will support our people with industry leading tech and solutions to enhance their capabilities as we continue to focus on people, process and technology. I'll turn it over to Arun now to provide an update on the innovation we're delivering to strengthen our customer and carrier experience, increase AGP yield, and improve operating leverage."
},
{
"speaker": "Arun Rajan",
"content": "Thanks, Michael and good afternoon, everyone. I'm excited about my recent transition into the role of Chief Strategy and Innovation Officer. I'm proud of the team's accomplishments over the past couple of years to build a solid foundation for our digital and operational strategy. Since I joined the organization in the fall of 2021, we have taken a surgical, data-driven approach to technology investments to accelerate our digital transformation and deliver financial outcomes. These efforts have now matured into digitally oriented operating structures that power core parts of our business such as digital brokerage, revenue management and operational excellence teams. The success of these collective efforts has enabled us to transition some of these digitally oriented operating structures into our core operations, thereby enabling me to shift my focus to accelerating actions in support of our broader enterprise strategy and innovation to drive profitable growth. Strategy process is not static. Leveraging our operating model, we will diligently monitor execution towards strategic outcomes and the constantly evolving external landscape to take advantage of opportunities to accelerate our strategy as we expand our leadership position in the logistics industry. Innovation is at the heart of Robinson's competitive differentiation. We are leading and innovating at scale in our processes and our products for the benefit of both sides of our two-sided marketplace in alignment with our strategy to drive profitable market share growth. As an example, on the carrier side, we've launched an enhanced load matching platform for carriers called Digital Dispatch. This innovative tool utilizes advanced algorithms to match carriers with loads that best fit their needs and provides real time customized load recommendations right to carriers' phones via text or email. In addition to enabling carriers to run fewer empty miles, Digital Dispatch books loads four times faster than traditional methods on average, transforming hours spent searching into valuable hauling time. Digital Dispatch first became available in February to carriers that own one to 10 trucks and we have plans to expand it to larger carriers in the future. For Robinson, we expect this innovative tool to help with the acquisition, retention and growth of our carrier base and therefore, provide greater access to capacity for our customers, especially when the market turns. On the customer side of the marketplace, we continue to innovate and leverage GenAI to respond faster than ever to dynamic market conditions with the tools and capabilities we've developed. Last quarter, we shared the example of using GenAI to automatically respond to transactional truckload quote emails, which drives faster speed to market, increases our addressable demand and reduces manual touches. Another touchpoint where we're leading is using GenAI to translate order emails and generate on system orders. With GenAI, we've been able to reduce the time to generate an order by more than 80%, thereby enabling us to provide faster service to customers and to effectively scale our operations when the market returns to growth. In addition to improving the customer and carrier experience, innovations such as Digital Dispatch and products that leverage the power of GenAI are designed to improve the employee experience and improve productivity. These productivity improvements serve as a critical input into creating operating leverage. We also continue to increase the rigor and discipline in our pricing and procurement efforts in Q2, resulting in improved AGP yield across the NAST and Global Forwarding portfolios. With continued innovation in dynamic pricing and costing, investment in contract management systems and increasing revenue management rigor, we are responding surgically and faster than ever to dynamic market conditions. Finally, as Michael mentioned, we believe we are getting the balance of people versus tech right. Getting this balance right includes the active role that our people play from a human in the loop perspective to drive continuous feedback and improvements to our algorithms and GenAI implementations. With that, I'll turn the call over to Mike for a review of our second quarter results."
},
{
"speaker": "Mike Zechmeister",
"content": "Thanks, Arun and good afternoon, everyone. Disciplined revenue management in the face of continued soft freight market conditions resulted in second quarter total revenues of $4.5 billion and adjusted gross profit, or AGP, of $687 million, which was up 3% year-over-year, driven by a 5% increase in NAST and a 3% increase in Global Forwarding. On a monthly basis compared to Q2 of last year, our total company AGP per business day was down 5% in April, up 1% in May, and up 15% in June. Overall Q2 AGP results reflect progress on the revenue management initiatives that were referenced earlier. The AGP per business day improvement through the quarter also reflects both seasonal increases in freight demand and easier year-over-year comparisons as the quarter progressed. Michael covered the details of our Q2 NAST performance. I'll cover the performance of our Global Forwarding business where the team has had success growing the business profitably and been highly engaged with our customers to help them navigate the ongoing conflicts in the Red Sea. The transit interruptions in the Red Sea have resulted in vessel reroutings that have extended transit times. In Q2, this put a strain on global ocean capacity and created varying levels of port congestion and container shortages. While the Asia to Europe trade lane has been most affected, the impact has also extended to other trade lanes as carriers adjust the geographic placement of vessel capacity based on shipping demand. As we mentioned on our first quarter earnings call, ocean rates had come down from the February peak as capacity was repositioned and new vessel capacity entered the market. In May and June, however, ocean rates rose again as capacity tightened. Given our mix of contractual and transactional business, the impact of changing market rates generally takes one to two months to flow through to our profit per shipment. So even though rates came down from the February peak, our profit per shipment held up through March and into April as we started realizing the declines in May and the first half of June. When the ocean markets rose in May and June, our same one to two-month lag meant we started realizing the positive impact to our profit per shipment in the second half of June and now into July. While the Red Sea disruption continues without any clear timeline of when it will be resolved, ocean rates have declined slightly in July but remained elevated compared to 2023. Our team performed well in Q2, with our ocean forwarding AGP increasing 8.6% year-over-year, driven by a 4% increase in shipments and a 4.5% increase in AGP per shipment. Sequentially, shipments increased 6%, while AGP per shipment declined 2.5%. There are some indications that customers may be pulling forward some of their peak season ocean freight due to ongoing concerns about geopolitical issues and capacity disruptions, as well as the potential for labor issues on the East Coast ports of the United States. One measure of this is that our ocean volume per business day grew 8% sequentially in June versus May compared to a 2% sequential decline over the same period last year. Time will tell as to whether this pulls from the normal July to September peak season in ocean. Turning now to enterprise expenses. Q2 personnel expense was $361.2 million, including $9.4 million of restructuring charges related to workforce reductions. Excluding restructuring charges this year and last year, our Q2 personnel expenses were $351.8 million, down $12.4 million, or 3.4% year-over-year, driven by our continued productivity efforts and partially offset by higher incentive compensation. Our average Q2 headcount was down 10% compared to Q2 last year. We continue to expect our 2024 personnel expenses to be in the range of excluding restructuring, but likely below the midpoint of that range. With that, we expect a slower pace of net headcount reductions in the second half of 2024 compared to the first half. Moving to SG&A. Q2 expenses were $148.1 million, including $5.7 million of restructuring charges, which were driven by reducing our office footprint. Excluding restructuring charges this year and last year, SG&A expenses were $142.4 million, down $12.2 million, or 7.9% year-over-year. The expense reduction was across several expense categories as we continued to eliminate non-value-added spending. We continue to expect SG&A expenses for the full year to be in the range of $575 million to $625 million, excluding restructuring charges, but likely below the midpoint of that range too. SG&A includes depreciation and amortization expense, which we still expect to be $90 million to $100 million in 2024. Our effective tax rate in Q2 was 19.4% compared to 14.9% in Q2 last year and was in line with our expectations. We continue to expect our 2024 full year effective tax rate to be in the range of 17% to 19%. In Q2, our capital expenditures were $19.3 million, down 20.6% year-over-year on more focused technology spending. We now expect 2024 capital expenditures to be toward the lower end of the previously provided range of $85 million to $95 million. Now onto the balance sheet. We ended Q2 with approximately $925 million of liquidity, comprised of $812 million of committed funding under our credit facilities and a cash balance of $113 million. One key differentiator for Robinson is our financial strength. This allows us to continue investing and improving our capabilities even through this prolonged freight recession. As a result, we expect to emerge stronger when the market tightens. Our debt balance at the end of Q2 was $1.6 billion, which was down $127 million from Q2 of last year. Our net debt to EBITDA leverage at the end of Q2 was 2.4 times, down from 2.73 times at the end of Q1, primarily driven by the performance of the business and the resulting decrease in our net debt balance and increase in our trailing 12-month EBITDA. As I depart Robinson for retirement, I'd just like to add that I couldn't be more proud of the accomplishments of the team and I couldn't be more excited about the direction of the company. It feels terrific to be leaving the company in such great hands with a sound strategy and solid momentum on the business. From the deployment of the new operating model to the growth potential from the market segment and vertical focus to the incredible upside of generative AI to enhance the capabilities of our industry leading people, the future looks incredibly bright. I will miss working with the best logistics experts in the business, but will be cheering for Robinson as a shareholder. Best wishes to the entire Robinson team. And with that, I'll turn it over to Damon for a few comments."
},
{
"speaker": "Damon Lee",
"content": "Thanks, Mike and good afternoon, everyone. I'm excited about joining C.H. Robinson and partnering with the rest of the senior leadership team as we execute on a strong strategic plan. I'm eager to leverage my past experiences and a focus on operational excellence to drive improved results and deliver more value for Robertson shareholders. I'd also like to reiterate Dave's comments and thank Mike Zechmeister for his collaboration and partnership to ensure a seamless transition. The first three weeks of my tenure have been great and I look forward to talking with all of you as we continue on this exciting journey. I'll turn the call back to Dave now for his final comments. Dave?"
},
{
"speaker": "David Bozeman",
"content": "Thanks, Damon. I want to commend our people for continuing to embrace the changes that we're making to deliver a higher and more consistent level of performance and for the high-quality Q2 results that they delivered in what continues to be a challenging market. As I mentioned earlier, all the changes that we're making are aimed at our North Star of generating incremental operating income and delivering higher highs and higher lows over the course of freight market cycles. We will do this by focusing on two main fronts, growing market share and expanding our operating income margins. We'll continue to grow market share by leveraging our robust capabilities to power vertical centric solutions, by reclaiming share in targeted segments, and by expanding our addressable market through value-added services and solutions for our customers and carriers that drive new volume to our four core modes. We'll also be more intentional with our go-to-market strategy to drive additional synergies and cross-selling across our portfolio. We'll expand our operating income margins by embedding lean practices, removing waste and expanding our digital capabilities. This will enable us to strengthen our productivity and optimize our organization structure in order to be the most efficient operator in addition to the highest value provider. We'll optimize our gross profit by monitoring key input metrics and responding faster to error states and changing market conditions with countermeasures and innovative technology that improves our execution. As we take action on all of these fronts, I'm excited about the work that we're doing to reinvigorate Robinson's winning culture and to instill discipline with our new operating model, removing with greater clock speed and urgency to seize opportunities and solve problems in order to win now and to be ready for the eventual freight market rebound. And we now have a plan to share more about our strategy, how we'll execute that strategy and the resulting financial targets at a 2024 Investor Day that is scheduled for December 12 in New York City. While there's a lot more work to do, I continue to see an opportunity for the company to reach its full potential and create more shareholder value by improving our value proposition, increasing our market share, accelerating growth, further reducing our structural costs and improving our efficiency, operating margins and profitability. Together, we will win for our customers, carriers, employees and shareholders. This concludes our prepared remarks. I'll turn it back to Donna now for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Your first question is from Jonathan Chappell with Evercore ISI. Please proceed."
},
{
"speaker": "Jonathan Chappell",
"content": "Thank you. Good afternoon. If I look at page 17 in the presentation, the first page in the appendix, when you have this elongated history of the transportation AGP margin, it's obviously taken two pretty big step ups sequentially in the last two quarters. When you think about the path forward on the market, sounds like it's still pretty volatile with July weaker than June. Is this something that's kind of market independent right now where you can see the AGP continue to move higher based on the initiatives that you put in place and the digital processes? Or at this point, do you really need kind of a market tailwind to help you kind of drive it higher above 16 and beyond?"
},
{
"speaker": "David Bozeman",
"content": "Hey, Jonathan, it's Dave. Good to hear from you. Hey, listen, I'm going to -- it's Michael's first call. He's going to jump in and add some more color to this. But I really want to start and say, number one, happy to see Michael and team drive the effects of the operating model, which is some of the things that you're seeing with the discipline within the business. And we expect to continue to drive that discipline. And as we said on our comments, there's more grass to cut on this, but we're off to a pretty good start on that. But we'll give you some more color around history wise and where we're going. Michael?"
},
{
"speaker": "Michael Castagnetto",
"content": "Yeah. Thanks, Dave. And again, thanks for the question. As we mentioned in some of our earlier comments, we're really starting to see the leverage of the tools related to our dynamic pricing and costing come to life over the last couple quarters. Certainly, the team has battled through what has been, as we mentioned, a continued elongated freight recession. And despite that, we're starting to see the efforts come to life. Really, when you take the ability to combine those technologically and product advancements with our operating model disciplines that we've been able to enact, we're really starting to be able to respond quicker and more surgically to our customers and really meet the dynamic market conditions more effectively. As we think about how we'll continue to do that forward, we still have opportunities to continue to improve as we implement our disciplined pricing strategy throughout the business. But I think I'd put it most simply in that I think we're making more deliberate and more informed decisions on the freight that we pursue, the manner in which we pursue it, and then also, just as importantly, how we match the right carriers to that freight to create the best transaction for both parties, and obviously an improved result for C.H. Robinson."
},
{
"speaker": "Jonathan Chappell",
"content": "Okay. Thank you, Mike. Thanks, Dave."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from Jeff Kauffman with Vertical Research Partners. Please proceed with your question."
},
{
"speaker": "Jeff Kauffman",
"content": "Thank you. And thank you for taking my question and congratulations. Just terrific quarter in a difficult environment. It's great to see some of these changes kicking in. Question for Michael, it's your first conference call. There were comments on how capacity hasn't really come out in the brokerage space the way it normally would. Little leniency. I'm just kind of curious, when you're out there talking to your customers, are the customer questions changing, given some of the financial strain that some of these smaller competitors of yours have been facing? And do you see any changes in the competitive dynamic of the marketplace?"
},
{
"speaker": "Michael Castagnetto",
"content": "Hey, thanks, Jeff. Really good question. And I think you asked really two things, right? So what are we seeing from, in terms of a carrier exits related to the marketplace, and then how are customers reacting to that? We have seen some acceleration of carrier exits throughout Q2, but as we said, not enough to materially impact the market. And really we're not seeing a change even throughout the quarter that we would see that to start impacting us in the near future. As we talk to customers, it's really twofold and it's around what is their look at the health of their long-term supply chain and how do they want to set that up and whether they're really looking at more of a short term or a long-term perspective. I think customers looking for a more long-term solution and long-term supply chain solution are certainly asking, what are we predicting in terms of when the market would change and when does that inflection come, and then how do we set up a supply chain solution that allows them to have a healthy route guide when the market does come back? When you think about it more transactionally or in a more shorter term, customers are being very aggressive and they're continuing to challenge us to meet them, whether it's in short term RFPs or in the transactional space with aggressive pricing."
},
{
"speaker": "Jeff Kauffman",
"content": "Okay. Thank you very much. That's my one."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from Chris Weatherby with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Chris Weatherby",
"content": "Yeah. Hey, thanks. Good afternoon, guys. Maybe wanted to come at the NAST business a little bit differently and think about kind of profitability through the cycle. So Dave, you talked about higher highs and higher lows. So as we've been in better freight environments, NAST has been able to generate sort of 40%-plus type of operating margins. I'm just kind of curious. We obviously saw a nice step forward in the second quarter, but we're in still, I guess, an uneven freight environment. So are those the right type [technical difficulty]"
},
{
"speaker": "Michael Castagnetto",
"content": "…the color on it, it is higher highs, higher lows. And I definitely would agree with you that it's still a tough freight market out there, as we stated in our comments. But long-term, that's still the right way to look at the business. We feel really good about it, especially with the things that we're doing and enacting, long-term 40% for NAST, 30% for GF. And that's what we still hold on to, and it's the right way to look at it. And again, we feel we've got confidence about that and what we're doing, but the market is the market right now, and we're going to continue to do the things that we're doing in the tough market right now and be prepared for this change in the market when it comes."
},
{
"speaker": "Chris Weatherby",
"content": "Okay. That's helpful. Thanks very much. Appreciate it."
},
{
"speaker": "Michael Castagnetto",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your question."
},
{
"speaker": "Tom Wadewitz",
"content": "Yeah. Good afternoon. And yeah, I would also certainly say congratulations on the good results. How do you think about the progression? I think, Mike, you mentioned the by month and the net revenue growth was a lot stronger in June. Should we think of that as a better representation of the growth as you look at July and as you look forward? Or is there something we should be mindful of that would have made June a lot stronger? I think you mentioned a little easier compensation, but just some more thoughts on kind of that greater strength in June and whether that gives us a look forward or if we should be more cautious. Thank you."
},
{
"speaker": "Mike Zechmeister",
"content": "Yeah. Thanks, Tom. I did make a comment on AGP per day for the enterprise, and you're right, we were down 5% in April, up 1% in May, and then up 15% in June. Probably I would point to three things that were helping us in that regard. Number one, obviously our operating model is still coming into its own, and I would expect that as time passes we get better and the performance should reflect that. We also had some seasonal elements we talked about in last quarter. It wasn't a huge seasonal quarter, but we did see some strength in the backside of the quarter in June, particularly when you think about produce in the southern part of the United States. So there's a seasonal element there, too. But of course, the comparison was year-over-year, and then there were a little bit easier comps coming into June, the end of the quarter as well. So as you go forward from there, the business continues. I think you see a little bit of difference going on in NAST versus GF on the ocean side of the world. You've got -- it looks like there might be some pull forward, key season there, and we saw some additional demand, but pricing has come down a little bit too. And I think a lot of the pricing that we've seen in ocean is attributable to the issues in the Red Sea. And presumably over some period of time, those will right themselves and the capacity that exists in the market will kind of stabilize and it'll be back to a normal supply/demand dynamic. But as we've gone into the quarter, nothing significantly different, and we certainly haven't seen enough to call any definitive inflection in the marketplace."
},
{
"speaker": "Tom Wadewitz",
"content": "Does the read on July look kind of similar to June? Any thoughts on July?"
},
{
"speaker": "Mike Zechmeister",
"content": "Yeah. We've tried to get away from commenting on the first month of the quarter or specific months because, as you know, we've got to play the full quarter out. We've got to see how the quarter comes in and we'll certainly give you all the color on the next call."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Scott Group with Wolfe Research. Please proceed with your questions."
},
{
"speaker": "Scott Group",
"content": "Hey, thanks. Good afternoon. So, just following up there, I know there's obviously some noise in the forwarding results right now. Just directionally, did NAST see a similar trend in that monthly net revenue in terms of a big acceleration throughout the quarter? And then separately, just the headcount overall down 10% year-over-year, down another 3.5% sequentially, how much more is there to go on headcount here? Can we get -- I know you've been talking about it, but is there a lot more in terms of volume growth and headcount down 10%? Can that persist for a while?"
},
{
"speaker": "Michael Castagnetto",
"content": "Thanks, Scott. This is Michael, I'll start. You asked a direct question about NAST and our quarterly results, and we really saw a much more evened out quarter than maybe the folks in Global Forwarding. Certainly, as the quarter went on, we saw, as we mentioned in our comments, muted seasonality to the business. And so while there were some events related to road check or the holidays, and we saw some short term upticks in spot market pricing, the team did a really nice job of managing through that. And as we mentioned, implementing our revenue management rigor and operating model. And so I think the team did a really nice job of driving real positive results in all three months of the quarter. In terms of headcount, I'll probably pass it over to Mike and maybe Arun. From a NAST perspective, we continue to see the benefits of the investments we've made, both in AI and our overall technology. And certainly, we're confident in our efficiency metrics that we've committed to for 2024. And we believe there is still -- I like the saying Dave had, there's still some more grass to cut when it comes to our ability to drive out additional operational effectiveness and efficiency."
},
{
"speaker": "Mike Zechmeister",
"content": "Yeah. Just maybe an additional comment on the headcount part of your question. So we're going to continue our productivity initiatives. We continue to be committed to getting work out and therefore not needing folks to do that work and really helping our folks focus on the value-added things that they do. So far year-to-date, as you saw, we're down 10% headcount year-over-year. And so we've done quite a bit there. And what we've talked about and what our plan is for the back half is really a slower pace of net headcount reduction than you saw in the first half. And our guidance, you can read through our headcount into our expense guidance, and you can see that stabilization in the back half, particularly in personnel."
},
{
"speaker": "Scott Group",
"content": "Thank you, guys. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from Ken Hoexter with Bank of America. Please proceed with your question."
},
{
"speaker": "Ken Hoexter",
"content": "Hey, great. Good afternoon, Dave and team. Congrats on the new plan and the margin gains. And Mike Z, good luck as you move on. Mike, I guess just following up on that headcount commentary there, we've heard a lot in the press about significant sales layoffs. Is that really changing how you're selling or how you're organizing the business? And I guess now is there a difference in terms of how much is now automated, start to finish? I don't know if you can give numbers on that. And then, Mike, can you also talk about the market? The truckload you mentioned was up 1.5% on tonnage, pricing down only 2%. Are we starting to see that pricing leveling off? Is that kind of flattening out in terms of the market, the state of the market?"
},
{
"speaker": "Mike Zechmeister",
"content": "Yeah. Thank you again for those questions. First, from a sales perspective, I think it's really important, and we said it earlier, we are actively growing our sales team. What we did during the quarter was really changed the methodology and the process through our operating model to make sure that we're putting the right sales process in place and doing it with the right folks, with the right customers. And so while we had some changes in how we manage that group, our overall sales team, throughout the quarter and for year-to-date and throughout the rest of the year, our anticipation is that we're going to continue to add to that group and pursue growth opportunities where we have those opportunities. From a pricing perspective, we've said we're in an elongated freight recession. Pricing has certainly been pretty low and it has been pretty relatively inactive for the quarter. And while we think -- we saw some spot market movement during events or specific weeks during the quarter, nothing that would stick and really nothing that would say there's a market inflection going on, and that we think there's an immediate and consistent change to the marketplace."
},
{
"speaker": "Ken Hoexter",
"content": "Thanks, Mike. Thanks, team."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from the line of Daniel Imbro with Stephens. Please proceed with your question."
},
{
"speaker": "Daniel Imbro",
"content": "Yeah. Hey, good evening, guys. Thanks for taking our questions. Dave, I can follow up on that last question, just about the overall state of the market. We've heard anecdotes of shippers preferring maybe locking in asset-based capacity at this point in the cycle. I'm curious how you've seen that progressing into the back half. Volume was up nicely in 2Q. But I think you mentioned routing depth fell in July. So curious if that's any softening in the trends. And then just how you're thinking about overall spot activity and underlying demand as we head into the back half from what you're seeing. Thanks."
},
{
"speaker": "Michael Castagnetto",
"content": "Hey, Daniel, this is Michael. Thanks again. Good question. As Dave mentioned, route guide, they're holding, right? We're not seeing a lot of freight fall out of those route guides and into the transactional space. And you saw that even in our own ratio as we moved from a 65/35 contractual transactional mix to a 70/30. Really, I think what we're seeing is customers are being aggressive in how they're planning their route guides. So far, the market is continued to be oversupplied. So we're seeing those route guides hold. But really I think it's -- and we've mentioned this, it's about long-term health of those route guides. And that's where we're going to have to lean into our operating model and revenue management rigor once the market does inflect. But as we mentioned, at least for the foreseeable future, we're not seeing any shoots that would say that, that we're in the middle of that right now."
},
{
"speaker": "Daniel Imbro",
"content": "Thanks for the color."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Brian Ossenbeck with JP Morgan. Please proceed with your questions."
},
{
"speaker": "Brian Ossenbeck",
"content": "Hey, thanks. Afternoon. Appreciate taking the question. I wanted to ask the headcount question maybe a little bit differently, maybe to Arun or Dave. But do you think you're at the point where you've decoupled headcount from volume growth? Obviously, headcount's been coming down volumes up, but looking beyond where you are right now, have you reached that point? Do you have line of sight to it? Because typically the model gets a bit margin squeezed on an upturn, so that might help. And then, Dave, you can give some quick thoughts just on portfolio, obviously the sale of the surface transportation in Europe, but what do you think -- what are you and the Board discussing from here on out in regards to the portfolio? Thanks."
},
{
"speaker": "Arun Rajan",
"content": "Yeah. Thanks a lot for the question. I'll go ahead and start and answer your tech question and productivity. So as it relates to productivity, our tech investments are very well lined up. We've delivered 17% productivity improvements in '23, another 15% targeted for this year. Combined those investments give us very high confidence that we've decoupled headcount and volume growth. In terms of our continued investments, we think there's still opportunity and we will continue to go after that opportunity in '24 and '25, but we feel very confident with our investments and the takeout as it relates to touches, which is the most important measure in that context."
},
{
"speaker": "David Bozeman",
"content": "Yeah. Brian, I think on the other part of your question, first of all, thanks for the question. On the portfolio, if you recall, one of the things in my diagnosis is to really look at the company under the auspice of four P's, people, product, process and portfolio. And in doing that, that diagnosis, that's actually how we executed on it, is to really look and drive for focus. We told you guys that we're going to be fit, fast focus, and this is really just driving focus within the portfolio, and that focuses on our four core modes. And we're getting to what we do well, and that is truckload, LTL, ocean and air. This allows us to really drive that focus for the company going forward, and that's what you're seeing in that. So I think that was the essence of the question."
},
{
"speaker": "Mike Zechmeister",
"content": "Yeah. Maybe I'll just add a couple more points on that. The sale of EST, since you asked about it. But over time we hadn't proven that we could scale or be consistently profitable. When you consider covering a portion of allocated corporate overhead that goes to the business on EST, which is one of the reasons for the sale. And secondly, I would just make a couple comments about the size of the business. And you know that EST had a minor impact on our enterprise results. And just to put some numbers to that, in Q2, it was about 2% of our enterprise AGP. And it's in the other -- all other segment. It's the smallest business unit within that all other segment."
},
{
"speaker": "Brian Ossenbeck",
"content": "Great. That's all very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Christopher Kuhn with Benchmark Company. Please proceed with your question."
},
{
"speaker": "Christopher Kuhn",
"content": "Yeah. Hi, good afternoon. Thanks for taking my question. Dave, can you maybe just again talk about the incentive compensation structure? Has that changed under the new model, and how should we think about going forward when sort of the freight market starts to improve?"
},
{
"speaker": "David Bozeman",
"content": "Yeah. Hey, Christopher, good question. Yeah. The short answer is, yeah, it has changed, but I would call it modified as part of the way that we're operating. And I will tell you that we will continue to tweak our operations to make sure that we're driving and doing the things that we're getting from an efficiency perspective. Right now, I would say we feel really good about how we've got that lined up on our overall incentives. And really, if you think about it, we don't -- I don't look at it as if, hey, when the market changes, then your incentive has to change. You really should be fixing those things now, which is what we're doing. That's part of the operating model. So we feel pretty good about the elements of the business that we're doing now, that when the market inflects that, we're already set and ready to go. And so when it comes to the alignment, the organization, we feel pretty good. That doesn't say that we won't continue to tweak some things if we see it, but that's discovery, and that's part of the discipline of the operating model. Michael, anything you would add to that?"
},
{
"speaker": "Michael Castagnetto",
"content": "No. I think through the work that Arun mentioned, our ability to disconnect volume growth from headcount growth really gives us that flexibility that from a leader's perspective, I'm hoping that our incentive compensation does increase with the return of the market and we get an opportunity to reward our team of who -- obviously we think are the best people in the industry, but we've done it in a way that allows us to continue to grow operating leverage throughout each part of the cycle."
},
{
"speaker": "David Bozeman",
"content": "Yeah. And just to put a period on that, I mean, at the end of the day, all of that is going to support our two key themes, and that is, growing market share and expanding margins. That's ultimately what all of this is setting up to do. And I think what you're seeing is some of that operational discipline, and we've got a lot more to go and do, and that's what we're going to go out and do."
},
{
"speaker": "Christopher Kuhn",
"content": "That's helpful. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Stephanie Moore with Jefferies. Please proceed with your question."
},
{
"speaker": "Stephanie Moore",
"content": "Hi. Good afternoon. Thank you. First question is more of a follow up of just -- the kind of the questions that kind of the last couple on AGP. If you could just talk a little bit if it would be helpful on just how NAST AGP typically looks 2Q to 3Q in this environment. I know that very challenging, given the environment we're in, but any kind of typical color would be helpful just to kind of round out the really strong performance in 2Q and then, kind of our thoughts going into 3Q? And then secondly, more strategic question, with the sale of the EST business, would love to get your thoughts on an appetite to explore maybe other strategic sales of other businesses within the enterprise. Thanks."
},
{
"speaker": "Michael Castagnetto",
"content": "Sure, Stephanie. And thanks again for the questions. I'll start and then hand it over to Dave. From a NAST perspective, I think I'd point you back to the comments we made about the Cass Shipment Index. And normally we do see a slight decline from Q2 to Q3 from a seasonality perspective. But overall, I'd say we've seen muted seasonality throughout Q2. We're continuing to see that, or it's really hard to say whether, how far that will head into Q3. And then, as Mike mentioned, it's pretty rare that the first month of the quarter gives a great predictor. And so we really won't comment on it much further, but I'll hand it over to Dave to talk about the Europe question."
},
{
"speaker": "David Bozeman",
"content": "Yeah. Hey, Stephanie, good to hear from you. Just to -- again, look at portfolio, we're going to always look at our portfolio. I mean, like any company would do. But again, we feel really good about where we are. We like our four core modes, truckload, LTL, ocean and air, feel good about those businesses, feel good about what they're doing, and more importantly, where they're going to go and continue to go. So right now, I would say what you saw was something that we were doing to drive focus. And Mike gave color on a little bit of the technicalities of the EST business. But that's just -- that's the step we took for that. And I think that moves us closer to those four core modes. And right now, that's what we feel pretty good about."
},
{
"speaker": "Stephanie Moore",
"content": "Thank you, guys. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude our question-and-answer session. I'll now pass the floor back over to Mr. Ives for closing remarks."
},
{
"speaker": "End of Q&A",
"content": ""
},
{
"speaker": "Chuck Ives",
"content": "That concludes today's earnings call. Thank you for joining us today, and we look forward to talking to you again. Have a great evening."
},
{
"speaker": "Operator",
"content": "Thank you. Ladies and gentlemen, this does conclude today's event. We thank you for your participation. You may disconnect your lines at this time."
}
] |
chrw | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good afternoon, ladies and gentlemen, and welcome to the C.H. Robinson First Quarter 2024 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded Wednesday, May 1, 2024."
},
{
"speaker": "",
"content": "I would now like to turn the conference over to Chuck Ives, Director of Investor Relations. Please go ahead."
},
{
"speaker": "Charles Ives",
"content": "Thank you, Donna, and good afternoon, everyone. On the call with me today is Dave Bozeman, our President and Chief Executive Officer; Arun Rajan, our Chief Operating Officer; and Mike Zechmeister, our Chief Financial Officer."
},
{
"speaker": "",
"content": "I'd like to remind you that our remarks today may contain forward-looking statements. Slide 2 in today's presentation list factors that could cause our actual results to differ from management's expectations."
},
{
"speaker": "",
"content": "Our earnings presentation slides are supplemental to our earnings release and can be found in the Investors section of our website at investor.chrobinson.com. Our prepared comments are not intended to follow the slides. If we do refer to specific information on the slides, we'll let you know which slide we're referencing."
},
{
"speaker": "",
"content": "Today's remarks also contain certain non-GAAP measures, and reconciliations of those measures to GAAP measures are included in the presentation."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Dave."
},
{
"speaker": "David Bozeman",
"content": "Thank you, Chuck. Good afternoon, everyone, and thank you for joining us today. Our first quarter results and adjusted EPS of $0.86 reflects a change in our execution and discipline as we began implementing a new lean-based operating model."
},
{
"speaker": "",
"content": "And although we continue to battle through an elongated freight recession with an oversupply of capacity, I'm optimistic about our ability to continue improving our execution regardless of the market environment."
},
{
"speaker": "",
"content": "As part of my initial diagnosis of the company, I identified an opportunity to refocus our mindset on root causing and definitively solving problems, including making decisions amid uncertainty and acting with greater clock speed. Following my diagnosis, I brought in additional talent to assist the senior leadership team and me on improving operational execution across the business and to deploy a new operating model that is rooted in Lean methodology."
},
{
"speaker": "",
"content": "In Q1, we began deploying the new model at the enterprise, divisional and shared service levels, which is evolving our execution and accountability by bringing more structure to our continuous improvement cadence and culture. This new way of operating is starting to enable greater discipline, transparency, urgency and consistency in our decision-making based on data and input metrics that can reliably lead to better outputs."
},
{
"speaker": "",
"content": "It's also setting the tone of how we operate and hold ourselves accountable, helping us make systemic improvements, build operational muscle and drive value at speed. We began to see the benefits of our new operating model in our Q1 execution. As a result of disciplined pricing and capacity procurement efforts, we executed better across our contractual and transactional portfolios in our NAST business in Q1 and in particular, in our truckload business. This resulted in improved optimization of volume and adjusted gross profit per truckload, which improved sequentially despite an increase in our line haul cost per mile for the full quarter versus Q4."
},
{
"speaker": "",
"content": "Additionally, our truckload volume reflects growing market share, and we outpaced the market indices for the third quarter in a row. In what continues to be a difficult environment, our resilient team of freight Experts is responding to the challenge and embracing the new operating model and the innovative tools that we continue to arm them with."
},
{
"speaker": "",
"content": "Our people have a powerful desire to win, and I thank them for their tireless efforts. They continue to be a differentiator for us and for our customers and carriers, and I'm confident in the team's willingness and ability to drive a higher level of discipline in our operational execution. We're moving in the right direction, and at the same time, everyone understands that we have more work to do."
},
{
"speaker": "",
"content": "Now I'll provide some details on our Q1 results in our NAST and Global Forwarding businesses. In our NAST truckload business, our Q1 volume declined approximately 0.5% year-over-year, which outpaced the market indices. Our truckload AGP per load improved as we moved through the quarter. And although spot costs within the market came down after the winter storms in January, our new operating model and improved pricing discipline led to better AGP yield within both our committed and transactional business, while our procurement teams improved our cost of hire more than the market average."
},
{
"speaker": "",
"content": "We had an approximate mix of 65% contractual volume and 35% transactional volume in our truckload business compared to the same mix in Q4 and a 70-30 mix in Q1 last year. In our LTL business, Q1 shipments were up 3% on a year-over-year basis and 1% sequentially on a per business day basis. AGP per order declined 1% on a year-over-year basis, driven primarily by lower fuel prices. Our LTL AGP per order improved within the quarter and also benefited from our pricing discipline and the new operating model that I mentioned earlier."
},
{
"speaker": "",
"content": "In our Global Forwarding business, we've been highly engaged with our customers to help them navigate the ongoing conflict in the Red Sea and to ensure flexibility and resilience in their supply chain. The transit interruptions in the Red Sea and resulting vessel reroutings have extended transit times, which has reduced global ocean capacity."
},
{
"speaker": "",
"content": "While the Asia-to-Europe trade lane has been most affected, the impact has also extended to other lanes as carriers adjust routes based on shipping demand. As a result, ocean rates increased sharply in Q1 on several trade lanes, including Asia to Europe and Asia to North America. While the red sea disruption continues without any clear time line of when it will be resolved, ocean rates have come down from the February peak as capacity has been repositioned and new vessel capacity enters the market."
},
{
"speaker": "",
"content": "While rates remain elevated compared to 2023. As a global logistics provider, with the scale and expertise to strategize and implement contingency plans, we have grown our ocean market share by providing differentiated solutions and customer service and by leveraging investments in technology and talent, leading to the addition of new customers and diversification of the verticals and trade lanes that we serve."
},
{
"speaker": "",
"content": "In Q1, our ocean forwarding AGP increased by 2.5% year-over-year, driven by a 7% increase in shipments and partially offset by a 4% decrease in AGP per shipment. Sequentially, AGP per shipment increased 13.5%. As the Global and North American freight markets fluctuate due to seasonal, cyclical and geopolitical factors, we remain focused on what we can control, including deploying our new operating model, providing best-in-class service to our customers and carriers, gaining profitable share in targeted market segments, reducing complexity in the organization and optimizing our structural costs, streamlining our processes by removing waste and manual touches and delivering tools that enable our customer and carrier-facing employees to allocate their time to relationship building, value-added solutioning and exception management."
},
{
"speaker": "",
"content": "Our continued focus on productivity improvements is one part of our plan to address and optimize our enterprise-wide structural cost. After exceeding our productivity targets in 2023, with 17% improvement in NAST and 20% improvement in Global Forwarding, we have carried our productivity momentum into 2024. We are on track to hit our 2024 target of an additional 15% improvement in NAST shipments per person per day, an additional 10% improvement in Global Forwarding shipments per person per month, both of which will result in compounded productivity improvements of 32% or better over '23 and '24 combined."
},
{
"speaker": "",
"content": "Our commitment to deliver quality, value and continuous improvements to our customers continues to be validated by high Net Promoter Scores. Over the past 4 quarters, these scores have been higher than any point over the past few years and higher than the last similar point in the cycle, which we believe has contributed to our market share gains and puts us in good position with customers ahead of the eventual rebound in the freight market."
},
{
"speaker": "",
"content": "Our customers continue to value the quality, innovation and reliability that we provide as they work to optimize their transportation needs. They want a partner who has financial strength and the ability to consistently invest through cycles in the customer experience. They also want a customer-centric partner who can meet their increasingly complex logistics needs by providing expertise and a breadth of innovative solutions, enabled by technology and people that they can rely on to serve as an extension of their team."
},
{
"speaker": "",
"content": "C.H. Robinson is that partner, with the combination of people, technology and scale to deliver an exceptional customer experience and with the breadth of capabilities to meet all their logistics needs, including value-added solutions for cross-border freight, drop trailer capacity and retail consolidation. We deliver integrated global solutions with no equal as evidenced in how we are helping our customers navigate disruptions in the Red Sea and restrictions on transit via the Panama Canal as well as supporting their growth in cross-border trade between the U.S. and Mexico."
},
{
"speaker": "",
"content": "As we continue to improve the customer experience and our cost to serve, I'm focused on ensuring that we'll be ready for the eventual freight market rebound with a disciplined operating model that decouples volume growth from headcount growth and drives operating leverage."
},
{
"speaker": "",
"content": "Our commitment to continuously improving the experience of our customers and carriers and eliminating inefficiencies from our processes will make us a company that is faster, more flexible and more effective in solving problems for our customers, delivering better customer service and creating operating leverage and profitable growth."
},
{
"speaker": "",
"content": "I'll turn it over to Arun now to provide more details on our efforts to strengthen our customer and carrier experience, increase AGP yield and improve operating leverage."
},
{
"speaker": "Arun Rajan",
"content": "Thanks, Dave, and good afternoon, everyone. As Dave mentioned, we increased the rigor and discipline in our pricing and procurement efforts in Q1, resulting in improved AGP yield across the contractual and transactional portfolios in our NAST business. With continued investment in our pricing science, contract management and digital brokerage technology and deployment of our new operating model, we are responding faster than ever to dynamic market conditions with the tools and capabilities we've developed."
},
{
"speaker": "",
"content": "These tools and operating routines, together with our scale, data and customer and carrier relationships, underpin our revenue management function through which we can be more surgical in how we implement the disciplined pricing and profitable growth strategy based on individual customer value propositions."
},
{
"speaker": "",
"content": "We also continue to make progress in Q1 on concurrent work streams that are improving the customer and carrier experience and delivering process optimization by eliminating productivity bottlenecks. One of those work streams is aimed at using generative AI to automatically respond to transactional truckload quote e-mails to drive faster speed to market, increase our addressable demand and reduce manual touches."
},
{
"speaker": "",
"content": "Responding to transaction with truckload quote requests is time consuming for account teams, and we must respond quickly to be competitive. Through our automated process and utilizing our GenAI technology, more than 2,000 truckload customers are getting the benefit of faster response time with our automated e-mail quotes. And we will continue to scale this technology to cover more customers and other modes."
},
{
"speaker": "",
"content": "GenAI puts the power of large language models into the hands of our frontline teams. With more data and history to leverage than any other 3PL, we have opportunities to harness the power that generative AI now offer us to further capitalize on our information advantage, and we'll continue to look for and pursue those opportunities."
},
{
"speaker": "",
"content": "In addition to an improved customer experience, our efforts are increasing the digital execution of critical touch points in the life cycle of an order, from quote to cash, thereby reducing the number of manual tasks per shipment and the time per task. This translates to productivity improvements measured in terms of shipments per person per day, which creates operating leverage."
},
{
"speaker": "",
"content": "As we deliver further process optimization and an improved customer experience, we plan to deliver the compounded cost structure benefits of additional 2024 productivity improvements of 15% NAST and 10% in Global Forwarding, with technology that supports our people and processes."
},
{
"speaker": "",
"content": "With that, I'll turn the call over to Mike for a review of our first quarter results."
},
{
"speaker": "Michael Zechmeister",
"content": "Thanks, Arun, and good afternoon, everyone. The continued soft freight market conditions outlined by Dave resulted in first quarter total revenues of $4.4 billion and adjusted gross profit, or AGP, of $658 million, which was down 4% year-over-year, driven by a 7% decline in NAST and partially offset by a 1% increase in Global Forwarding."
},
{
"speaker": "",
"content": "On a monthly basis compared to Q1 of last year, our total AGP per business day was down 16% in January, down 3% in February and up 7% in March, reflecting market conditions and improved execution driven by the rollout of our new operating model. The new operating model will help simplify decision-making for our teams by focusing on what matters most and helping to ensure clear accountability around delivering results."
},
{
"speaker": "",
"content": "Turning to expenses. Q1 personnel expenses were $379.1 million, including $7.9 million of restructuring charges related to workforce reductions. Excluding restructuring charges this year and last year, our Q1 personnel expenses were $371.1 million, down $8.4 million or 2.2% year-over-year driven by our cost optimization efforts and partially offset by expected higher incentive compensation."
},
{
"speaker": "",
"content": "Our average Q1 headcount was down 11.3% compared to Q1 last year, and our ending headcount was down 10.2% to 14,734. We continue to expect our 2024 personnel expenses to be in the range of $1.4 billion to $1.5 billion, excluding restructuring charges, with productivity initiatives and lower headcount offsetting increases driven by the restoration of target incentive compensation related to the expected improvement in our financial performance."
},
{
"speaker": "",
"content": "We continued to eliminate nonvalue-added tasks to enable our teams to handle more volume. We expect these initiatives will help drive a 15% increase in shipments per person per day in NAST and a 10% increase in Global Forwarding, which comes on top of improvements last year of 17% in NAST and 20% in Global Forwarding that Dave and Arun referenced earlier."
},
{
"speaker": "",
"content": "Moving to SG&A. Q1 expenses were $151.5 million including $5 million of restructuring charges, driven by the impairment of certain internally developed software as we focus the efforts of our product and technology teams on the strategic initiatives that best accelerate the capabilities of our teams."
},
{
"speaker": "",
"content": "Excluding restructuring charges this year and last year, SG&A expenses were $146.5 million, up $5.1 million or 3.6% year-over-year primarily due to a nonrecurring benefit in Q1 last year related to our credit loss reserve. We continue to expect SG&A expenses for the full year to be in the range of $575 million to $625 million, excluding restructuring charges, with cost reduction efforts offsetting expected inflation. SG&A includes depreciation and amortization expense, where we continue to expect $90 million to $100 million in 2024."
},
{
"speaker": "",
"content": "Shifting to expenses below operating income. Our Q1 interest and other expense totaled $16.8 million, which was down $11.5 million year-over-year. This included $22.1 million of interest expense, which was down $1.5 million versus Q1 last year, driven by the $307 million year-over-year reduction in our average debt balance."
},
{
"speaker": "",
"content": "Another factor that drove Q1 results in other was a $3.9 million gain on foreign currency revaluation and realized foreign currency gains and losses, which compared to the $9.6 million loss in Q1 of last year. As a reminder, our FX impacts are predominantly noncash gains and losses related to intercompany assets and liabilities."
},
{
"speaker": "",
"content": "Our effective tax rate in Q1 was 15.8% compared to 13.5% in Q1 last year. As a reminder, our tax rate is typically lower in the first quarter of the year due to the incremental tax benefits from stock-based compensation deliveries in Q1. We continue to expect our 2024 full year effective tax rate to be in the range of 17% to 19%. Our Q1 adjusted or non-GAAP earnings per share of $0.86 excluded $12.9 million of restructuring charges and the $3.1 million tax provision benefit related to those restructuring charges."
},
{
"speaker": "",
"content": "Turning to cash flow. Q1 cash flow used by operations was $33 million compared to $255 million generated in Q1 of last year. The year-over-year decline in cash flow was primarily driven by changes in net operating working capital."
},
{
"speaker": "",
"content": "In Q1 of last year, we had a cash inflow of $235 million from a sequential decrease in net operating working capital driven by the declining cost and price of purchased transportation in the market at that time. In Q1 of this year, we had a cash outflow of $135 million from a sequential increase in net operating working capital driven primarily by higher ocean rates in Global Forwarding."
},
{
"speaker": "",
"content": "In Q1, our capital expenditures were $22.5 million, down 16.6% on more focused technology spending. We continue to expect 2024 capital expenditures to be $85 million to $95 million. We also returned $91 million of cash to shareholders in Q1 primarily through dividends."
},
{
"speaker": "",
"content": "Now on to the balance sheet. We ended Q1 with approximately $842 million of liquidity comprised of $720 million of committed funding under our credit facilities and a cash balance of $122 million. Our debt balance at the end of Q1 was $1.7 billion, which was down $172 million from Q1 last year but up $120 million from the end of Q4 due to the increase in net operating working capital that I mentioned earlier."
},
{
"speaker": "",
"content": "Our net debt-to-EBITDA leverage at the end of Q1 was 2.73x, up from 2.34x at the end of Q4, primarily driven by the sequential increase in our net debt balance. Our capital allocation strategy remains grounded in maintaining an investment-grade credit rating, which allows us to optimize our weighted average cost of capital."
},
{
"speaker": "",
"content": "Overall, I'm encouraged by our improved execution, the deployment of the new operating model, opportunities for continued market share gains and the plans in place to deliver the compounded benefits of continued productivity improvements in 2024. Improved growth in cost savings are expected to continue from the robust pipeline and process simplification, technology enablers and waste elimination initiatives. Continuing to leverage AI to take the capability of our people to an even higher level positions Robinson well to further reduce waste and drive structural cost changes that improve our operating leverage and help deliver on the long-term operating income margin expectations that are imperative to the success of the business."
},
{
"speaker": "",
"content": "With that, I'll turn the call back over to Dave for his final comments."
},
{
"speaker": "David Bozeman",
"content": "Thanks, Mike. I want to commend our people for their performance in what continues to be a challenging market. I believe our team of logistics experts are the best in the business, and they continue to embrace the innovative technology that is acting as a force multiplier and making the industry's best people even better. I'm excited about the work that we're doing to reinvigorate Robinson's winning culture and instilled disciplined with our new operating model."
},
{
"speaker": "",
"content": "If what you're hearing about our execution sounds different, it's because it is. As we continue to deploy our new operating model, we're now monitoring key input metrics and responding faster to error states and changing market conditions with countermeasures that improve our execution. As we continue to chart our path forward, we're on a mission to be fit, fast and focused in order to win now and to be ready for the eventual freight market rebound."
},
{
"speaker": "",
"content": "We'll get fit by embedding lean practices, removing waste and expanding our digital capabilities. This will enable us to strengthen our productivity and optimize our organization structure in order to be the most efficient operator in addition to the highest value provider and achieve our profitable growth objectives."
},
{
"speaker": "",
"content": "As our customers' logistics needs continue to become increasingly complex, we'll leverage our robust capabilities to power vertical-centric and value-added solutions. We'll move fast with greater clock speed and urgency to seize opportunities and solve problems for our customers and carriers. We will arm our team of experts with the right capabilities to bring us into the future, enabled by our innovative and cutting-edge technology. And we'll be focused on profitable growth in our 4 core modes, North American truckload and LTL and global ocean and air as the engines to ignite growth by continuing to reclaim share and expand our addressable market through value-added services and solutions that drive new volume to the core modes."
},
{
"speaker": "",
"content": "As we take action on all of these fronts, our journey to unlock the power of our portfolio is moving forward. I continue to see an opportunity for the company to reach its full potential and create more shareholder value by improving our value proposition, increasing our market share, accelerating growth, further reducing our structural cost and improving our efficiency, operating margins and profitability."
},
{
"speaker": "",
"content": "I'm confident that, together, we will win for our customers, carriers, employees and shareholders. This concludes our prepared remarks. I'll turn it back to Donna now for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Today's first question is coming from Scott Group of Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "So you mentioned this new operating model a lot. I just don't know that we got any color on what it actually is, so maybe just some details of what's actually changing here. And then just as I think about this net revenue inflection in March, is this just truckload spot rates that moderated throughout the quarter? How sustainable is this? Does this -- do we get positive net revenue in Q2? And I guess, what about this new model, what happens when we see the eventual spike in spot rates as gross profit per load gets squeezed again? So I know there's a lot, but..."
},
{
"speaker": "David Bozeman",
"content": "Yes. Scott, this is Dave. Thanks. A big question there. Let's unpack that a bit. First one on the operating model, I just want to start by saying, hey, I'm pretty serious about this model, and I've got the experience with this model. I've done it in other places, and I know it works."
},
{
"speaker": "",
"content": "And Scott, I told you before we want to take time to diagnose the company for a few months. And after coming out of that, one of the things that we looked at was really the need to drive better discipline, accountability, responsibility. And as we went to implement that, bringing in the right talent to help do that, it's really embedded in Lean principles in driving input versus output."
},
{
"speaker": "",
"content": "So we took the time to put all of the critical inputs and instead of being an output-based company, just looking at outputs and going backwards. Now we have the discipline that we're starting to drive. And again, it's early innings. A lot more work to do. But as we're driving our enterprise strategy maps and our scorecards, we're looking at ourselves from inputs."
},
{
"speaker": "",
"content": "And what that allows you to do is really binary. It's red or green, and we drive countermeasures to -- when we're off plan. What are the things we're going to do to get back on plan? But it also brings up error states. It allows us to solve problems fast and allows us to really attack the things we need to attack and just be aggressive and focused."
},
{
"speaker": "",
"content": "And so I'd say it really comes down to discipline. This is embedding discipline into a company that was already a great company but a company with scale. And now you kind of supercharge it by putting that discipline and accountability and responsibility. And that's what you're really kind of seeing in the first quarter."
},
{
"speaker": "",
"content": "Now again, a lot more work to do, but I feel really good about where we're going. I feel good about the momentum, and that really is going to attack the other parts of your questions. I'm going to have Mike and Arun jump in on that, but this is why the base of that operating model was so important about us going forward when it comes to the other 2 parts of your question."
},
{
"speaker": "Michael Zechmeister",
"content": "Yes. So Scott, you asked about the inflection that we saw in March, and you're referring back to the comments I made about our enterprise AGP per day, and we went from down 3% in Feb to up 7% year-over-year in March."
},
{
"speaker": "",
"content": "And we -- Dave talked about the implementation of the operating model, which is part of the success there. You've heard enough from the industry about how difficult January was related to snowstorms across the U.S. and things like that. And so while that was happening, we were putting our operating model in and we were beginning to execute better. So we feel pretty good about how we progressed through the quarter. We're not accustomed to giving monthly result. Obviously, we do give you that total enterprise AGP per shipment -- or per day to help you understand."
},
{
"speaker": "",
"content": "But we feel good about the progress we made. We've got a lot more work to do, and we've got to keep moving in that direction. And so as we go into Q2, Q2 has typically been a quarter with volumes that sequentially are up versus Q1. And that's historical, and you got to pull out the impact of the pandemic in there. But generally speaking, that's what we see, and it's really because the produce market comes back in Q2. You've got beverages that come back in Q2. So there are some seasonal items that create sequential strength for us, and we typically see that going into the second quarter. So again, we're going to control what we can control. We feel good about our move into Q2, and we'll keep going from there."
},
{
"speaker": "Arun Rajan",
"content": "Scott, just a little bit more on that in terms of how we actually achieved some of these results and input to the operating model, is our revenue management practice that we discussed in the last call. And while we're not immune to market inflections, but the point is we've invested in pricing science, costing science and technology that allows us to respond quickly to whatever event causes an inflection, whether that be short term or long term. And January, you saw a short-term inflection due to weather, but we had signals that we could respond to quickly and adjust based on revenue management principles."
},
{
"speaker": "David Bozeman",
"content": "And just to finish up here, Scott, it's -- I mean, it comes down to this company. The behaviors are changing. I mean if you look at the fidelity of our conversations, the speed of it, the ability to fail fast and really get after what we see could be broken, that's really starting to change. I'm trying to put on the table, what the front too. Like what's the difference here?"
},
{
"speaker": "",
"content": "And the difference is really about the fidelity of the conversations and how we're actually attacking our problems, identifying those problems and then driving it. And this particular model is really kind of linked. It ladders up from the divisional scorecards all the way up to the enterprise scorecards. And when you get that linkage, you really start connect to the entire company. And I would say the scaffolding is up, and we're starting our sustainable journey here but really feel good about it."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jeff Kauffman of Vertical Research Partners."
},
{
"speaker": "Jeffrey Kauffman",
"content": "Congratulations to see numbers like this. Mike, a question on the working capital because I want to come back to this. Thank you for explaining that the ocean rates were driving the use of working capital. But I guess given what's going on in the world, is this going to continue to be a drain? And could we be looking at negative free cash flow for the first half or 2/3 of the year?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes. Thanks for the comments, Jeff, and the question. And as you've seen how the cost of purchase transportation impacts our working capital through the cycle, you've seen that when costs and therefore, prices start to go up, because our DSO is greater than our DPO, we tend to absorb cash as we ride that inflection up. And so that may very well be in our future."
},
{
"speaker": "",
"content": "However, the converse is also true. And you saw that as cost of purchase transportation came down and we received a net of about $1.5 billion back into our cash flow at the end of the last cycle as that came down. So you really can think about it as where your view is on where the cost and price are going on truckload, LTL, ocean and air and that -- and our working capital trends will tend to follow it. Now having said that, we're -- we expect, obviously, to have positive cash flows through the cycle and have demonstrated that in the past."
},
{
"speaker": "Jeffrey Kauffman",
"content": "Okay. And if we weren't having this unusual increase in some of these ocean rates and things going on around the world, just seasonally, should we be seeing better free cash flow as the year moves forward?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "The next question is coming from Christopher Kuhn of Benchmark Company."
},
{
"speaker": "Christopher Kuhn",
"content": "Dave, can you maybe just talk about any changes to the compensation structure as part of this new model and if some of those changes impact maybe some of your better [ agents ]? And how are people reacting to some of the changes that you've implemented?"
},
{
"speaker": "David Bozeman",
"content": "Yes. Thanks a lot, Christopher. On -- it's a good question. I like it because part of our operating model, we've talked about discipline and also connecting the company throughout. And part of that would be our compensation structure, and we feel good about that in 2 forms here."
},
{
"speaker": "",
"content": "One, it's about balance, right? You heard us talk about being fit, fast, focused. When I look at the balance, and this is very, very important for the company and the culture, we're unapologetic for driving 2 things. It's going to be productivity plus growth. So it's volume, but it's profitable growth. It's a balance of getting our AGP and also getting our volume."
},
{
"speaker": "",
"content": "And if you look at our -- essentially our base compensation, it's really about that 50-50 split for our people, and our people are incented to do that. And that's super important for us. And that's what you're kind of seeing in that."
},
{
"speaker": "",
"content": "Now using the model to actually bring that forward, I mean, we do that. We do that on a good timely basis that would allow us to see kind of some of those inflections of inputs. And then that allows us to inspect, go deeper and really try to see if we're off on some of those metrics here. But it's really about that balance of profitable growth and volume, and that's what we're going to continue to drive here."
},
{
"speaker": "Christopher Kuhn",
"content": "Okay. And just maybe any thoughts on -- you've been there now for over a year, the portfolio review, some of the noncore businesses. I don't know if you have any thoughts on that and where those would be in the future."
},
{
"speaker": "David Bozeman",
"content": "Yes. As I said before, 4 Ps, people, product, process portfolio, that's going to -- that's not just static. That's dynamic. I'm going to continue to look at the company under those 4 Ps, but I've also said we're going to drive focus, right, and focus within our company in North America truckload, LTL, ocean and air. That's really just getting the company back to having that focus and driving that very well and implementing and performing very well within those kind of core focus stacks."
},
{
"speaker": "",
"content": "That's what my near-term focus is, and I will always examine the company across those 4 Ps and make the necessary decisions that drive us back to that focus because, ultimately, that will drive better results for customers, better results for employees and ultimately, our investors and shareholders."
},
{
"speaker": "Operator",
"content": "The next question is coming from Stephanie Moore of Jefferies."
},
{
"speaker": "Stephanie Benjamin Moore",
"content": "Dave, I appreciate -- I think you do a great job of kind of outlining kind of your future and your vision for the company. And I think we clearly understand where you're trying to go and have certainly made some progress here at year-end into the first quarter. But could you maybe give us a little bit of insight in terms of what has been implemented across the organization to allow you to either move faster or follow the inputs? I mean things like going from being more centralized to more centralized, I don't know if it's installing new systems that now give you some daily KPIs, comp structure changes, any kind of more tangible examples that's been driving some of these results?"
},
{
"speaker": "David Bozeman",
"content": "Yes. Thanks for the question. There's been a number of things in these -- the first 10 months. I mean as we talked and we talked in person and on the calls, the first thing is to really diagnose. I mean you can't start any type of fix or treatment if you don't really understand or, as I said before, I needed to go to Gemba, right? That's goal to the work and really understand the company."
},
{
"speaker": "",
"content": "So took a good amount of time to just go down to the desk, visit various offices, make sure just kind of understand the life of an order, just understand the company itself. I was super pleased when I did that because our people really are awesome. I mean everywhere I go, they have awesome stories. They love this company, and they really put it in. So I was really pleased for that."
},
{
"speaker": "",
"content": "But I would also came back and looked and I said, hey, there's opportunities here. There's opportunities to -- for simplification. There's opportunity to reduce complexity, drive discipline, the ability to fail fast. It's just things that I thought, at our scale, we could do better."
},
{
"speaker": "",
"content": "And so I did bring, as I said before, some outside talent in -- Jim Reutlinger in to stand up the project management office and really to help kind of this Lean deployment. After a couple of months of really understanding, seeing the company and really getting -- going with implementation in first quarter, Jim and I, along with the senior leadership team, started to drive this operating model, which now takes a lot of our key inputs."
},
{
"speaker": "",
"content": "And there are a number of different things that we look at, Stephanie, on the inputs, from headcount, shipments per person per day, cost per shipment, cost to serve, our customer service impacts, our AGP dollars per shipment, a number of different things that are linked to the various divisions. And that -- and now put that on a scheduled kind of cadence that we have that drives our operating model, starting with the senior leadership team and then it breaks out into the various divisions and then continue down within the organization."
},
{
"speaker": "",
"content": "That took time to kind of build that, link it up and then drive that implementation -- start the implementation in the first quarter. That's different for this company. It's different in that, in this operating model, you have to address those things. Our new President of North American Surface Trans, Michael Castagnetto, has done a great job at really starting and driving that execution and that discipline into NAST."
},
{
"speaker": "",
"content": "He has to drive his particular meetings that link to the enterprise, meetings on our inputs. And we're -- we don't talk about just outputs now. It's driving those inputs. And why? You do that because we can move the timescale up. And so when we're driving something and Michael is on a red for a particular input metric that we're looking at, we attack it then. We attack it right away. What resources do we need in the company to go attack it? What help do you need? It's visual management and driving that."
},
{
"speaker": "",
"content": "That has moved us into solving things much faster and deliberate, but it's also given us learning about other things that are happening in the company that we can solve. So that's something that's been different. We've moved and I've combined marketing and communication and just making sure we drive synergies for that."
},
{
"speaker": "",
"content": "And there's a number of other things that are internal in the company that we're moving for, but you do that off of learnings and making sure that whatever moves we're doing, it ultimately supports our strategy for more profitable growth and better returns to shareholders, a better environment for employees but better value and execution for customers as well."
},
{
"speaker": "",
"content": "So that's how we're going about this, Stephanie. It's anyone that's been in Robinson. It feels different because it is different, and we're not going to stop at it. And we're on early innings here, as I said before, and we're -- you're going to keep seeing that as we go through the year."
},
{
"speaker": "Stephanie Benjamin Moore",
"content": "Got it. And then just a follow-up to a question that was asked earlier. In terms of the AGP per day inflection that we saw kind of going from January to positive in March, I'm kind of -- we kind of all hear the same trends or we've been hearing the trends for the last week or so about it still being a pretty weak freight environment. Rates from what we track haven't changed too much. So can you really talk a little bit about what you were able to do to execute on kind of such an inflection in results?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes, Stephanie, I'll take that one. And so you hear from Dave. You've heard about our operating model. There's execution inside that. We could pile on in terms of some of the examples. Dave talked about incentive changes coming into this year, the balanced volume and margin expectations on the business."
},
{
"speaker": "",
"content": "And I think when you compare our results to the results of maybe some others, what you see is that we did have differential improvement as we went through the quarter. And one thing I would emphasize is, for example, on truckload. Our truckload cost per mile went up in Q1 versus Q4. So we had a sequential increase there, but we were still able to deliver margin expansion, both at the AGP level and at the operating income level."
},
{
"speaker": "",
"content": "And so the yield management, the science, the data behind pricing, the work that's been going on, on that front, you want to see results, right? And so one indication, one metric that we try to show you guys to help understand that we're getting traction here and delivering results is in our shipments per person per day because that's really the measure of how productive our folks have been."
},
{
"speaker": "",
"content": "And one of the pivots we've made on that front is, I think, we've done a better job of balancing how technology can support the talent of our people. And one of the things we're most proud of is the expertise, the deep knowledge, the talent, the relationships with customers that our folks have. And what we've tried to do with our technology is figure out how to reduce manual tasks, manual touches, and we really target those areas so that our people can focus on what they do best and the relationships and solving problems for our customers. And so you see some of that starting to get traction."
},
{
"speaker": "",
"content": "The other thing I would point to is generative AI. And one of the hallmarks of the freight industry is the amount of variation that exists. And that variation exists across all the modes and across all the lanes, and it's rooted in the fact that our customers have very specific demands about picks and drops and size and configurations. And the better you understand exactly what they need, the better you can solve their freight issues. But that variation runs counter to some of the productivity that has historically been machine learning, which requires a lot of programming inside of our proprietary software."
},
{
"speaker": "",
"content": "But the high variation is actually something that generative AI can handle much more effectively. And so a lot of the efforts there have also been beneficial to helping us deliver those productivity numbers, the shipments per person per day numbers and the 17% NAST last year, the 20% in GF. And of course, we've got targets of 15% in NAST and 10% in GF this year."
},
{
"speaker": "Arun Rajan",
"content": "Yes. I'll just add that in terms of optimizing yield, this goes back to revenue management. And I'd say I'd describe it as Dave has the operating model installed, and I'd describe it as active management of optimizing volume and AGP. That happens every day, and it's a marriage of our science and our people. And I'd say we just manage it much more actively than we ever have, both on the cost side as well as a pricing side. That's what yields the AGP."
},
{
"speaker": "Operator",
"content": "The next question is coming from Elliot Alper of TD Cowen."
},
{
"speaker": "Elliot Alper",
"content": "This is Elliot Alper on for Jason Seidl. I wanted to ask about ocean capacity. We've heard some other ocean players that shippers have already adapted to a lot of the concerns whether it be the Red Sea or Panama Canal that appears to have been easing a bit. I guess we've seen spot rates come down notably from mid-February levels. I guess how should we think about pricing sequentially and maybe the puts and takes on growing the ocean business in the second quarter?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes, Elliot, this is Mike. I'll take that question. So I think our view is consistent with what was implied in your question. And as the Red Sea disruptions happened as the Canal issues kind of came and have now -- haven't completely been solved but are more solved, that repositioning of capacity really puts a pinch on the market and what drove prices up."
},
{
"speaker": "",
"content": "But once that capacity has been repositioned, and it largely has, then those prices have come back down, and you're now back to the basic principles of supply and demand. And on the supply side, the capacity side, the observation for the remainder of the year is there's more capacity coming into the ocean market than is coming out. And so there should be a fair amount of capacity there."
},
{
"speaker": "",
"content": "Now there may be some repositioning to accompany some of the changing dynamics in trade lanes where there's more density there, but net-net, more capacity coming in. So then you're back to the demand side. And we've seen a little bit of demand there, but no green shoots yet to suggest that we've got a trend moving for the remainder of the year. So your prediction of where it goes really depends on your view about the world economy and the U.S. economy, and we'll see how that plays out."
},
{
"speaker": "David Bozeman",
"content": "Yes, Elliot, and just to pin a couple of things on that as well. I mean we've said this in the past. We're -- our -- on average, our contract business for Global Forwarding is 30% to 40% in contract. So the remaining 60%, 70% of spot, obviously, we have an opportunity to do business in."
},
{
"speaker": "",
"content": "But also, as Mike said, on the Panama Canal and to the essence of your question, I mean, it's improved as far as water levels. But the crossings, and we track that right now, are 27 a day, but that's normally 36 a day. So it's somewhat muted. As Mike said, we haven't seen any major green shoots there, but we watch that business with -- intently."
},
{
"speaker": "Operator",
"content": "The next question is coming from Tom Wadewitz of UBS."
},
{
"speaker": "Thomas Wadewitz",
"content": "Yes. Wanted to see if you could give some thoughts on -- I know you talked about the progression. Within April, are you seeing kind of a similar dynamic to what you said in margin, that improvement? And is that kind of more of a volume improvement? Or is that a gross margin percent improvement if you think about NAST?"
},
{
"speaker": "",
"content": "And then I guess I also wanted to just think about productivity drivers. You're doing a great job on that productivity number, that 15% in NAST. But do you think you get there more by volume growth picking up? Or is it -- you get some more sequential headcount reduction? Or is that just kind of depends on the market?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes, I'll take your productivity side and then maybe pass it off to take another shot at the trends going forward in the market. But on the productivity front, the shipments per person per day front, we really have to be flexible to adapt our productivity delivery based on what kind of market we're in."
},
{
"speaker": "",
"content": "So what we're really doing, I think, now differentially from the past is thinking about installed capacity, thinking about how to handle demand without the need to bring on people when the demand comes back. But if the demand does not come back, we still got to deliver that productivity number. And so we really are trying to build the flexibility into our model to handle both a demand-based year or a soft market like we're in right now."
},
{
"speaker": "David Bozeman",
"content": "Yes. And I think -- Tom, this is Dave. The -- adding on to that, I -- where the team is doing a really nice job is -- at the end of the day, you have to look at work differently and take it away, the manual work that in a sense is capacity, right, I mean when you -- at our scale, when we have our people doing nominal task, that eats up capacity of a person."
},
{
"speaker": "",
"content": "And I think Arun and team have done a really nice job at this is where you do use technology and large language models and a number of other things to now remove a lot of those kind of menial tasks and allowing our people to just kind of focus on the things they need to focus on, in a sense, gaining capacity, right, in doing that."
},
{
"speaker": "",
"content": "So that's really important on achieving this productivity part of shipments per person per day. It's getting smarter about the work and implementing that work. So I just want to add on to that."
},
{
"speaker": "",
"content": "I think on trends, and Mike, you could jump in too. It's -- we feel good about where we're at, and we're concentrated on what we can control. I mean this is a soft market, and everyone is dealing with that. This is why we're staying disciplined, driving our model to execute."
},
{
"speaker": "",
"content": "And what we're saying is no matter what the marketplace is going into Q2, we want to execute within that market. I mean dealing with the lows of the markets and excelling at the highs of the market is something that we're laser focused on. And we're going to do that with our operating model, with our science and pricing and a number of the things we talked about today."
},
{
"speaker": "Thomas Wadewitz",
"content": "Does anybody else want to add any comments on kind of April and what it looks like and what might be driving it, kind of volume or gross margin?"
},
{
"speaker": "Michael Zechmeister",
"content": "Yes. I think we've covered that."
},
{
"speaker": "Thomas Wadewitz",
"content": "For April -- or sorry, I might have just missed that earlier."
},
{
"speaker": "Michael Zechmeister",
"content": "Yes. We made comment earlier about Q1 and the progression that we made Q1 and our confidence in some of the progress we've made and the various elements inside the operating model. And as we move into Q2, just the way that a typical Q2 unfolds is that we get the produce business. We get the beverage business, and that strength is usually in the back half of Q2 for our business model."
},
{
"speaker": "Thomas Wadewitz",
"content": "Okay. So the year-over-year is still looking good."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jonathan Chappell of Evercore ISI."
},
{
"speaker": "Jonathan Chappell",
"content": "Just a quick one on the competitive landscape. You're winning share. You've done better than other markets for 3 straight quarters, but at the same time, you're being disciplined on price."
},
{
"speaker": "",
"content": "So is this a function of maybe smaller players exiting the market? There's been an interesting chart that's been circulating on the, I guess, exit of brokers. Do you feel like the capacity in the broker industry is closer to balance than maybe it is in the asset-heavy side of the equation?"
},
{
"speaker": "",
"content": "And is that helping you win share? Or is it more kind of company specific and the things that you've been talking about for the last half an hour or so that's driving those share gains?"
},
{
"speaker": "Arun Rajan",
"content": "Yes. I would -- thanks for the question. I think it's both. This disciplined execution on our side, we've talked about that a lot. But clearly, there's pressure in the brokerage industry. And I think you've seen some of the exits. You saw Convoy last year. And I think we continue to get reports of smaller brokers who are unable to sustain this market. So I think it's both."
},
{
"speaker": "",
"content": "I will say that while there might be some benefit from the market and smaller brokers or other brokers not doing well, I would over-index to the success being as a result of our operating model and the inputs and the discipline in that context."
},
{
"speaker": "Jonathan Chappell",
"content": "That makes sense. Do you have a sense, just as a quick follow-up, that the broker business at large is closer to balance, maybe closer to, let's call it, 2019 levels than the truckload market from an asset-heavy perspective is?"
},
{
"speaker": "David Bozeman",
"content": "No. Jonathan, this is Dave. I would say it's not at the levels of 2019. We don't see that. Just as we see the influx on capacity and carrier capacity, we -- while that's coming down, we don't -- that's not at levels that we think it should be at this period in the cycle. But as far as brokers specifically, no, I would say that we're not at those levels of 2019."
},
{
"speaker": "Operator",
"content": "At this time, I'd like to turn the floor back over to Mr. Ives for closing comments."
},
{
"speaker": "Charles Ives",
"content": "Thanks, everyone, for joining us today. That concludes today's earnings call, and we look forward to talking to you again. Have a great evening."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for your participation. 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."
}
] |
chtr | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to Charter Communications Fourth Quarter and Full Year 2024 Investor Call. We ask that you please hold all questions until the completion of the formal remarks, at which time, you will be given instructions for the question-and-answer session. As a reminder, this conference is being recorded today. If you have any objections, please disconnect at this time. I will now turn the call over to Stefan Anninger."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, operator, and welcome, everyone. The presentation that accompanies this call can be found on our website, ir.charter.com. I would like to remind you that there are a number of risk factors and other cautionary statements contained in our SEC filings, and we encourage you to read them carefully. Various remarks that we make on this call concerning expectations, predictions, plans, and prospects constitute forward-looking statements, which are subject to risks and uncertainties that may cause actual results to differ from historical or anticipated results. Any forward-looking statements reflect management's current view only, and Charter undertakes no obligation to revise or update such statements. As a reminder, all growth rates noted on this call and in the presentation are calculated on a year-over-year basis unless otherwise specified. On today's call, we have Chris Winfrey, our President and CEO, and Jessica Fischer, our CFO. With that, let's turn the call over to Chris."
},
{
"speaker": "Chris Winfrey",
"content": "Thanks, Stefan. In 2024, we managed the end of the Affordable Connectivity Program successfully. Outside of normal churn, we kept roughly 90% of former ACP customers connected. Our Spectrum Mobile business continued to grow at a rapid rate. We added over 2 million Spectrum Mobile lines in 2024. We're the fastest growing mobile provider in the US with the fastest connectivity at the best price. Our expansion initiative continued to deliver good passings growth, driven by our subsidized rural initiative and normal construction and fill-in activity. In 2024, we grew revenue by 1%, while full year EBITDA growth accelerated to 3.1%, driven by continued strong mobile growth, our cost efficiency initiatives, and political advertising. Late last year and early this year, we had unexpected natural disasters from Hurricane Helene impacting Florida, the Carolinas, and the broader Southeast, with Hurricane Milton across Central Florida, and most recently, the Los Angeles fires. There are, of course, subscriber and financial impacts which Jessica will cover, but our employees work and live in these communities, so it's also personal. Stories of our frontline employees' commitment abound, including employees helping to reestablish connectivity for customers despite losing their own homes and countless employees traveling in from other regions to stay and to help. Really proud of how our frontline employees have responded. And from Stamford, we learned some lessons on how to put customers at ease sooner, and we got better with our communications along the way. Part of our customer commitment is to always improve, and we are. As we look to 2025 and beyond, the environment for broadband, mobile and video remains competitive, but we had better visibility than this time last year. The impact of the elimination of the ACP is now behind us. Cell phone Internet net additions appear to have peaked or at least stabilized, and we continue to compete well against new fiber overlap. In the meantime, we haven't stayed still, which sets us up well for the future. Our multiyear investment initiatives, including network evolution, network expansion and execution, including the investment in frontline employees and tenure to benefit our service, are all delivering tangible results. And last September, we relaunched the Spectrum brand and its promise to customers through Life Unlimited, with our first -- a market-first customer service commitment and making better use of our unique assets through converged seamless connectivity across 100% of our network and now seamless entertainment and video. The positive impacts from our customer commitment and brand refresh investments take time to be recognized, but you can already see the positive effect from our new pricing and packaging in video results. In late 2022, we launched a number of strategic initiatives and communicated a significant one-time capital investment to enhance our growth potential long-term. While the investments put temporary pressure on our near-term free cash flow growth, these were a unique set of non-recurring and generational industry investments. They include the largest broadband expansion since 1980s, the largest physical upgrade of the network since 1990s, market-leading convergence of our wireline and wireless capabilities, and an exciting video transformation, which will help drive our connectivity business. 2025 will have a slightly higher level of investment than 2024, but this year will also be our peak capital investment. So, this is a fitting time to highlight where our strategy leaves us competitively, operationally, and financially for the coming years. We have a unique set of assets and significant scale, as shown on Slide 4. Spectrum has the fastest Internet, the best WiFi, the fastest mobile product, and is the leading video provider in the US with over 900,000 miles of network infrastructure, 57 million residential and SMB passings, and over 300,000 fiber lit buildings. Of course, we have significant competition from wireline overbuild, cell phone Internet, and satellite across all of our products. The power of our network, though, continues to improve, with symmetrical and multi-gig speeds, allowing product developers to create applications and use cases that require high capacity, low latency, high reliability and edge compute. Product and software developers can rely on the ubiquitous deployment across all the major cable networks in the US, so we're very well positioned. In fact, it's always been the US cable companies that have built the fully-deployed platforms that have enabled the development of next-generation products and services, despite the handicap of being regional operators competing against national and now global competitors. The ability to provide the very best of our products across our entire footprint is unique. That includes new features we're developing for seamless connectivity and seamless entertainment. Convergence is a popular phrase amongst our competitors now. And while it's flattering to hear our own wording adopted by others, Slide 5 of our presentation today speaks for itself. We're very underpenetrated relative to our converged connectivity capabilities. Having the best network and product capabilities by itself isn't enough, and that's why we've always focused on the ability to have the most value in our packages, combining the best products with ways for customers to save hundreds or even thousands of dollars a year, whether at promotion or retail prices. And anytime you have new entrants, consumers can be enticed to try a new provider even at lower quality and higher all-in prices, but in the long-term, we believe the best products and best pricing across a package of those services will win. The Slide 6 of our presentation is example of that advantage across typical broadband and mobile packages. Together with our upcoming seamless entertainment offers, highlighting this value is the goal of our recent pricing and packaging under the Life Unlimited brand refresh. I spoke about the sequencing of our seamless entertainment launches on last quarter's call, and that timing in 2025 hasn't changed, so I won't repeat the steps and priorities. But we look forward to fully rolling that out in the first half of this year and delivering even more value to consumers, up to $80 of retail app value when subscribing to our video packages. That customer proposition is shown on Slide 7 of our presentation. Similar to mobile, taking video as part of the package now ensures a lower price for Internet, both at promotion and retail. And, of course, we couple all that with high-quality service. We've always believe that investing in customer service and satisfaction creates a virtuous cycle in our business: better customer service translates to fewer customer transactions; fewer transactions produces higher customer satisfaction and lower churn; lower churn reduces cost and increases in penetration; and lower cost gives us the ability to offer better pricing, which works for customer acquisition, service and satisfaction and positions us for growth. Our sales and service is a 100% US-based, made in America, if you will, using our own employees with good paying jobs and benefits. Employees are also Spectrum customers, committed to developing their local communities and their career at this company. That is a competitive advantage, an investment we already made in wages, benefits and real estate that's difficult to replicate. And that existing investment is also why it was so easy for us to make our market-leading customer commitments. We stand behind our commitments, service credits when we miss the mark. As a reminder, we've provided a summary of those commitments on Slide 8. For years, we've been investing in machine learning and now AI, and much of our effort is making frontline work easier and more efficient, which drives higher customer and employee satisfaction. Some of those examples include full service, network, CPE, and billing telemetry on the account, which is automatically presented to an agent now when answering the phone. In addition, AI is also listening to the conversation, providing proactive optimized solutions, customer sentiment, ChatGPT-style technical support, call summarization, and flagging post-call training opportunities. AI call summarization also helps the field technician assess the issue before they even get to the door, improving the customer interaction. And that's in addition to rolling out our own [ChatGPT] (ph) on their handheld devices to more accurately pinpoint issues and recommend the best fix to the field tech. We deal with millions of transactions every year, and, honestly, there aren't millions of best outcomes. So, transactions can be more effective. It can be shortened and reduced, driving higher customer satisfaction and lower churn, but also higher employee satisfaction, which drives lower attrition or tenure and, therefore, better service, which, of course, produces less transactions as a result. Taken together, that is our strategy and competitive positioning. The best network, best products, most value with unmatched service, driving more household penetration, higher product penetration per household, lower service transactions in churn and lower operating and capital cost per customer, which allows us to have the lowest pricing, a virtuous cycle. The financial output is high-quality revenue per home passed with free cash flow growth and high return on investment. We're not perfect and we've always got room for better execution and speed, but I believe we have a great recipe for growth of our existing products with the investments we've already made. And we have strategic assets in our network, our fully US-based sales and service employees. Those will enable future products and revenue streams and operational efficiencies that aren't even considered in our financial plans today. In the meantime, we position the company for customer and profitability growth, clear visibility to free cash flow growth, and improving capital allocation and return philosophy. This is a winning formula. It's with a fully dedicated and a hungry team. So, we're excited about 2025 and beyond. And with that, let me hand it over to Jessica."
},
{
"speaker": "Jessica Fischer",
"content": "Thanks, Chris. Before discussing our fourth quarter results, I want to mention that today's results include a number of Hurricane Helene and Hurricane Milton impacts, which hit the Southeast US in late September and early October. Our fourth quarter customer results include over 20,000 additional disconnects related to the storms. Fourth quarter adjusted EBITDA was reduced by approximately $35 million, primarily driven by hurricane-related customer credits and revenue, and the storms drove approximately $125 million in total incremental capital expenditures in the fourth quarter. Today's results do not include any impact related to the wildfires that hit Southern California in January. Our first quarter results will include some lost customers and passings related to the fires. We're still assessing impacted areas, and we expect to incur capital expenditures to recover and rebuild lost passings. We've been providing bill credits to customers in impacted areas and those one-time credits will offset some first quarter revenue. We may also have some incremental operating expense, although we expect that to be relatively small. And we'll isolate the impact of the fires when we report our first quarter results. Unrelated, we recently completed an extensive review of our serviceable passings to clean up duplicate passings and other data and to identify new passings. As a result, we reduced total estimated passings in our trending schedule for all periods presented by 1.7 million passings. Additionally, because of the GAAP requirement, our cost to service customers expense line has been divided into two new cost lines, field and technology operations and customer operations. The best way to forecast these two new line items is to combine them into one figure as presented in the past as cost to service customers, And that's how I will refer to them today when reviewing our expense results. Let's please return to our customer results on Slide 10. Including residential and SMB, we lost 177,000 Internet customers in the fourth quarter. In mobile, we added 529,000 lines. Video customers declined by 123,000, with the improvement driven by the rebundling we launched in September along with our Life Unlimited brand refresh. Video performance does not yet reflect the benefits of incorporating seamless entertainment apps in our product. Wireline voice customers declined by 274,000. In addition to the 20,000 Internet disconnects driven by the hurricanes, the end of the ACP program drove higher fourth quarter non-pay and voluntary churn among former ACP customers for a total estimated fourth quarter ACP impact of approximately 140,000 Internet losses, primarily non-pay disconnects and some voluntary churn. Looking forward, we believe we're past the one-time ACP-related impacts to our customer base. Beyond ACP and hurricane impacts, we were generally pleased with our fourth quarter customer results, and core Internet results, which exclude ACP and storm-related losses, were better than last year. We continue to compete well across our footprint. As Chris discussed, we continue to pursue initiatives that are intended to drive customer and financial growth, including network evolution, new pricing and packaging, converged connectivity product development, and footprint expansion, including our subsidized rural initiative. As of year-end, we had launched symmetrical 1-gigabit speeds in all eight of our Step 1 markets. Earlier this year, we launched 2 x 1 gigabit service in two of these markets, Lexington, Kentucky and Cincinnati. And we plan to launch 2 x 1 service in additional markets later this year. Demand for faster Internet speeds continues to grow as data usage grows. In the fourth quarter, monthly data usage by our residential Internet customers, who don't have our traditional video product, reached over 800 gigabytes. Our WiFi also continues to improve, driven by our advanced WiFi product and our new WiFi 7 router. Our WiFi supports our converged connectivity product including Spectrum Mobile, which is only in about 8% of passings, but remains the fastest-growing mobile service in the United States and offers the fastest overall speeds. Turning to rural, we ended the quarter with a total of 813,000 subsidized rural passings. We grew those passings by 117,000 in the fourth quarter and by nearly 400,000 over the last 12 months, and we generated 41,000 net customer additions in our subsidized rural footprint in the quarter. 2025 customer growth should benefit from 2024 rural passings growth as well as passings growth in 2025. We expect rural passings growth of approximately 450,000 in 2025, our biggest year so far, in addition to continued non-rural construction and fill-in activity. Moving to fourth quarter revenue results on Slide 11. Over the last year, residential customers declined by 2.2%, while residential revenue per customer relationship grew by 1.7% year-over-year, given promotional rate step-ups, rate adjustments, and the growth of Spectrum Mobile. Those factors were partly offset by a higher mix of non-video customers, growth of lower-priced video packages within our base, $34 million of hurricane-related residential customer credits, and $37 million of costs, which accounting principles required to be allocated to programmer streaming apps and netted within video revenue. As Slide 11 shows, in total, residential revenue declined by 0.4%. Turning to commercial, total commercial revenue grew by 1.9% year-over-year, with SMB revenue growth of 0.3%, reflecting higher monthly SMB revenue per SMB customer, primarily due to rate adjustments. Enterprise revenue grew by 4.4%, driven by enterprise PSU growth of 5.2%. And when excluding all wholesale revenue, enterprise revenue grew by 5.2%. Fourth quarter advertising revenue grew by 26%, given political revenue growth. Excluding political, advertising revenue decreased by 8.2% due to a more challenged national and local advertising market. Other revenue grew by 14.6%, primarily driven by higher mobile device sales. And in total, consolidated fourth quarter revenue was up 1.6% year-over-year, and 1% when excluding advertising revenue and hurricane-related customer credits. Moving to operating expenses and adjusted EBITDA on Slide 12. In the fourth quarter, total operating expenses grew by 0.3% year-over-year. Programming costs declined by 9.1% due to an 8.7% decline in video customers year-over-year and a higher mix of lighter video packages, along with $37 million of costs, which accounting principles required to be allocated to programmer streaming apps and netted within video revenue, partly offset by higher programming rates. Other costs of revenue increased by 16.2%, primarily driven by higher mobile device sales and mobile service direct costs, as well as higher advertising sales expense related to higher political revenue. Cost to service customers, which combines field and technology operations and customer operations, declined 0.5% year-over-year given productivity from our tenure investments, including lower labor costs. Sales and marketing costs grew by 3.2% as we remain focused on driving customer acquisition and given our Life Unlimited brand relaunch in September. Finally, other expenses declined by 0.7%. Adjusted EBITDA grew by 3.4% year-over-year in the quarter and by 1.8% when excluding advertising. As we look ahead to the full year 2025, we face headwinds that we didn't last year, including the lack of political advertising revenue and the full year impact from the prior year Internet customer losses primarily due to the end of ACP. But our plan is to grow adjusted EBITDA in this year. Turning to net income, we generated $1.5 billion of net income attributable to Charter shareholders in the fourth quarter compared to $1.1 billion last year, given this quarter's higher adjusted EBITDA and a larger pension remeasurement loss in the prior-year period. Turning to Slide 13, capital expenditures totaled $3.1 billion in the fourth quarter, up about $200 million from last year's fourth quarter. Line extension spend totaled $1.1 billion, driven by our subsidized rural construction initiative and continued network expansion across residential and commercial greenfield and market fill-in opportunities. Fourth quarter capital expenditures, excluding line extensions, totaled $2 billion, about $130 million higher than last year. The increase was mostly driven by CPE due to purchase timing and higher scalable infrastructure spend. 2024 capital expenditures totaled $11.3 billion, less than our original expectation for $12.2 billion to $12.4 billion, given lower network evolution and line extension spending, both due to timing. We expect total 2025 capital expenditures to reach approximately $12 billion, including line extension spend of approximately $4.2 billion and network evolution spend of approximately $1.5 billion. On Slide 14, we've provided our current expectations for capital spending through the year 2028, excluding any line extension spending associated with the BEAD program as we are still in the early stages of bidding, and we have a lower appetite to bid due to regulatory conditions. Our current multiyear CapEx outlook is largely unchanged in total versus our prior outlook, with retiming across years and slight changes across categories. We expect total line extension capital expenditures to decline after 2025 even inclusive of BEAD, which we wouldn't expect to be more than a few hundred million dollars per year for the four years starting in 2026. And our RDOF build is still expected to be completed by the end of 2026, two years ahead of schedule. We now expect our total network evolution initiative capital to reach $5.4 billion over the period 2024 to 2027 versus $4.6 billion previously, given our [full plant walkout] (ph) and the finalization of more detailed project plans. Looking beyond 2025, we expect total capital spending in dollar terms to be on a meaningful downward trajectory, even inclusive of BEAD spending. And after our evolution and expansion capital initiatives conclude, our run rate capital expenditures should be below $8 billion per year. Just to highlight, that reduction in capital expenditures on its own from approximately $12 billion in 2025 to less than $8 billion in 2028 is equivalent to $25 of annual free cash flow per share based on today's share count. And while we always prioritize our free cash flow for organic opportunities first and then accretive M&A and buybacks, there are currently no organic capital expenditure opportunities on the horizon that give us concern with that capital expenditures outlook. Fourth quarter free cash flow totaled $984 million, a decrease of approximately $80 million compared to last year's fourth quarter. The decline was primarily driven by higher capital expenditures, cash taxes and cash interest, partly offset by a larger cable working capital benefit, driven by the implementation of our supply chain financing program and higher adjusted EBITDA in this year's fourth quarter. Just a brief comment on 2025 cash taxes. We currently expect under existing tax legislation that our calendar year 2025 cash tax payments will total between $1.6 billion and $2 billion. We finished the quarter with $93.8 billion in debt principal. In December, we financed -- we refinanced most of our 2027 maturity tower, extending about $13 billion of our credit facilities to 2030 and 2031. After that refinancing, our maturities in each of the next three years are less than $4 billion per year. Our weighted average cost of debt remains very attractive at 5.2%, partly driven by our long-dated fixed rate profile. Our current run rate annualized cash interest is $4.9 billion. In the fourth quarter, we repurchased 292,000 Charter shares and Charter Holdings common units, totaling $113 million at an average price of $384 per share. As of the end of fourth quarter, our ratio of net debt to last 12 month adjusted EBITDA moved down to 4.13 times and stood at 4.24 times pro forma for the pending Liberty Broadband transaction. Our leverage ratio may decline further given our pause in buybacks, but we are still targeting the midpoint of our 4 times to 4.5 times target leverage range, though now pro forma for the pending Liberty Broadband transaction. We look forward to resuming our open market buyback program following the shareholder vote for the Liberty Broadband transaction scheduled for February 26. As laid out, we've invested in a strong platform for growth, which we expect to see materialize across the business over the last -- over the next several years. And as our capital spending peaks this year, we are poised for strong free cash flow growth and shareholder returns. And with that, I will turn it over to the operator for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question will come from Jonathan Chaplin with New Street Research. Please go ahead."
},
{
"speaker": "Jonathan Chaplin",
"content": "Thanks, guys. A question on CapEx. So, I'm wondering if you can give -- just remind us what the end status for the network upgrade in terms of -- I think it's 100% of the footprint will have a high split, and then a portion of the footprint will be upgraded to DOCSIS 4.0 by the end of 2027. Can you remind us how that -- what that is and how it might have changed based on the new guidance? And then, for line extension CapEx, I see that the total spend is down, but the number of rural locations is up. Have you reduced the pace of line extensions that you expect to build in non-rural locations? Thank you."
},
{
"speaker": "Jessica Fischer",
"content": "Yeah. So, Jonathan, I'll start with the line extension one. Two things happened inside of that. We've pulled back a bit on our proactive commercial build. And our expectations are a bit lower for greenfield given that the housing market remains sluggish, though even that, I would say, hasn't meaningfully reduced our passings growth outlook. So, I think, what you see is correct. We do have a few more rural passings than we had before, but it's offsets in there that are bringing the total number down. As far as the net network upgrade goes, our plan for the split across the three steps hasn't changed. So, we're still 15%, that will be 1.2 gigahertz. 50% then moves to distributed access architecture, but still at 1.2 gigahertz, and 35%, that then moves up to 1.8 gigahertz, and really is, I guess, the way that you would think of it in DOCSIS 4.0. I don't know, Chris, if you have follow-up on that that you want to talk about otherwise."
},
{
"speaker": "Chris Winfrey",
"content": "Well, look, it'll be a 100% high split. The mix hasn't changed in terms of where we're going, and the ability from there to use a combination of DOCSIS 4 and DOCSIS 3.1 extended on the increment is very low, if any incremental real capital expenditure. So, we feel really good about the plan. The one thing I would add is, keep in mind, as we go through on these nodes, we're putting in OLTs as well, which allows us to do fiber-on-demand or a fiber-drop-on-demand, almost similar to an enterprise customer, but to be able to do that in residential and SMB as well. And so, the network is very much capable in terms of wherever things go. You still maintain all the benefits that you have through power in the network, which allows you to hang cycle of radios through our CBRS deployment, which is going very well."
},
{
"speaker": "Jonathan Chaplin",
"content": "And, Chris, I assume that 35% ultimately goes to 100% at 1.8 over time. The assumption is that all happens within business as usual CapEx of less than $8 billion."
},
{
"speaker": "Chris Winfrey",
"content": "Yes. And what you have over time, one, I'm not sure if and when the need is going to take place, but, two, when you get into that less than $8 billion capital expenditure environment, the benefit that you'll have is the amount of node splits and CMTS upgrades that historically took place virtually be non-existent. You can reallocate capital to the extent you want that would have been spent into those segmentation areas into doing drop-ins into the actives, but that's all it would really require. And so, it could be done on the increment within the envelope."
},
{
"speaker": "Jonathan Chaplin",
"content": "Got it. Thanks, guys."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Jonathan. Leila, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Benjamin Swinburne with Morgan Stanley. Your line is now open."
},
{
"speaker": "Benjamin Swinburne",
"content": "Good morning. You had, I think, it's about 450,000 ACP-related subscriber losses or impact in '24. I'm just wondering if you guys are thinking you can grow -- you can improve your broadband results in '25 versus '24 when you consider no ACP? Obviously, storms are a wildcard, but you'll have more and more rural footprint behind you. And then, Chris, I can't remember the last time your video subscriber numbers outperformed both customer metrics and broadband metrics. Sounds like you guys are maybe selling into the base a bit and subsidizing that with some broadband. Maybe you to talk a little bit about what's happening inside of your offers and inside the business that's creating this kind of mix shift and how we might think about that as we move forward? Thanks so much."
},
{
"speaker": "Chris Winfrey",
"content": "Sure. Look, Ben, from a outlook perspective, we're really confident about the mid-term, our ability to grow Internet. And -- but we're also sensitive to the fact that there's -- you're on the cusp in particular periods of time between net loss versus net gain. And so, I'm not going to comment on short-term small impacts to gross adds or disconnects and have a big impact. But we won't have the ACP losses this year, and so that's a huge benefit. And it's still competitive in terms of fiber and cellphone Internet overlap, but that gives it a little better visibility, as I mentioned, than we had last year. The peak cell phone Internet impact, we seem to have gotten there, and there will be a declining pace of fiber overbuilt. So, you then add on to that in terms of growth rate over time, rule passings, the fact that data consumption continues to increase, investments we've made in network evolution to outpace the capabilities of our competitors, and then using in a more effective way than we already are the wireless convergence, and then what's coming, seamless entertainment. I ask people just step back and think about it from a consumer perspective. We have faster connectivity of unique set of products. Those products are available everywhere we sell, which is the point I was making with the slide that we showed today. And we save customers hundreds and thousands of dollars with Internet when similarly combined with mobile. So, I like where we sit, and I expect our seamless connectivity product and its value to really win in the marketplace over time. In the meantime, we're pushing through for all these things, but not having ACP losses inside this year is huge. And I'm not going to give a short-term outlook other than to say we better be better this year than we were next year -- or last year. So -- and then on video, the benefit that you saw to our net additions in the fourth quarter are simply a function of re-bundling video in with our connectivity sales. And we had moved away from actively attaching video to our broadband sales because we were unconvinced that over time, that would be an asset to the customer relationship because of the value equation that existed in selling a video product that had been commoditized, had a high price, and was able to be repackaged elsewhere through direct-to-consumer apps and otherwise at a lower cost. And so, for years, we had moved away from attaching video to our broadband sales because, what used to be a benefit was concerning us as maybe not being a benefit. That being said, once we had moved to an environment where we had more flexibility to use packaging in a way that created packages that were valuable to a customer and then attach the direct-to-consumer apps to our expanded packages in a way that allowed customers to take advantage of the full retail value of the apps as a way to save money, and the introduction of Xumo, which allows you to have unified search and discovery, and combine all of those services that you now get as part of your expanded service, as well as any other DTC or SVODs that you take separately in a single place. We thought the combination of that actually did provide the value and utility that we're looking for, and that's only going to get better. And so that's just the beginning. We haven't rolled out the full set of seamless entertainment packages and marketing yet, but we felt confident enough beginning in late September to start selling video again actively together with our broadband subscriptions and, as a way to create value and utility in the overall package, not just for video, but really to add value back into the broadband relationship. And what we did with our Spectrum pricing and packaging that we offered in September is it allowed us to when you take two or three sets of products between really broadband, mobile, and video, allowed us to offer Internet at a lower price both at promotional and retail value and to offer a price lock based on the bundle that you were taking and offer lower roll offs on the move from promotion to retail pricing, all of which has a long -- both short-term impact on your abilities from acquisition standpoint as well as from a retention standpoint. So, we feel good about where it's going. It's only going to get better. And that doesn't mean -- that's not a quarterly outlook on video. Don't get me wrong. It's just saying that over time, as our capabilities increase, our selling capabilities, and training to re-bundle these services is enhanced. I think it gives us real benefits not just to video, but also into broadband and to mobile."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thanks so much."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Ben. We'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Craig Moffett with MoffettNathanson. Your line is now open."
},
{
"speaker": "Craig Moffett",
"content": "Hi. I'm going to try to squeeze in two questions. First, just given the importance of your wireless bundling strategy, I'm going to leave aside the comments that you just had about video, can you point to any real evidence of what wireless is doing for your broadband business, and the way that you think about whether it's through churn or something else that suggests that the convergence strategy is having a meaningful impact? It's obviously topical because Comcast essentially said they're going to try to emulate the strategy that you've already been pursuing for a couple of years. And then, also on the topic of Comcast, you mentioned organic growth opportunities. I have to ask because we get the question so often. How do you think about inorganic growth opportunities? And with the commentary so frequently being discussed about the possibility of combining with Comcast, how do you think about getting bigger as a cable operator?"
},
{
"speaker": "Chris Winfrey",
"content": "There's a lot in there, Craig, but they're good questions. So, from a wireless standpoint and the benefits to convergence, if you think back to what we were doing and we continue to do with Spectrum One offer, it was really using the broadband relationship and offering a time of acquisition or retention of free mobile line. And what that was driving is additional attach, obviously, the mobile line, which was actively used, but additional mobile lines that were attached. And so, we were using broadband really for the benefit of mobile. And what we had seen along the way, some of due to the convergence benefits and the seamless connectivity, and some of it, obviously, with self-selection that takes place, and there's bias there. So that's why we've been careful, is that we saw a much lower churn rate in those broadband customers when they had mobile versus when not. Now, some of that is clearly self-selection, and we've always recognized that. And that's why we've been careful not to report out on that too heavily, but it's not all self-selection. And there's a clear benefit, and it's a better product, and it saves customers tremendous amounts of money. What we did with the new pricing and packaging is we recognized that we now have a brand recognition in the marketplace of Spectrum Mobile, which is the fastest mobile product. It's now widely recognized both from a brand and capability standpoint. It does have superior speed, and it has better connectivity through the Spectrum Mobile SSID attach as well as Speed Boost. And we decided, when at acquisition or retention, we can use mobile, and doesn't need to be always priced at $0 for the first line for free, and we can use it to drive improved acquisition and retail pricing for Internet and flip it a little bit. Doesn't mean that we've stopped using Spectrum One, but we still have Spectrum One active in the marketplace and it works well. But we can also use the Life Unlimited bundles, as I like to call them, to enhance our capabilities for Internet selling. That's early stages, but I think it's clearly going to have benefits. So, I think the convergence strategy works. The point I was making in the slide that we showed in today's presentation says we have a unique capability to deliver that where nobody else really does across their entire footprint. And so, to the extent that convergence matters, we think it does, we think we're in the best position to do that."
},
{
"speaker": "Jessica Fischer",
"content": "And I just want to make sure that we address there as well that not only does mobile benefited the broadband subscriber, but mobile also has financial benefits all on its own. It drives additional margin at the customer level."
},
{
"speaker": "Chris Winfrey",
"content": "Correct."
},
{
"speaker": "Jessica Fischer",
"content": "By attaching it to more customers, we drive sort of additional margin across the business. And, really, it's one of the key sort of cornerstones to how we can get comfortable with a plan for EBITDA growth inside of 2025, because we have that mobile revenue and, therefore, mobile margin as a driver of growth in the business."
},
{
"speaker": "Chris Winfrey",
"content": "It's become significant. And just to add on to that, it's not just -- you mentioned convergence. You could think about convergence as really the wireline and wireless capabilities together, but also with video. And that hasn't been the case, but I was mentioning to Ben, I think video can become an asset again. It doesn't mean that we're going to grow video. I'm not saying that. But I think we can use it as a significant asset that's also unique to us compared to most of our competitors together with mobile to find ways to drive growth to unique set of products and to save customers a lot of money. On the M&A front, I know there's a lot of chatter out there. Our strategy, Craig, is it's really to create value has never been dependent on M&A. In fact, it's really been moving in purely from an organic growth perspective and how do we create value for shareholders from that perspective. And you do that by being a great operator. You do that by saving customers lots of money, providing great service, doing that with in-sourced onshore employees, and being, hopefully, a good allocator of capital. But, by being a good operator, that also, I think, opens acquisition opportunities over time. And, the rest of the cable industry, when you sit back and think about it, it's all family-owned or family-controlled, and they'll decide. This is not like Time Warner Cable where there's another large publicly-traded company out there. And so, it's really in the hands of these families or family-controlled businesses who get to decide when's the time that they'd like to combine. And the other thing I would tell you is that, the door for M&A, I think there's a lot of chatter that it's also wide open. I don't think it's wide open. I think any M&A transaction that you have to do in any administration, anytime, it has to be good for customers, and has to be good for jobs. And, when you think about our organic operating strategy that drives growth, that's been helpful in that respect in the past in terms of our ability to get things done as well. But it's not -- it's a potential add-on to our strategy. It's not the core of our strategy, and it's not the only way that we can create value."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Craig. Leila, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Sebastiano Petti from JPMorgan. Your line is open."
},
{
"speaker": "Sebastiano Petti",
"content": "Thank you for taking the question. If perhaps, Jessica, you could comment, just around EBITDA, you do expect growth for the year. Any color perhaps at a OpEx level across the different buckets that we should be assuming? Obviously, as Spectrum Life Unlimited ramps, and what you and Chris have talked about, creates more attach opportunities. There's probably sales and marketing costs that come with that. So, just maybe trying to frame that a little bit would be helpful against the backdrop as well of improving costs that you implemented in 2024. And then maybe just thinking about the CapEx guide, obviously, it was helpful. Does not include BEAD. Limited BEAD appetite per se, but maybe how you're thinking about any changes to tax policy? Should we get an extension of bonus depreciation? How would you perhaps maybe think about that across the buckets of shareholder returns versus maybe improving or accelerating some of your network efforts? Thank you very much."
},
{
"speaker": "Jessica Fischer",
"content": "Yeah. So, I can -- I'll start on EBITDA growth. We said we plan to grow EBITDA growth in 2025. I think we do that through a combination of growth in the mobile business, customer benefits from the new pricing and packaging. There's Spectrum One promotional roll-off, and some other rate benefits that we'll see. And then, continued efficiencies in the business, particularly in cost to serve, as you heard Chris sort of talk about with some of the benefits that we see from machine learning and AI and just driving around the customer commitments to have fewer transactions with customers, but also the continuing benefits of our -- of what we've done on the expense side. In that respect, I think, across programming and cost to service customers, I generally expect that we'll be flat to slightly down, acknowledging that we think about programming on a per video customer basis, and that mix does matter there a lot. And so, to the extent that, that mix -- the mix of products that customers take changes as a result of the inclusion of the seamless connectivity app -- or the seamless entertainment apps. I think that one, ultimately will be dependent on results, but that's what we expect. In sales and marketing, as you point out, there, I think, there's a little more growth, maybe low- to mid-single-digits, given what we're doing to drive cost and grow customers and to rollout or continue the rollout of the Life Unlimited brand. And so, that's where I'm sitting on the expense side. And I don't know, Chris, do you want to talk about..."
},
{
"speaker": "Chris Winfrey",
"content": "Taxes, usually, where Jessica would take, but -- so if we're talking about capital allocation, maybe we tag team this one, but, if needed. Look, if -- we don't know where tax legislation is going to go, but if it was enacted, it is obvious that we'd have potentially a very sizable reduction in our cash taxes versus the outlook that Jessica has been talking about. Whether that's rate or interest deductibility or bonus depreciation, actually, all three of those are really important to an infrastructure builder, and that's what we do is we build the infrastructure here in the US to highway the pipeline for all of these applications and traffic. And so, any of those three things, and, hopefully, it's all three, which is rate, interest deductibility, and bonus depreciation, would make the return on all of our capital projects that might have been less attractive to be much more attractive. I don't think that means that you should run and say it's one for one in terms of dollar for dollar in terms of incremental, but to projects that are very good for customers and very good for our communities that might have been on the edge from a returns profile, suddenly can get really enhanced. And I think that's good for the economy and for jobs and for shareholders all in one."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Sebastiano. Leila, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Jessica Reif Ehrlich from Bank of America. Your line is open."
},
{
"speaker": "Jessica Reif Ehrlich",
"content": "Thank you. I guess on LA, I know you said you'd be more specific on the first quarter call, but is there any early read that you can give? I mean, I don't know what you're assuming for homes coming back, but is it a step -- a multiyear step down? And then, a follow-up with both video and M&A. The video seems to be working before you were even marketing. Can you give us some color on what your marketing plans are for what is clear value for customers? And then, on M&A, Chris, you made a remark at the beginning about national and global competition. So, could you just talk about, like, how you would compete with more national competitors? What you -- what benefits you would get? Is it all, like, cost or revenue? Like, any color you can give?"
},
{
"speaker": "Chris Winfrey",
"content": "Sure. So, from LA perspective, what's widely reported is there's roughly 15,000, 16,000 passings that have burned and no longer inhabitable. And you should assume that the entirety of LA is really our footprint, and so that reflects passings for us. In the grand scheme of overall Charter at 57 million passings, that's not that large, but it's near and dear to home. And so, it's, like I said, personal to us. So, there's a penetration rate on that. That should be the subscriber impact that's immediate. Those homes, over time, so they'll be taken out of passings. They'll be taken out of customer relationships. And over time, if you know that area, and I know you do, it'll get rebuilt and those will become new passings and new homes inside of our footprint. We're already looking at the exact plans for rebuild and starting in many cases to do so. That'll drive, as Jessica mentioned, clear leasing capital, which we'll be able to highlight. There'll be a subscriber impact, which we'll highlight definitively once that's -- in our next earnings call. There will be credits along the way for customers who were impacted through -- obviously, if they lost their home, but in addition to that, through evacuation and otherwise, we're -- we've got policies in place to do that. And so, there'll be a number of one-time financial impacts, and similar to other times, we'll just go through that list, and Jessica will do that on the next call. The video, from a marketing perspective, look, from a competitive standpoint, I'm not going to sit here and articulate everything that we're doing, but I think strategically positioning our video product and our package of services in a way that allows customers to have more product than they'd be able to afford otherwise and to save significant amounts of money, when you look at that slide, the page that we concluded, not all of those apps are yet deployed, including, for example, Peacock, which will come within the next month or so. But once we've got all the apps fully activated for inclusion and once we have a consumer-friendly way for them to upgrade into the ad-free versions, which is for the benefit of us, the programmer, and the consumer, and we have that in a store that allows customers to go through at least the perception of a unified authentication process that's customer-friendly, then you'll start to see us push more and more into driving that, not just for video sales, but as a way to contribute to the broadband connectivity and the mobile relationship. One of the key features, that we've had as part of our negotiations with the programmers along the way is to say, we need to cooperate. This is a partnership, and it shouldn't be that every four or five years, we're going to go do battle and try to find a net zero gain. This is really about -- because that hasn't worked. The net zero gain actually must left to -- led to significant losses for everyone, including the customer, but as well as obviously programmers and even us. And so, the idea here is to form a true partnership where we can get behind each other's products, that we can co-market together. They have fantastic brands. They have fantastic IP. The way that Spectrum, as good as our brand is, would be difficult to replicate. And we're out there selling their product every single day with 25,000 frontline sales and retention people. And we are very good at distribution, but I think having them get behind and help us advertise the value that's here can work well for the programmer, but also work well for us. And, obviously, it works very well for the customer because they save money. They are able to take more product, and they can actually upgrade to the ad-free version, which creates additional revenue for the programmers and for us over time in a way that works as a much better ecosystem. So, without getting into any tactics around marketing, I think you can see where we're trying to make sure that the incentives are very much aligned between the programmers, us, and the customer in a way that, from our perspective, really works to sell more connectivity relationships. From a scale perspective, which is what you asked, if we as Charter, if we had more scale, I think the brand recognition of our mobile services, Internet tends to be a little bit more local, but, clearly, when you think about us competing against national mobile operators, when you think about us in the video space, there's Amazon, there's Google. And so, across really all of our products, you can think about where there's marketing advantage to having some additional scale. We have scale today, and it's sufficient not to say that we're deprived of that, but I think we could do better for customers. By having that scale, I think we could save customers, additional money. I think we could in-source jobs the way that we did with Time Warner Cable and Bright House and bring more US jobs back from offshore call centers on to onshore environments that create good paying jobs as well as bringing contract labor into in-house as well. So, I think we can be good for ourselves in terms of scale. For consumers, in terms of scale, I think we can be good for jobs. And then finally, if you think about an environment that we've talked a lot about is AI development, to actually enhance our service capabilities, to make these onshore in-house jobs better for our employees. AI is not cheap. And the more scale you have for that, to the extent you could become less regional and closer to a national operator to compete, it'll allow you to invest more into AI and to actually have lower cost per customer to do so and to drive additional benefits for customers that way. Look, I could go on and on. We have enough scale to operate well today, and we're doing it. But having additional scale, of course, is always beneficial when you operate a large, fixed network, high-capital business."
},
{
"speaker": "Jessica Reif Ehrlich",
"content": "Thank you."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Jessica. Leila, we'll take our last question, please."
},
{
"speaker": "Operator",
"content": "Our final question will come from Kutgun Maral with Evercore ISI. Your line is now open."
},
{
"speaker": "Kutgun Maral",
"content": "Good morning, and thanks for taking my question. Just a follow-up on the M&A discussion from a different lens and maybe focus on wireless. You've scaled your mobile efforts quite meaningfully, and I know that you've had a lot of success with migrating traffic onto your own network. But as that business grows and perhaps Comcast's efforts also ramp, is there a change to your view on whether owners' economics would make more sense on a standalone basis or through a partnership? I just wanted to revisit the topic because the common pushback that we get on your mobile and convergence efforts is that your margins there and the opportunity more broadly are naturally limited because of the MVNO relationship, and therefore, you just don't get as much credit on the success that you've had. So, we'd appreciate your perspectives. And just a quick one on rural. The new passings have continued to tick-up sequentially, but customer net adds were flattish. Can you just help us think about penetration trends over there? And if -- as your new patent accelerates around 450,000 in 2025, should we still assume that rural sub net adds will also accelerate, or are there other nuances that we should be mindful of? Thank you."
},
{
"speaker": "Chris Winfrey",
"content": "I was trying to think the best way to answer your question on the mobile business. When we got into the mobile business, it really was because it was an extension of our broadband business. And so, when you think about our mobile business today, where 87% of the traffic has really carried on our network already today, we've deployed thousands of radios for CBRS. We'll be deploying that nation -- across our entire footprint, deploying 1,000 more this year of radios for CBRS in a multitude of markets. And so, that number, the 87% is only going to increase through CBRS deployment, but as well as, our WiFi capabilities and the cooperation amongst these regional cable operators to enable WiFi auto authentication across these networks as we compete against national MNOs. So, the offload can continue to increase. Already, our margins aren't very good on the product. And so, there's no driving force for us to say that we need to have owners' economics. We don't look at the product as a standalone basis. We have the capability to look at EBITDA growth that way, which we do just for really more from a capital markets perspective, and its significant contribution, this year, in 2025, to our growth rate. But it's really a combined product. For us, mobile is an extension of our broadband product that ties into our seamless connectivity capabilities. And so, there's no pressure from our perspective to feel like we need to have owners -- additional owners' economics beyond the 87% that we already have today. I don't know if you want to comment on the rural?"
},
{
"speaker": "Jessica Fischer",
"content": "Yeah. On the rural piece, so there are a couple of things going on. First off, if you think about where a preponderance of our rural build is, there's a large amount in the Carolinas and in Florida. And so, from a sales perspective, I think there was a bit of impact there from the hurricanes inside of Q4. I do also think from a timing perspective, so second one, you have passing sometimes that get placed in service very late in the quarter, and so some of those passings might not have aged quite as much as you would think if you sort of assume that they're coming in at a steady rate. And the last one is there is a little bit of competition in those rural markets on the cell phone Internet side. I don't think that that changes where we end up sort of from a terminal penetration in those markets' perspective because the desire in those spaces for wired broadband is still quite high. But as to the speed with which we terminate some of the -- or the way we penetrate some of those passings very early on, there's a little less jump at the very beginning than what we had seen previously."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Kutgun. Leila, that concludes our call. Right back to you."
},
{
"speaker": "Operator",
"content": "Thank you all for joining the call today. The session is now concluded, and you may now disconnect."
}
] |
chtr | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Hello and welcome to Charter Communications' Third Quarter Investor Call. We ask that you please hold all questions until the completion of the formal remarks, at which time you will be given instructions for the question-and-answer session. Also, as a reminder, this conference is being recorded today. If you have any objections, please disconnect at this time. I will now turn the call over to Stefan Anninger."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, operator, and welcome, everyone. The presentation that accompanies this call can be found on our website, ir.charter.com. I would like to remind you that there are a number of risk factors and other cautionary statements contained in our SEC filings, and we encourage you to read them carefully. Various remarks that we make on this call concerning expectations, predictions, plans, and prospects constitute forward-looking statements, which are subject to risks and uncertainties that may cause actual results to differ from historical or anticipated results. Any forward-looking statements reflect management's current view only and Charter undertakes no obligation to revise or update such statements. On today's call, we have Chris Winfrey, our President and CEO; and Jessica Fischer, our CFO. With that, I'll turn the call over to Chris."
},
{
"speaker": "Christopher Winfrey",
"content": "Thanks, Stefan. We had a busy quarter, executing our operating strategy and building on the foundational investments of the past couple of years. We're also successfully managing the transition of customers previously on the government's Affordable Connectivity Program in a period of new competition. And while we expect some normalization of external factors as we head into 2025 and much lower capital intensity beyond 2025, we're not standing still, evidenced by the series of announcements we made in September, a market leading customer service commitment, new pricing and packaging that makes better use of our unique assets in the marketplace, encapsulated in a brand refresh through Spectrum's Life Unlimited promise. There was a lot of flattering press about the importance of wireline networks and convergence this past quarter. We remain the only true convergence pure planner footprint with a fully distributed gig capable wireline and wireless network across a growing 58 million passings everywhere we operate, soon to be symmetrical and multi-gig in all of our communities. Our seamless connectivity capabilities are evidenced by our continued market leading mobile growth. And in just over a year, we completed a full cycle of programming renewals and the launch of Xumo to fundamentally reposition video again as an important part of the connectivity bundle, whether full value hybrid DTC linear packages, smaller non-sports streaming packages or the addition of a la carte programmer apps to our broadband and video customers. We're well positioned to provide seamless connectivity and this new form of seamless entertainment to customers wherever they want to go. Before discussing the quarter, I want to express our sympathy and commitment to the communities across the Southeast impacted by hurricanes Helene and Milton. These were devastating storms. The initial impact was significant, mostly because of power outages, downed poles and trees and drops. All but approximately 10,000 of our customers, including homes and businesses fully lost, have had their service restored. In particular, we're still very active in the Asheville, North Carolina area and some remaining pockets at Tampa Bay. I'd like to keep I'd like to thank our frontline personnel for their dedication and effort in keeping our customers connected. That includes our employees who live in the area and were directly impacted themselves and the teams of employees from across the country who volunteered to help in the restoration. During the third quarter, we lost 110,000 internet customers. We added 545,000 Spectrum mobile lines and over 2.1 million lines year-over-year. Revenue grew by 1.6% in the quarter, while adjusted EBITDA grew by 3.6%. Were it not for the impact at the end of the ACP program in June, we would have grown our internet customers during the third quarter. Importantly, we've been successful in keeping low income households connected. We continue to compete well against both wireline overbuild and cell phone internet, each with expanded footprints. And we remain confident in our ability to return to healthy long-term growth. Our internet product is faster and more reliable. Our pricing is lower and similarly bundled with mobile. We expect market activity and selling opportunities to pick up over time. The cell phone companies will face challenges as customer bandwidth demands continue to grow. As I mentioned, in the meantime, we're not standing still. In mid-September, we made a series of important announcements, including the brand relaunch, a unique customer service commitment and the new pricing and packaging structure. Our strategy has not changed. We offer high quality products to customers in a package and at a price point that our customers can't replicate. We pair that with unmatched customer service. Our fully deployed high bandwidth network with ubiquitous and seamless connectivity and entertainment products creates opportunities and removes barriers to help customers in every aspect of their lives, which led us to our new brand platform, Life Unlimited. While part of that is a new look and feel for the Spectrum brand, it's also about our increasingly converged set of products and building more trust with our customers. Our new customer commitment is comprised of four key promises: Reliable connectivity we're committed to keeping our customers connected 100% of the time and promptly resolving any issues. Transparency at every step We're committed to clear and simple pricing and timely service updates and we will take responsibility when things go wrong. Exceptional service. We're committed to providing exceptional customer experiences. And finally, always improving, meaning we act on our customer's feedback to improve our products and customer service. We back up those commitments with guarantees. For example, to fix any service disruptions quickly, we commit to dispatch a technician the same day if the customer requested prior to 5 PM. If a customer needs help on a professional installation, a technician will be available the same or next day. We now back those commitments with proactive service credits if we miss the mark. We also don't have residential or SMB contracts. And if a customer is not completely satisfied with any services within the first 30 days, we give them their money back. We're making these commitments because we can, because we already made the investments in a 100% US based sales and service with our own employees in frontline tenure through pay, progression, market leading benefits, and tools and systems to make the job better for the employee and our customers. Our Life Unlimited brand relaunch also includes new pricing and packaging that better utilizes our unique product assets, which work better together to provide lower promotional pricing and lower persistent bundle pricing. Our new pricing and packaging will drive more sales with higher selling of our best products, grow customer ARPU at Connect despite lower product pricing, and reduce billing, service and retention calls, while reducing churn. For example, we now offer our gig internet product at $40 per month when bundled with two unlimited mobile lines and or video. Customers that take the new double play will receive a two year price lock, and customers that take our new triple play will receive a three year price lock. And in that package, customers also get our top mobile tier, Xumo and Cloud DVR at no additional charge. For customers who want our popular Spectrum One offering, that remains available. Now with a higher starting speed of 500 megabits per second with one free unlimited mobile line included for a year. Existing customers can also opt into our new bundles at persistent bundled pricing. And we have also increased internet speeds for existing flagship and ultra-customers. It's still very early, but so far, our new pricing and packaging is showing promising results, including more video sell-in, more mobile lines per sale and more gig sell-in. I expect those results and broadband sales to accelerate the seasoning of our marketing and sales approach over time. Our operating strategy remains simple, sell more products to more customers, driving higher penetration against our large fixed asset, reducing the operating capital cost per product with lower churn to ultimately drive more cash flow capacity. And we're making investments in that large fixed asset through our network evolution initiative, which brings multi-gigabit speeds to 100% of our customers. We've launched symmetrical internet service in our step one markets, including Reno, St. Louis, Cincinnati, Dallas Fort Worth, Louisville, Lexington, Rochester, Minnesota, and Rochester, New York. We're now broadly marketing our symmetrical speeds in seven of these eight markets. The high split upgrade process should be largely complete in all of our step one markets by the end of this year. We're making progress on Step 2 DAA and Remote PHY markets and we've deliberately slowed these markets to get the software fully certified to our specs. That has pushed back equipment purchasing and operational deployment and we now expect our network evolution initiative project to be completed in 2027. Excluding the benefit of future capital and operating cost savings, our network evolution has and will cost a very low incremental $100 per passing. We have full visibility to that outcome. We'll update our multiyear capital expenditures outlook, including the new phasing of our network evolution spend when we report our fourth quarter results in January. In Video, over the past year, we transformed all of our major programming agreements in a way that works for our customers and for Charter, including a recent early renewal of Warner Bros. Discovery and then NBCU. These agreements give customers greater overall package flexibility and the ability to include all the key streaming apps from programmers within our Spectrum TV Select packages. That enables us to offer what we now call seamless entertainment, the first for the industry at no extra cost. We also have passed for customers to upgrade to the ad free version of these apps and we will sell programmer apps a la carte to broadband and skinny package video customers. We also had the renewed support from our programming partners to get behind each other's products and distribution for a healthier video ecosystem and better choice and value for customers. More to come on this, but the inclusion of Max with its HBO content and TV Select and how we plan to promote Max to our broadband customers and vice versa will show how we and the programmers more broadly can support one another with our customers front and center. By early 2025, we'll be providing our TV Select customers up to $80 per month of retail streaming app value at no additional cost, including the ad supported versions of Max, Disney+, Peacock Premium, Paramount+, ESPN+, AMC+, Discovery+, BET+ and ViX. Seamless Entertainment, even easier with Xumo, which proves unified search and discovery with a market leading voice remote and the highest rated pay TV streaming app in the US. Over the last couple of years, we've moved away from bundling video in our offers because the value proposition to customers had fallen. We still have some work to do to operationalize the new customer proposition, including the customer front end for programmer app authentication and programmer credentials, but we're proud of what we can offer customers, existing and new in terms of value and utility. And that breakthrough is why we are including video in the new bundles we launched in September. Fundamentally, we believe that maintaining and evolving the video business, even if it isn't growing, helps customer acquisition and retention by making use of our scale and capabilities and adding more value into our unique seamless connectivity relationship. Video still has positive cash flow and provides us with option value. So a lot of exciting things happened in the third quarter. Our continued success in mobile is certainly one of those. Our mobile offering continues to evolve, driving strong results and supporting our new pricing and packaging efforts. We had our highest port ends quarter ever. Our highest mix of ads on unlimited plus driving higher customer value and ARPU. And our lines per customer continues to grow nicely. Today, approximately 8% of our total passings take our converged offering of internet and mobile. So we remain under penetrated despite having a differentiated and superior offering with market leading pricing at promotion and retail. As we work through the one-time impacts of ACP this year, new competition with expanded footprint and our unique non-recurring subsidized network expansion investment, we remain confident in our ability to drive healthy, long-term connectivity customer growth. Now in the future, we have the best fully deployed network uniquely capable of delivering seamless connectivity or convergence everywhere we operate, with pricing and packaging that saves customers money with the best products, and a service capability investment that has yet to be fully realized as a competitive advantage. Our team is executing well on these multiyear initiatives, a team that's hungry with a tremendous drive to win for our customers, the communities we serve, our fellow employees, and for our shareholders. Jessica?"
},
{
"speaker": "Jessica Fischer",
"content": "Thanks, Chris. Before discussing our third quarter results, I want to mention that today's results do not include any impact related to hurricanes Helene and Milton, which hit the Southeast in late-September and early-October. Our fourth quarter results will include some lost customers and passings related to the storm from both suppressed gross additions and the damaged or destroyed plant that Chris mentioned. We're still assessing the impacted areas and we expect to rebuild lost passings over time as our customers rebuild. We currently expect to incur approximately $100 million in incremental capital expenditures, the vast majority of which will be captured in our rebuild capital expenditures line. We have been providing bill credits to customers in impacted areas and those onetime credits will offset some fourth quarter revenue. We may also have some incremental operating expense, although we expect that to be relatively small. And we'll isolate the storm impacts when we report our fourth quarter results. Let's please turn to our customer results on Slide 8. Including residential and SMB, we lost a 110,000 internet customers in the third quarter, while in mobile, we added 545,000 lines. Video customers declined by 294,000 and wireline voice customers declined by 288,000. The end of the ACP program drove higher third quarter non-pay and voluntary churn among former ACP customers for a total estimated third quarter impact of approximately 200,000 internet losses. Incremental non-pay disconnects drove more than half of those losses and the rest of the impact was primarily driven by voluntary churn with a small impact from lower connects. We continued to do a very good job in managing the end of the program and we've retained the vast majority of our customers who were previously receiving an ACP benefit. Beyond ACP, we competed well across our footprint, but note that our third quarter internet net additions benefited from seasonal back-to-school connects and a work stoppage at one of our competitors, while fourth quarter customer results will include impacts from the storms up and about 100,000 incremental non-pay disconnects and some lagging voluntary disconnects, both related to the end of ACP. After those effects in the fourth quarter, we expect the onetime impacts from ACP to be behind us. Turning to rural. We ended the quarter with 696,000 subsidized rural passings. We grew those passings by a 114,000 in the third quarter and by 381,000 over the last 12 months. And we had 41,000 net customer additions in our subsidized rural footprint in the quarter. We now expect to activate close to 400,000 new subsidized rural passings in 2024. About 35% more than in 2023, but lower than our original 2024 plan of 450,000 due to shifting construction labor to rebuild activity in storm impacted markets. We expect our subsidized Rural Construction activity to recover by the end of the fourth quarter and that reacceleration of activity to put us on a higher pace in 2025 as planned. Our RDOF build should still be completed by the end of 2026, two years ahead of schedule. Moving to third quarter revenue on Slide 9. Over the last year, residential customers declined by 1.8%, while residential revenue per customer relationship grew by 1.8% year-over-year given promotional rate step ups, rate adjustments, the growth of Spectrum Mobile and $63 million of residential customer credits in the prior year period related to the temporary loss of Disney programming in September 2023. These factors were partly offset by a higher mix of non-video customers, growth of lower priced video packages within our base and $25 million of costs allocated to programmer streaming apps, which are netted within video revenue. As Slide 9 shows, in total, residential revenue grew by 0.3% year-over-year. Turning to commercial, total commercial revenue grew by 2% year-over-year with SMB revenue growth of 1% year-over-year, reflecting higher monthly SMB revenue per SMB customer, primarily due to rate adjustments. Enterprise revenue grew by 3.7% year-over-year, driven by enterprise PSU growth of 5.7 percent year-over-year. And when excluding all wholesale revenue, enterprise revenue grew by 5.9%. Third quarter advertising revenue grew by 18% year over year given political revenue growth. Excluding political, advertising revenue decreased by 6.3% year over year due to higher levels of inventory in the market, partly offset by higher advanced advertising revenue. Other revenue grew by 11.6% year-over-year, primarily driven by higher mobile device sales. And in total, consolidated third quarter revenue was up 1.6% year-over-year, which is 0.6% year-over-year when excluding advertising revenue and $68 million of customer credits in the prior year period related to the temporary loss of Disney programming in September 2023. Moving to operating expenses and adjusted EBITDA on Slide 10. In the third quarter, total operating expenses grew by 0.2% year-over-year. Programming costs declined by 10% year-over-year due to a 9.5% decline in video customers year-over-year, a higher mix of lighter video packages, and costs allocated to programmer streaming apps, which are now netted within video revenue, partly offset by higher programming rates and a $61 million benefit in the prior year period related to the temporary loss of Disney programming in September 2023. Other costs of revenue increased by 15.8%, primarily driven by higher mobile device sales and higher mobile service direct costs. Cost-to-service customers declined 0.5% year-over-year given productivity from our 10-year investments, including lower labor costs, partly offset by modest year-over-year growth in bad debt expense. Sales and marketing costs grew by 4.4% as we remained focused on driving customer acquisition and given our Life Unlimited brand relaunch in September. Finally, other expense grew by 2.3%. Adjusted EBITDA grew by 3.6% year-over-year in the quarter. And when excluding advertising, EBITDA grew by 2.7% year-over-year. Turning to net income. We generated $1.3 billion of net income attributable to Charter shareholders in the third quarter, in line with last year, as higher adjusted EBITDA was mostly offset by higher other expenses, primarily due to noncash changes in the value of financial instruments. Turning to Slide 11. Capital expenditures totaled $2.6 billion in the third quarter, down about $400 million from last year's third quarter. Line extension spend totaled $1.1 billion, $16 million higher than last year driven by our subsidized Rural Construction initiative and continued network expansion across residential and commercial greenfield and market billing opportunities. Third quarter capital expenditures excluding line extensions totaled $1.5 billion, which was lower than the prior year period by about $400 million. The decline was driven by core CapEx items, including CPE timing and lower than originally expected spend on network evolution given what Chris discussed earlier with respect to our Step 2 software certification. We now expect total 2024 capital expenditures to reach approximately $11.5 billion, down from approximately $12 billion previously. That update reflects full year 2024 line extension spend of approximately $4.3 billion, down from $4.5 billion, partly offset by slightly higher core CapEx, primarily due to the shift of some of our construction labor from rural efforts to hurricane rebuild activity. The update also includes 2024 network evolution estimated spend of approximately $1.1 billion, down from the previous estimate of $1.6 billion. Much of that originally planned 2024 spend is being pushed into 2026 and 2027. As Chris mentioned, we will update our multiyear capital expenditures outlook when we complete our 2025 operating plan and report our fourth quarter results in January. We now expect our total BEAD spend will be substantially less than our spend in RDOF, in each case, net of subsidies. That lower outlook reflects the most recent broadband map updates in terms of available unserved passings near our network and a little less favorable rules framework in BEAD when compared to RDOF and state grants. We have been in regular communication with the states in which we operate and we are generally the largest rural builder in our states through RDOF, ARPA and other grants. While we're still finishing the 2025 operating plan, it's clear 2025 capital expenditures will not exceed the range of capital spend that we outlined in January of this year, even inclusive of a small amount of initial BEAD pending. Looking beyond 2025, we expect total capital spending in dollar terms to be on a meaningful downward trajectory, even inclusive of BEAD spending. So total capital intensity is now poised to decline significantly after 2025 even including the unique onetime opportunity that subsidized rural spend and network evolution has presented us. While we always prioritize our cash flow for organic opportunities first and then accretive M&A and buybacks, there are no organic capital expenditure opportunities on the horizon that give us concern with that capital intensity outlook. Free cash flow in the third quarter totaled $1.6 billion, an increase of approximately $520 million compared to last year's third quarter. The year-over-year increase was primarily driven by higher adjusted EBITDA and lower CapEx. We finished the quarter with $95.1 billion in debt principal. Our current run rate annualized cash interest is $5.0 billion. We repurchased just under 850,000 Charter shares and Charter Holdings common units totaling $260 million at an average price of $311 per share, less than we had originally expected as we became restricted as a result of our negotiations with Liberty Broadband. As of the end of the third quarter, our ratio of net debt to last 12-month adjusted EBITDA moved down to 4.22 times. We remain committed to our levered equity strategy and to share repurchases as a component of that strategy. Our leverage ratio may decline further given our pause and buybacks, but we look forward to resuming our program when we are able and we have not changed our target leverage. And with that, I will turn it over to the operator for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question will come from Kutgun Maral from Evercore ISI. Please go ahead."
},
{
"speaker": "Kutgun Maral",
"content": "Good morning and thanks for taking the question. Just one on broadband. Net adds in the quarter were very encouraging with a return to a quite meaningful sub growth, excluding ACP. Is there any color you can provide on the competitive backdrop and perhaps any early reads on the underlying broadband trends in the fourth quarter, excluding the incremental ACP net losses you called out? Thank you."
},
{
"speaker": "Christopher Winfrey",
"content": "Sure. A very much anticipated question. So maybe I tried to talk about the market more generally, both inside of the third quarter. What we're -- what we think about the fourth quarter and where that does or doesn't position us for next year. But I think as you mentioned, there's a lot of puts and takes inside the third quarter. Underlying all that is that we are competing very well in a marketplace that still has lots of competition, lots of new competition with expanded footprint. In the third quarter, we did have some benefits that are unique to the third quarter, seasonality, which is typical. We also had a some, not large, but some impact from -- positive impact from a competitor who had a work stoppage. I think that's well understood. And then we had obviously the downside of significant ACP primarily through nonpay disconnects and voluntary churn, but we're managing that well. And in the fourth quarter, when you think about the seasonality and the work stoppage benefits, we won't have those inside the fourth quarter. We'll still have approximately 100,000 nonpay to deal with from ACP that we expect to see early in the quarter, in the fourth quarter. And we also have some hurricane impacts. And so that will impact subscribers, credits, as well as, Jessica mentioned, some capital and rebuild. And so then I think the bigger question is, as you look out, where does that leave us? We're not about managing for short-term for quarters. We're really about thinking about the long-term for the business. In 2025, there won't be ACP and we'll still have the continued tailwind of newly built passings, both organic as well as rural footprint. And then I think there's just the big questions or variables that will exist. Is lower interest rate environment, does that impact mortgages in a way that drives higher move rates? Have we seen the peak cell phone Internet impact? And it appears that that's the case. And can we drive even higher Internet sales as well as all of the additional bundling and higher product value packaging that I described through our new pricing and packaging, and really even more so than today, start to fully realize the benefits of mobile, not just through churn, but through additional Internet acquisition rates. And then finally, really a bogey variable, one that we wouldn't bet on, but I think is out there in terms of option values, can video, a reconstituted video, can that really provide broadband acquisition and retention support? So that's probably much longer to look towards the tail end of next year and beyond. But I think we're making the right investments and doing the right things to compete. We are still very much in an atypical low churn environment when you exclude ACP. And despite that, it's still a competitive environment for new sales. So I think if you step back, it's too early to declare victory or even plateau, but certainly a better unit growth setup for 2024 for 2025 than what we saw for 2024, I think, for us and probably for the rest of the cable industry."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Kutgun. Operator, we'll take our next question."
},
{
"speaker": "Operator",
"content": "Our next question will come from Benjamin Swinburne with Morgan Stanley. Please go ahead."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thanks. Can you hear me?"
},
{
"speaker": "Christopher Winfrey",
"content": "Yes."
},
{
"speaker": "Benjamin Swinburne",
"content": "Great. Hey, Chris. Chris, as we look beyond cell phone Internet to Fiber, not that fiber is new, but as we think about the footprint expansion within Charter's footprint, can you talk a little bit about where that sits today, your sort of gig markets, where you see that going over the next, I don't know, three plus years? And kind of how you think your market share shakes out as you analyze your historical performance in fiber markets and think about sort of what's happening in the marketplace and all the things you're doing at Charter to compete. And I don't know if you'll be able to answer this, but could you talk about why the Liberty Broadband opportunity is interesting to Charter? And if you do come to an agreement, are you able to buy back stock pre-close? Is there a way to put a mechanism in place to get back in the market or does that have to close before you're able to get back in? Thank you so much."
},
{
"speaker": "Christopher Winfrey",
"content": "Sure. Let me start with the easy one, which is the last question you asked about Liberty Broadband. We've said what we can say for the time being through Liberty's 8-K and what there is very much public. I think we're going to have to stay quiet until there's something more to talk about in the meantime, at which point, of course, we'll talk through everything that you just asked. I know those are important questions. So unfortunately just going to have to deflect those for the time being. But if you step back to gig overlap, which includes all types of gig overlap in our footprint, it's roughly 55% today. And where it goes, I think, depends on people's access to capital, what happens in the M&A environment. But also, I think there are, as widely understood as I think there's probably some competing notions of that overlap footprint and where it may not be mutually exclusive. And as a result, I think people with the combination of scale back investment plans, plus recognizing that they're not going to be the X competitor that they thought they were going to be, may need or want to back off just because they're not going to be able to make returns. I've always thought that a wireline overbuild has very poor, if not negative, returns. And so when you start to have duplicative plans of multiple overbuilders, it really just makes it that much worse. It's actually terrible. So I think there is a realization that, that will take place. And so where it goes depends on somewhat the rational nature of our competitors and where they want to deploy capital. In the meantime, what can we do around that is we can continue to make the type of investments that we're making today is make sure that we have a symmetrical multi-gig wireline network across our entire footprint, have a seamless connectivity product through convergence that none of our competitors can ubiquitously use to compete. And then add to that the ability to save customers significant amounts of money, obviously, with mobile, where we offer tremendous advantage given our structure. But also in some of these rural footprints, as strange as that may sound, we offer customers the ability to save significant amounts of money with their wireline phone relative to what they pay. No. That's not in vogue to talk about, but the reality is something I think we could use specifically in that market to drive even faster penetration in the rural footprint. So overall, in our existing, inside of our new footprint, I think we have a great set of assets, a better and faster set of products, higher quality service because we're 100% onshore here in the US with sales and service, primarily with our own employees who are committed to that high-quality service. Then who knows, over time, the ability to add a unique video package that appeals to customers of all budget levels in terms of what they can afford and to deliver great value and utility inside the video package, I think, remains a big potential upside in terms of our ability to drive broadband and to compete against some of these competitors who don't have the same network seamless connectivity, packaging and product set and the ability to save customers money. I think we've got the best hand as it relates to our ability to compete in these marketplaces. What we typically see with any new overbuild, and that's not new, that's -- we have a lot of experience with this, it's been going on for probably 15 years, as you see an initial uptake, it can put a few points of penetration impact at the outset when somebody comes in for the first 18, 24 months and then the market kind of settles out. And so when we look to historical wireline overbuilders, many of which never got to the stated penetrations that today people say are required for return and that includes DSL conversion. I feel pretty good about where we can go over time, how we can compete. And the fact that at some point, the reality will be there that there's not a great financial return for wireline overbuilds when it's a single, much less if it's a multiple."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thanks so much, Chris."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Ben. Operator, we'll take our next question please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Jonathan Chaplin with New Street Research. Please go ahead."
},
{
"speaker": "Jonathan Chaplin",
"content": "Morning, guys. First, I'd like to just touch on the brand repositioning. From our perspective, I think, it's a pretty profound change in the strategy and would love to get some context for I mean it's probably too early, but are you starting to see any impact on gross adds or churn? Yes. And when do you think -- how long does it -- do you think it sort of takes to really start to be felt in the business? And then from the bill credits that come with the commitments that you're making, would we be expecting any impact on ARPU and costs from those or have you gotten your internal systems to the point where you're happy to give the bill credits because you know you're not going to have to give any?"
},
{
"speaker": "Christopher Winfrey",
"content": "Sure. It's a lot in that. Okay. I appreciate that you appreciate that the brand repositioning and the commitments that we're making are significant. I think it's really exciting for us and where we can go. It really comes about because we had made the significant investment in our own employees and investing in frontline tenure, which is progression and the ability for our employees to not just think about it as a job, but to have it as a career. And that gives us a higher quality craft than what you could have with contractors or offshore personnel. But at the same time, we really had not gotten the credit, I think, in the marketplace from customer satisfaction or NPS the way that we thought that reflected the investment that we've made. And so some of that comes down to doing a better job as a management team and avoiding some of the paper cuts that exist in customer service. The quality of service is there, the investment is there. This isn't a money issue. This is really trying to just, around the edges, how can you do better? That's one. Two is making sure that we had implemented some of the softer touch for customer service and to just give customers more recognition for their tenure with us and to remind them that we're local inside of their communities, and that these are committed employees to the company. And three is to really stand behind our service and back it up with guarantees, guarantees for service, and guarantees about what happens if we're honest when we fail to meet that service level that we've committed to customers and to stand behind that. And so most of that, which goes to your bill credit question, isn't going to be giving out bill credits. It's going to be reminding customers that that's the type of quality of service that they can expect from Charter from Spectrum. And to the extent that we miss, we're going to proactively apply credit and own it and apologize for where we don't get it right and to do a better job. I don't think the bill credits, there will be some incremental impact. I don't think it's going to be particularly material as it relates to ARPU. But what it does is it puts a pretty significant flashlight on us internally to make sure that what are those paper cuts, where are those service misses, and it provides a real incentive internally for us to go manage that down by providing even better and high quality of service. So a lot of this is just making sure that we get recognized for the investments that we've already made, but a lot of it also is forcing ourselves to be better and to do better. And then you match that service commitment at the same time with some of the ethos that was in what I described, which is around billing transparency and having high-quality services and products, which we do have, but even simple things about rounding the pricing, instead of $0.99, to rounding it to even dollars, and to having lower promotional pricing when bundled and lower persistent pricing when bundled in a way that not only saves customers money now, and we always did over time, but even more money over time to the extent they take more product from us. It's customer-friendly and competitive in the marketplace. So I'm really excited about it. There is, it is way, way too early, your question about any early impact of that. I think it's less about what you say and it's more about what you do and that takes time to be recognized in the marketplace. And so I think this is something that, maybe if we're lucky, back end of next year from just the customer commitments and service aspect, we could see the benefit of that. This is a multiyear process. It's not something that we're looking to immediately. But I think the good news, as you've highlighted, is we're very, very focused on our reputation in the marketplace, which impacts both customer acquisition as well as retention and the customer life, which has a better financial outcome for our shareholders as well as well as just being a great operator in the local communities we serve."
},
{
"speaker": "Jessica Fischer",
"content": "Maybe the one early item that I think is really clear that's worth pointing out though is that the bundled strategy in what was rolled out in the new pricing and packaging is being really successful in doing the things that we hoped that it would do, which collectively should drive higher customer ARPU in terms of getting customers to take higher tiered packages, getting customers to take more products inside of those packages, and also sort of expanding the number of mobile lines that we're seeing sort of taken per customer. So the one piece, I think, that's been easy to see upfront is that, that strategy around sort of pushing value back into the bundle and utilizing that to drive higher customer ARPUs, I do think will be quite effective."
},
{
"speaker": "Christopher Winfrey",
"content": "Yes. It's the old strategy that you can lower your product pricing and have higher customer ARPU, both at the time of sale as well as over time, and have longer customer lives and have lower operating costs and, therefore, have better returns by doing the right thing."
},
{
"speaker": "Jonathan Chaplin",
"content": "Thanks, guys."
},
{
"speaker": "Christopher Winfrey",
"content": "Thank you."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Jonathan. Operator, we'll take our next question please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Craig Moffett with MoffettNathanson. Please go ahead."
},
{
"speaker": "Craig Moffett",
"content": "Hi. Thank you. I'm going to try to squeeze in two if I can. First, this is an interesting question that we've been pondering a bit, that you've been building out FTTH networks yourselves in your edge out and expansion areas. How much of your plant today is FTTH rather than HFC? And what kind of differences do you notice competitively in places, I know a lot of those are noncompetitive markets, but what kind of differences do you see competitively when you do have fiber to compete with rather than relying on your HFC network? And then if I could squeeze in one extra. Chris, you talked about lower participation in the BEAD program. Does that open the door perhaps to say if you can't expand your footprint through subsidized building, there may be opportunities for small-scale M&A, sort of rural cable operators, for example, that might be attractive and could be acquired for less than the cost of building yourself in a lot of cases?"
},
{
"speaker": "Christopher Winfrey",
"content": "Sure. On the Fiber-to-the-Home expansion, I don't have that number in front of me. I know when we started our rural build, we had roughly 750,000 passings or 750,000 miles planned. I think we're well over 900,000 today. If you think about how that's evolved over time, at the time we were 750,000 miles planned, we were about 50-50 in terms of construction that was between HFC and FTTH and we're now at close to 90% of the new build that we do is Fiber-to-the-Home. We do that simply because, on the increment, it's fine to do. The reality is what we see from a competitive standpoint as well as from a service standpoint, we see absolutely no difference. In fact, in our Fiber-to-the-Home footprint, oddly enough, we have a slightly higher troubled call rate than we do inside of our HFC plant on a 10-year adjusted basis for customers and plant construction. So I think that will normalize over time. Some of that's more software-driven related to OLTs and whatnot. But my big point there is zero difference to us in terms of the service quality or what we see really in competitiveness between the FTTH plant where we operate with HFC. The HFC over time is going to have certain advantages relative to fiber. And I would start by saying that, remember that, of our HFC plant, I don't know the exact stat, but whether it's 99.5% or 99.8% of our HFC plant really is fiber. And it's really at the end that it's coax on the run, which often is the case with Fiber-to-the-Home, in home wiring as well. So we're essentially the same network, except at the end, we have the advantage of having the ability to have more telemetry because of power and the ability to hang small cells from a wireless strategy perspective in a very capillary way. So we're spending time on really thinking through, over time, is the HFC network actually superior as a result of some of the capabilities that it will lend. I'm not there making that claim today, but I think there are some real advantages to the plant. And today, there's really no difference for us from what we see between one and the other. Do you want to jump in on?"
},
{
"speaker": "Jessica Fischer",
"content": "Yes. On the lower BEAD participation and what we would do then in small-scale M&A. Craig, we always say we like cable businesses, we believe we operate them well. When there are small-scale opportunities that fit well with our footprint, we will often, go after those. They're typically so small that you sort of don't see them and how they fold in. But I think that we look at those opportunities the way that we look at any other opportunity and expanding our footprint in that way does make sense when it's at the right price. I don't necessarily foresee that there's a trade-off as between BEAD and doing small-scale M&A. I think we pursue both of those opportunities where they make sense and will drive returns for the company."
},
{
"speaker": "Christopher Winfrey",
"content": "I agree."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Craig. Operator, we'll take our next question please."
},
{
"speaker": "Operator",
"content": "Our next question will come from John Hodulik from UBS. Please go ahead."
},
{
"speaker": "John Hodulik",
"content": "Great. Thanks. And two sort of related questions. One, actually, Jessica, you may have -- you sort of touched on. I was just wondering, are there any sort of margin implications for the new pricing and packaging? It sounds like you're going to -- you expect to have better sell-in, which should lead to better margins. But sort of any -- when should we expect to see the sort of benefits of that, both in terms of margins and maybe changes in subscriber trends on the data side and video side? And then, obviously, you've seen some nice EBITDA acceleration through the year, probably will again in the fourth quarter with political advertising. Can you sort of point out any puts or takes as we try to get a sense for what EBITDA trends look like in 2025? Obviously, you don't want to give guidance now. But is there anything you can point to or that suggests the momentum you've seen through the year will continue in '25? Thanks."
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So starting on the margin implications for the new pricing and packaging. What we think about when we look at the success of the program is what Chris was describing in terms of how do you drive the most product value to the consumer that generates the most revenue. And then really, I guess, I think of it as sort of the most cash flow per customer, which isn't margin as a percentage. It's margin as an absolute dollar value. And in that case, I think that we're quite confident that the new pricing and packaging will be really successful in driving additional cash flow per customer because of the value that we've pushed into the bundles and what that means for the total margin that we can generate on the services offered to those customers. Does that mean that margin as a percentage will go up? That one is less clear. I actually think that the video product is a bit more attractive in the new pricing and packaging as we pull it together. And so because of that, your mix around how much video versus how much mobile and how much Internet might change. Mix tends to drive margin percentage across the company. And in this case, it might get you to the wrong answer because I think that we can drive the most collective margin by driving the most products to the customer. On the EBITDA front, thinking about the fourth quarter and next year, we still anticipate strong EBITDA growth in Q4, though it might not accelerate the way that we had hoped given that some of our expense reduction impacts, I think, came in a little earlier than we expected and we will have the storm impacts that hit inside of Q4. Still strong, but maybe not accelerating. And then going into next year, we're, of course, going to target EBITDA growth. But there are some meaningful headwinds, which I think include our Internet customer losses in 2024 and a nonpolitical year for advertising. Even with that, our expense reduction efforts, which I've mentioned before, include things that are both short-term and have already rolled in as well as some medium and longer-term items that are still building. I think that they'll put us in a good place. But there are meaningful headwinds as we go into next year."
},
{
"speaker": "John Hodulik",
"content": "Got it. Thanks, Jessica."
},
{
"speaker": "Christopher Winfrey",
"content": "John, on the first question, Jessica is right about we focus on cash flow margin. But even with the percent over time, so I'm not talking at acquisition, but over time, I think it's important to note that our triple play bundles of different combinations. They have the highest dollars of EBITDA -- not only the highest ARPU, but the highest dollars of EBITDA contribution. They also have the lowest churn and the longest customer life and they have the best ROI. And that still is the case today, which comes back to our launch of the new Spectrum pricing and packaging is you just have to make sure that there's real value in the products that you're putting on the bill. And if there is, and it's a high-quality product, there's value and you have utility all packaged together, you can be in an environment where you have higher dollars of ARPU. You have higher dollars of margin. You have lower churn and lower operating cost per PSU. And even as a result of having a mix with products with different direct costs in there, you can end up long-term with higher EBITDA margin even as a percent also because your operating cost is much lower. Your churn is lower. And as a result, your subscriber acquisition cost is lower because you're not having to replace customers that you lost with new ones to fill the hole. And instead you're using your subscriber acquisition cost to acquire net new customers, which has the impact of increasing your dollar margin as well as your percent margin over the long-term. And that's the unique competitive advantage, I think, that we have is we have all those products, seamless connectivity and seamless entertainment in 100% of our footprint. And that's what we're trying to do is make better use of those capabilities."
},
{
"speaker": "John Hodulik",
"content": "Got it. Thank you."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, John. Thank you. Operator, we'll take our next question please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Steven Cahall from Wells Fargo."
},
{
"speaker": "Steven Cahall",
"content": "Thank you. Can you hear me okay?"
},
{
"speaker": "Christopher Winfrey",
"content": "Yes."
},
{
"speaker": "Steven Cahall",
"content": "So Chris, you have a unique video offering at this point. And I know you've worked hard to add the streaming services to customers. When we think about where you can go from here, I'm not sure there's been an uptick kind of year-on-year in double and triple play customers yet. It sounds like you're thinking maybe later next year is when you might see the fruition of a lot of those efforts come together in those multiproduct customers. So I was just wondering how you could add a little more color to retention and acquisition and what the timing and the impact of that looks like at the customer level over the medium-term. And then just a small one. I know it's tough to unpack ARPU. But if we just think about roll to pay, you were very aggressive on Spectrum One about 18 months ago. Can you help us at all think about how much roll to pay is contributing to either revenue or ARPU at this point? Thank you."
},
{
"speaker": "Christopher Winfrey",
"content": "Why don't I take the first one, and Jessica, if you have thoughts on the second? I agree, we have a unique video offering and, at the same time, it's easy to get impatient as to how quickly we can get all that fully rolled out in a way that's easy for customers to understand, appreciate, sign up to, and utilize. And yet, when you think about that first half of 2025 that I talked about to fully operationalize it, it's really, that would only be 18 months from the time we first started to enter into these programming agreements. And so it's a relatively short period of time when we're going to be fully operationalized. So our goals, our priorities here was first to really focus on getting all these programming agreements done in a, I think, what turned out to be a 12 or 13 month period. So pretty quick to really run through all of those program agreements, some of which were early renewals because programmers were getting behind us. The second piece is to just physically get launched the programmer apps to form part of our seamless entertainment so that customers can subscribe to those. It's not the same because they have a broader direct-to-consumer businesses and we need to work with them on authentication as well as programmer specific credentials, which means that, in its current state, it's a high-value proposition, but it's not always easy to find and it's not always easy to subscribe and to manage your existing subscriptions potentially with those programmer apps. And so that's the environment that we sit today, which is good takeup, but not exactly the most customer-friendly proposition just yet, which is what we're working through. The second priority or the third priority, first is programming relationships, two was launch the direct-to-consumer app, third is to implement the ability for customers to upgrade to the ad-free version of these apps, only a couple of which has already been launched, so we're well in the progress with that as well. And then the final piece is really to put it all inside of what I would call a video portal, which allows you to manage all of your video subscription with us, including all of the programmer apps, when it's included as part of your offer, when it's upgraded to the ad free version, we have economics as well. And the ability to sell these programmer apps to our broadband customers or to our skinny package video customers, all in the same place where you can manage your subscriptions. And that's a compelling marketplace for video that we're developing today. And it requires for some pretty significant cooperation as well, as you can imagine, with the programmers. And we think we'll have all that placed in the first half of 2025 and be able to present that to customers as part of our pricing and packaging. I think there was some misconception in the marketplace that thought that we were going to do some big, huge marketing campaign and that would have a financial impact next year. That's really not the case. The investment we're making is the utility of finding all of this in a place that can manage your subscriptions and they've been able to activate all of that within Xumo in particular or other platforms. And the marketing and sales that we're doing really is tied to our new pricing and packaging as part of these bundles that we're putting out. So longer term, I expect all of that to have a pretty significant impact on acquisition and retention, certainly for video, but hopefully also with Internet when bundled together. Already without getting to that place that we expect to be next year we already see a significant uplift in the video sell-in just from the way that we're bundling and going to market with this new Spectrum pricing and packaging even without the benefit of that the video marketplace environment that I described. We're already seeing a pretty significant uplift. And the reason that we're comfortable with that is because we know the value is there, because of what's in place already today with some of the programmer apps and what's coming, what will be launched, and the ability to actually find and manage it in a better way. So we're pretty -- look, we're -- on one hand, we're excited about the space because it adds value. On the other hand, I want to be careful we're not forecasting video growth. We're simply saying that it's a way to add utility into our seamless connectivity relationships in a way that hasn't existed. And from our past experience, we know the value that can come about to the overall bundle by doing that right."
},
{
"speaker": "Jessica Fischer",
"content": "I'll take the other one on the mobile called roll-to-pay rates. We still see our free lines converting to being paying customers at very strong rates. In terms of the impact that has on ARPUs across the system, so once you get to, I'm going to say normalized, but once you get to a similar number of overall free lines inside of the system in a year-over-year, then you no longer end up with the same sort of boosts or impact of the year-over-year -- the same year-over-year impact on ARPU. So if I think about Internet ARPU there, as an example, Internet ARPU grew 2.8% on a GAAP basis. It would have been 3.1%, excluding the GAAP allocations, which is a closer tie between the two of those than what we've seen previously. And I think going forward, you'll find those coming together. On the other side, mobile ARPU actually was up and is looking really good. But the increase that you see in mobile ARPU related to the uptake of our Unlimited Plus plans, which really has been driven by anytime upgrade and I think could be driven further given some of the incentives that we have around it in the new pricing and packaging plans. So we're seeing, I guess, good growth in ARPU, but not as much at this point related to the roll-off of free lines in the system, not because the free lines aren't performing well, but just because the free lines now as a portion of the total base are more normalized."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Steven. And that concludes our call today. Operator, we'll pass it back to you."
},
{
"speaker": "Christopher Winfrey",
"content": "Thank you very much."
},
{
"speaker": "Jessica Fischer",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "This concludes our call. You may now disconnect."
}
] |
chtr | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Hello. And welcome to Charter Communications' Second Quarter Investor Call. We ask that you please hold all questions until the completion of the formal remarks, at which time you'll be given instructions for the question-and-answer session. Also, as a reminder, this conference is being recorded today. If you have any objections, please disconnect at this time. I will now turn the call over to Stefan Anninger."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, operator, and welcome, everyone. The presentation that accompanies this call can be found on our website, ir.charter.com. I would like to remind you that there are a number of risk factors and other cautionary statements contained in our SEC filings, which we encourage you to read carefully. Various remarks that we make on this call concerning expectations, predictions, plans, and prospects constitute forward-looking statements, which are subject to risks and uncertainties that may cause actual results to differ from historical or anticipated results. Any forward-looking statements reflect management's current view only and Charter undertakes no obligation to revise or update such statements. On today's call, we have Chris Winfrey, our President and CEO, and Jessica Fischer, our CFO. With that, let's turn the call over to Chris."
},
{
"speaker": "Chris Winfrey",
"content": "Thanks, Stefan. During the second quarter, we lost 149 ,000 internet customers, most of which was driven by the end of the Affordable Connectivity Program. We added over 550,000 Spectrum Mobile lines and close to 2.2 million lines year-over-year. Revenue was up slightly in the quarter, while adjusted EBITDA grew by 2.6%. We put a lot of effort into the ACP program, and it wasn't renewed. Beginning early this year, we've been actively working with customers to preserve their connectivity. Our service and retention teams are handling the volume of calls well, and we've retained the vast majority of ACP customers so far. The real question is customers' ability to pay, not just now, but over time. I expect we'll have a better view of the total ACP impact once we're inside the fourth quarter. The lack of ACP will also drive higher levels of market churn and selling opportunities for connectivity services over time. Turning back to today's results, the second quarter already tends to be a seasonally weak quarter. The loss of ACP impacted both churn and low-income broadband connects, helping drive the Mobile-only broadband category back to pre-pandemic levels. That shift added to an already low level of move activity and overall market connect volume. That said, we performed better than our expectations for Internet in a quarter, and we competed well compared to previous quarters against both wireline overbuild and cell phone Internet, each with expanded footprints. Overall churn remains at low levels, even with the end of the ACP program, and we remain confident in our ability to return to healthy, long-term growth. Our Internet product is faster and more reliable. Our pricing is lower when similarly bundled with mobile. We expect market activity and selling opportunities to pick up over time, and the cell phone companies will face challenges. as a customer bandwidth demands continue to grow. If we take a step back, our success will be premised on our high capacity, fully deployed network and the products it can deliver. We already have a one gigabit network everywhere we operate across 58 million passings. And when our network evolution initiatives complete, we'll have a ubiquitous, symmetrical, multi-gig capable network supporting continued growth in data demand from customers and new applications such as AR, VR and AI. All at an incremental investment of just a $100 per passing. Those wireline network capabilities are combined with mobile capabilities everywhere we operate, creating the nation's first converged network. Uniquely providing seamless connectivity and the fastest mobile service where 87% of traffic is delivered by our own gigabit capable WiFi network. And our converged connectivity product set is poised to get better through speed upgrades and over 43 million access points, which will grow with our own and our partner's ongoing WiFi router and CBRS access point deployment. That converged network is also expanding, covering more passings as we grow our footprint with high ROI construction opportunities in both rural and non-rural areas. As we show on slide 4 of today's investor presentation, we are very well positioned competitively with higher quality products, lower pricing, and the ability to deliver a converged bundle of products. In Internet, data usage continues to grow and demand for faster speeds will grow with it. During the second quarter, roughly 30% of residential internet customers who do not buy traditional video from us, used over a terabyte of data per month, which together with overall usage is increasing. This quarter, we saw the most additions to our gig speed tier ever, an area we can grow. Our mobile offering continues to evolve, driving strong results. Our second quarter mobile line Net Ad performance was better than the first quarter results, even without the incremental benefit of our free mobile retention offer to former ACP customers. And we also had our highest port ends quarter ever. In April, we began offering Anytime Upgrade to new and existing Unlimited Plus customers. Anytime Upgrade allows Unlimited Plus customers to upgrade their phones whenever they want, eliminating traditional wait times, upgrade fees, and condition requirements. And during the second quarter, customers increasingly chose our Unlimited Plus package priced at $40 versus $30. In April, we also launched a new repair and replacement plan for just $5 per month. That price point is very competitive in driving higher take rates. These new affordable value-added services enhance our profitable growth and competitively open access to new customer segments. Along those lines, in May, we launched our new phone balance buyout program. Now when a customer switches to the Spectrum Mobile from another provider and purchases at least three lines, we'll pay off their existing phone balance on ported lines up to $2,500 for five lines. This new program helps multiline mobile customer prospects with device balances and other providers to more easily switch to Spectrum Mobile. And of course, Spectrum One continues to perform well at both Connect and at promotional roll-off, offering the fastest connectivity with differentiated features. Today, approximately 8% of our total passings take our converged offering of internet and mobile. We've remained underpenetrated despite having a differentiated and superior offering with market -leading pricing at promotion and at retail. Finally, turning to video, losses continued in video where we've seen downgrade churn from programmer rate increases, we passed through. The loss of ACP in the second quarter also impacted video downgrades as customers made choices based on affordability. Over the last several years, due to margin pressure from programming increases, we've moved away from selling bundles with traditional discounts. But as we look to better differentiate ourselves in a competitive marketplace, we are considering ways to better leverage our unique capabilities across our full set of products, including video, particularly now that we're adding significant value back into the video product for consumers with hybrid linear DTC bundles, more economical package choices, and with our Xumo Box. In May, we reached a new agreement with Paramount that gives us the ability to offer the ad-supported versions of Paramount's direct-to-consumer services, Paramount Plus and VET Plus, to our traditional cable package customers at no additional cost. We plan to launch the Paramount DTC inclusion offer to our customers around Labor Day. Earlier this month, ViX, the leading Spanish language DTC product from TelevisaUnivision became available to a large number of customers with eligible spectrum video packages at no extra cost. We launched Disney Plus Basic to TV Select customers as a DTC inclusion in January, and will begin to offer Disney Plus Premium to add free version of Disney Plus to customers as a $6 upgrade later this quarter. We also have planned to offer Hulu to our TV Select customers at the incremental retail price for Disney's duo basic bundle $2 in the fourth quarter. So our efforts to deploy a new hybrid DTC linear model first for the industry remain on track and we expect it to be fully deployed next year. Together with Xumo our goal is to deliver utility and value for our customers irrespective of how they want to view content and better and more stable economics for programming partners. But the associated DTCs have to be part of the full package service. Customers can't be forced to pay twice and if the DTC standalone pricing is less expensive at retail, then that's what we really should help programmers sell instead. Fundamentally, we believe that evolving the video business even if it isn't growing helps customer acquisition of retention, still has positive cash flow, it provides us with option value. And over time, we believe a high quality video product gives us the opportunity to reintroduce more value into the converged connectivity relationship. So stepping back, we're executing well on many multiyear transformational programs. We're growing EBITDA despite the loss of ACP and a competitive cycle by driving efficiency without impacting our service and sales capabilities. We remain fully focused on driving growth using our unique set of scaled assets and the highest quality products and services in order to create long-term value for shareholders. With that, I'll turn the call over to Jessica."
},
{
"speaker": "Jessica Fischer",
"content": "Thanks, Chris. Let's turn to our customer results on slide 6. Including residential and SMB, we lost 149,000 Internet customers in the second quarter. While in Mobile, we added 557,000 mobile lines. Video customers declined by 408,000 and wireline voice customers declined by 280,000. As Chris mentioned, our second quarter Internet losses were primarily driven by the end of the ACP program. ACP program connects ended in early February. In May, the program's original $30 subsidy was reduced to $14. And in June, that subsidy was reduced to zero. We estimate that the end of the program's impact on our second quarter internet gross additions and churn drove over 100,000 of our 149,000 internet losses in the quarter. And from a financial perspective, there was an approximately $30 million headwind to second quarter revenue from onetime non-recurring ACP related items in the quarter. In addition, similar to the end of the Keep Americans Connected program in June 2020, many of our ACP customers had past due balances that had been fully reserved for accounting purposes. We took steps to eliminate a portion of those back balances for certain customers and put a portion of their remaining balances on payment plans. For certain customers with a low likelihood to pay post ACP, we have been recognizing revenue on a cash basis, resulting in slightly less revenue and less bad debt in the second quarter than we would have otherwise had. So far, we are performing well with ACP retention, but the largest driver of Internet customer losses associated with the end of the ACP program will be in non-pay disconnects, and they will occur in the third and fourth quarters, likely weighted to the third. We continue to do everything we can to preserve connectivity for former ACP subsidy recipients. We have a number of products and offers to assist those that have lost their ACP subsidy, including our Spectrum Internet Assist program, our Internet 100 products, and we've been offering all of our ACP customers a free mobile line for one year. And we continue to market offers targeted at low income customers, a segment that we have historically served well. Turning to rural, we ended the quarter with 582,000 subsidized rural passings. We grew those passings by 89,000 in the second quarter and by 345,000 over the last 12 months. We had 36,000 net customer additions in our subsidized rural footprint in the quarter. We continue to expect to activate approximately 450,000 new subsidized rural passings in 2023, about 50% more than 2023. We also continue to expect our RDOF build to be completed by the end of 2026, two years ahead of schedule. Moving to second quarter financial results starting on slide 7. Over the last year, Residential customers declined by 1.3%. Residential revenue per customer relationship grew by 0.4% year-over-year, given promotional rate step-ups, rate adjustments, and the growth of Spectrum Mobile, partly offset by a higher mix of non-video customers, growth of lower-priced video packages within our base, and some internet ARPU compression related to retention offers extended to customers that previously received an ACP subsidy. As slide 7 shows, in total, Residential revenue declined by 0.6% year-over-year. Turning to commercial, SMB revenue grew by 0.6% year-over-year, reflecting SMB customer growth of 0.2% year-over-year and higher monthly SMB revenue per SMB customer, primarily due to rate adjustment. Enterprise revenue grew 4.5% year-over-year, driven by enterprise PSU growth of 6.1% year-over-year. And when excluding all wholesale revenue, enterprise grew by 5.9%. Second quarter advertising revenue grew by 3.3% year-over-year, given political revenue growth. Core ad revenue was down about 2% year-over-year. Other revenue grew by 6% year-over-year, primarily driven by higher mobile device sales. And in total, consolidated second quarter revenue was up 0.2% year-over-year and 0.1% year-over-year when excluding advertising revenue. Moving to operating expenses and adjusted EBITDA on slide 8, in the second quarter, total operating expenses declined by 1.4% year-over-year. Programming costs declined by 9.8% year-over-year due to a 9.5% decline in video customers year-over-year and a higher mix of lighter video packages, partly offset by higher programming rates. Other costs of revenue increased by 12.6%, primarily driven by mobile service direct costs and higher mobile device sales. Cost-to-service customers declined 4.2% year-over-year given productivity from our 10-year investments, including lower labor costs and lower bad debt expense, as we saw some favorability and our mobile bad debt as a portion of revenue due to an improved customer tenure and credit profile. And, as I mentioned earlier, a portion of our uncollectible billings offset revenue in the quarter. Sales and marketing costs grew by 1.9% as we remain focused on driving customer acquisition. Finally, other expense grew by 4.7%, mostly driven by an insurance expense benefit from the prior year quarter. Adjusted EBITDA grew by 2.6% year-over-year in the quarter, and when excluding advertising, EBITDA grew by 2.4% year-over-year. While we don't manage the business at a single product line P&L level, we continue to compute allocations internally, and this quarter, for the first time, our standalone mobile adjusted EBITDA was positive, even when including the headwind of subscriber acquisition costs and without the benefit of GAAP revenue allocation to mobile revenue. Our mobile profitability this quarter marks a significant milestone. It shows that we're on the path to establishing a mobile business that is very profitable. Overall, our goal is to deliver solid EBITDA growth, and we believe we can continue to do that even as we make significant investments in the business and face a challenging competitive environment and the end of the ACP program. Our expense management process is working with growing realization of impacts in the second quarter. We continue to expect accelerating EBITDA growth in the back half of the year, given our expense management initiatives, Spectrum 1 promotional roll-off, and political advertising revenue. Turning to net income on slide 9, we generated $1.2 billion of net income attributable to Charter shareholders in the second quarter, in line with last year, as higher adjusted EBITDA was mostly offset by higher other operating expense, primarily due to restructuring and severance costs and net amounts of litigation settlements. Turning to slide 10, capital expenditures totaled $2.85 billion in the second quarter, in line with last year's second quarter spend. Line extension spend totaled $1.1 billion, $37 million higher than last year, driven by our subsidized rural construction initiative and continued network expansion across residential and commercial green sales and market fill-in opportunity. Second quarter capital expenditures, excluding line extensions, totaled $1.7 billion, which was similar to the prior year period. For the full year 2024, we now expect capital expenditures to total approximately $12 billion, down from between $12.2 billion and $12.4 billion previously. Our reduced outlook for 2024 capital spending reflects lower internet and video customer net additions, including the impact of the end of the ACP program, which drives lower CPE costs. We're also actively managing vendor rates and construction materials to make our capital expenditures more efficient. We still expect line extension spend of approximately $4.5 billion, and network evolution spend of approximately $1.6 billion. Turning to free cash flow on slide 11, free cash flow in the second quarter totaled $1.3 billion, an increase of approximately $630 million compared to last year's second quarter. The year-over-year increase was primarily driven by higher adjusted EBITDA, lower cash taxes due to timing, and a favorable change in working capital. On that front, we've been managing the balance sheet to provide us better overall cash flow and increased flexibility. Over the last several quarters, we sold our towers portfolio, which generated almost $400 million in proceeds. We launched our EIP securitization program in the second quarter, which backs a new $1.25 billion credit facility at favorable interest rates. And we've been working with our vendor base to extend our payment terms, utilizing a supply chain financing tool to support our working capital favorability. We will continue to identify and capitalize on balance sheet opportunities to help fund our unique one-time capital investments. We finished the quarter with $96.5 billion in debt principle. Our current rent rate annualized cash interest is $5.1 billion, and we repurchased $1.5 million Charter shares and Charter Holdings common units, totaling $404 million at an average price of $271 per share. Given our long dated and 86% fixed rate debt structure, our sensitivity to higher rates is relatively low. If we refinanced all of our debt due in 2025 and 2026 at current rates, the impact to our rent rate interest expense would be less than $60 million. As of the end of the second quarter, our ratio of net debt to last 12 months adjusted EBITDA moved down to 4.32x. We expect to continue to move closer to the middle of our 4x to 4.5x target leverage range through the end of this year. And we remain fully committed to maintaining our split rated debt structure, including access to the investment grade market, given the significant benefits that it offers to all of our capital providers. We continue to be confident in the long-term trajectory of the business. We have the best products at the best prices in our industry, and we remain under penetrated relative to our long-term potential. That combined with the investments that we're making in the business and our expense savings initiative will continue to drive strong EBITDA growth and value creation for many years to come. And with that, I'll turn it over to the operator for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from Craig Moffett with MoffettNathanson."
},
{
"speaker": "Craig Moffett",
"content": "Hi. Thank you. Perhaps no surprise. I'd like to drill down a little bit more on the ACP impacts. A couple of questions. First, to what extent are you seeing ACP showing up in reduced gross editions that is just lower market activity because new customers can't sign up for or ACP customers who are moving can't continue to sign up for the program even before you start to see non-pay disconnects. And then second, what impact is it having on ARPU? You reported 1.7% broadband ARPU the same as last quarter. Had it not been for ACP, could you just tell us what that would have been as you're starting to now lap some of the Spectrum 1 discounts that were included in the numbers in the past?"
},
{
"speaker": "Chris Winfrey",
"content": "Sure. Hey, Craig. I'll take the first one. Jessica can take the second. For ACP, we estimated the impact was well over 100,000 inside the quarter to net editions loss. And for us to say that means that we have a high level of confidence probably higher than that. So half of which was from voluntary churn and the other half was coming from reduced gross editions, as you mentioned, from low income segments that had been connecting at a higher rate at a much lower rate once ACP disappeared. Of course, we saw some of that impact already inside of Q1. And we saw the same inside of Q2. So that's the drivers inside there, about half and half. And it's really the combination of those when I mentioned that we saw a reversion to the pre-pandemic mobile only broadband category where you've seen that category increase, which is taking out volume from the marketplace in terms of a source of acquisition. It's temporary. It's one time in nature. And so as we've spoken about before, it's really about just managing through that one-time impact and trying to make sure that we're doing all the right things for preserving that base, and keeping them connected, which we're doing, but also making sure that we're making the right investments and the right moves for the business as usual underlying growth trajectory. Jessica on the ARPU."
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So Internet ARPU increased 1.7% year-over-year in the quarter. If you adjusted, Craig, for the $30 million in one-time ACP related items that I mentioned and for the impact of the mobile revenue allocation, that ARPU growth would have been 2.7%. I didn't incorporate the cash basis accounting impact that I mentioned earlier. It's small, and unless those customers do end up paying at a rate that's higher than our expectation, I think it recurs in revenue going forward. But so I think you would have been, but for those two items, that's a 2.7%"
},
{
"speaker": "Stefan Anninger",
"content": "Thanks Craig. Operator, we will take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Sebastiano Petti with JP Morgan."
},
{
"speaker": "Sebastiano Petti",
"content": "Hi, thanks for taking the question. I think, Chris, in the prepared remarks, you said you competed well against fixed wireless and fiber, even though their footprints are expanding. Given the prevalence of what we're seeing in terms of open access and other host cell provider getting into the mix and increasing the fiber availability, have you seen a demonstrable change in the fiber deployments year-to-date as you think about that insurgent or non-incumbent fiber bill to some extent? And again, just trying to think about that increase in open access and wholesaler, how does it change, if at all, how you're thinking about the competitive environment on a go-forward basis in terms of other converged players or options moving into your footprint?"
},
{
"speaker": "Chris Winfrey",
"content": "Sure. Look, the competitive fiber overbuild has maintained a relatively steady pace. If anything, it's slightly lower than what it had been. And so we don't see any dramatic change there. When I talked about maintaining our competitiveness means having a similar impact, despite the fact that you have an expanding footprint. So you could, if I was being bullish, I would argue that that's an improvement, and as opposed to just staying steady. And so we're competing well, both in the wireline overbuild space, which is more permanent, as well as the cell phone internet space as well. In terms of some of the experiments that you're seeing as it relates to wholesale access and whatnot, it's still a fiber overbuild at the end of the day. And there's still economics that need to be deployed. And those economics are, in my mind, are not very good. They haven't been for decades of the economics of an overbuilder on an existing footprint. So I don't think it, A, dramatically changes the outputs that they can provide because the economics aren't any different, and B, it's really small. What you're talking about that's been done is just a very small percentage of the U.S. footprint. So the ability to project products both from a sales and marketing and service perspective really is impacted by the ubiquitous nature of the technology that you have and the ability to provide those products in the marketplace. And so from our perspective, when we look at it and say, what's unique about us is we have a gigabit network deployed everywhere we operate. In addition to that, we're upgrading that wireline network to have symmetrical and multi-gig speeds everywhere, not just in redline pockets, but everywhere that we operate, and then you combine that with our WiFi and CBRS capabilities and a very strategic relationship that we have with a great partner in Verizon, it gives us the ability to provide seamless connectivity, converged broadband everywhere you go inside of our footprint, and that's unique. The only other operator who has those type of capabilities really is Comcast. And so I think that's the real strategic advantage for us, and it's not because we have that capability in 2%, 3%, or 5% of our footprint. We have it everywhere we operate, and it allows us to be loud in the marketplace, talk about not only the product advantages of having that seamless connectivity, but the ability to save customers hundreds and thousands of dollars really with a better product. And so I don't see anything that's really changed. Other than some of these joint ventures announcements that you've seen, if you really sit back and think about it from both a strategy and from a valuation perspective, I think it's flattering. It tells you the strategic asset that we have. And so if you take a look at the slide that we have on page 4 of the deck today, you think about everything that I said and our capabilities, and then you think about where others are trying to go, many of the MNOs, I do think that's flattering both from a strategic, from an operating and from evaluation perspective of what we have and what we're capable of doing. It has people's attention."
},
{
"speaker": "Sebastiano Petti",
"content": "And if I could ask a quick follow-up on wireless, it sounds, I think you noted that even excluding the retention offer for the ACP subscribers, mobile lines would have been up. I mean, can you help us think about what you're seeing in terms of just the contract buyout and some of the other offers you have in the market, and does your maybe go-to-market need to evolve at all as we think about obviously fears or concerns about what an upgrade cycle might mean from the Apple iPhone in the back half of the year. Thank you."
},
{
"speaker": "Chris Winfrey",
"content": "Sure. Well, mobile wasn't just up. What I was saying is it was up quarter-over-quarter. We had a very good first quarter. It was clearly up even more this quarter. And if you excluded the benefit of the ACP mobile only, mobile retention offers, we still would have been better than a very strong first quarter. That reflects just the general momentum that we have, but also, we have evolved the product. And so we've rolled out the Anytime Upgrade Program, which is unique in the market. We have even though it sounds small, it's attractive to customers, service, and repair function that's, I think, competitive. And now with the phone balance buyout program, which is also pretty unique in the marketplace. And all of those rolled out sequentially during the course of the quarter and have continued to improve our selling capabilities along the way. I think that positions us well in any market. We've not been, I think, where you were going, we've not been, we don't intend to be in the business of subsidizing phones. But we do have really good programs that make it attractive for customers to not only come in to be a customer spectrum mobile, but also to stay with us because we have the ability through the Anytime Upgrade Program to really at a low competitive cost, keep them current with their models of phones now and in the future. And stating the obvious, the biggest advantage here beyond just the devices really is the ability to provide a higher quality, faster mobile service, seamless connectivity, and to be able to save them hundreds or thousands of dollars a year. I mean, if you think about our pricing at $30 for unlimited and $40 for unlimited plus on one line and each incremental line, it's really competitive. It's very good. So we're happy with where we are with the product. We will continue to evolve it. I think some of those feature sets that will evolve really include things like mobile speed boost, which ties to the capabilities that we have with WiFi and wireline, and the ability to have spectrum mobile as an SSID. So those of you in the New York and LA markets, for example, what you'll notice is as you travel outside of your home with Spectrum Mobile, an auto-authenticated attachment to Spectrum Mobile SSID, which boosts your speed wherever you go, and it increases your access and your reliability, which is the nature of seamless connectivity."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Sebastiano. Operator, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jonathan Chaplin with New Street Research."
},
{
"speaker": "Jonathan Chaplin",
"content": "Thanks, guys. Two questions. One just on broadband market growth for Chris, and then one on free cash flow for Jessica. Chris, could you give us a little bit more context around the ACP impact from lower gross ads in 1Q? I think you said it was sort of roughly the same as in 2Q, so maybe it was 50,000, but what I'm trying to get to is an understanding of what's going on with underlying growth. It looks like it actually improved for you a little bit sequentially, and so either broadband market growth in aggregate isn't getting any worse, maybe it's getting a little better, or you're just doing better on market share relative to your competitors. And we'd love to understand that a little bit better. And then Jessica, it sounded like from your discussion of working capital that this isn't a timing impact in 2Q. You've changed how you manage working capital, and so you should expect to be able to sort of retain this benefit to free cash flow as we go through the year. I just wanted to confirm that. And then do you have to get all the way back to 4.2x to 4.25x leverage before you would accelerate share repurchases again? Thanks."
},
{
"speaker": "Chris Winfrey",
"content": "So Jonathan, there's I think a few derivatives inside of your question. And so let me try to give you what you're looking for in the way that we think about it. And inside of the first quarter, we had performed better relative to prior quarters and prior year on competitive switching. And so that was in the marketplace, so available subscriber ads and disconnects. But we saw, as you highlighted as well, once everybody had reported, we saw a significant reduction in the first quarter of this year in the available gross ads, a significant drop year-over-year and that was due to housing starts, rental vacancies, but also the removal of ACP for new connects, all of which driving your version to mobile-only back to pre-pandemic levels. That broadband market growth rate overall we still saw is significantly reduced for all those factors inside of Q1 but a dramatic drop, and so that put our performance in relative light given the overall market backdrop, a lot of which was one time in nature. In Q2, and while it's early because we don't have all the data, I think our evidence shows that for the first time and due to, again, all of the one-time factors and most dramatically the loss of ACP, the broadband market actually shrunk as a one-time event. And so if you put our performance and then our statements about relative competition in context with that, and I think we're doing pretty well. And that was the nature of the comments that I provided in the prepared remarks. I do think that, as I mentioned, moves will come back. It's hard to predict exactly when, but moves will come back, housing starts will return, apartment rental rates will go back up, and most importantly, the most dramatic effect is once you flush out the ACP impact between Q2 and Q3 predominantly, then you'll be able to get back into a much more normalized environment. And I think the product investments that we're making and the attractiveness of the value that we provide puts us in great position for when that volume returns, and we're doing everything we can in the meantime to preserve all the ACP customers doing really well, but at the same time making sure that we're ready to come out in a good light on the back end once the volume does pick back up."
},
{
"speaker": "Jessica Fischer",
"content": "On the free cash flow side, Jonathan, so I think we had previously talked about working capital for the year, coming back to being in a place that was relatively flat. As I said, we're working on the balance sheet and trying to make sure we can extract appropriate cash from the balance sheet to support what we're doing across the business. I think that we'll probably do better than that sort of flat working capital expectation, but I'm not prepared to say by exactly how much. The variability in working capital has a lot to do with exactly how expense timing and capital timing lands over the course of the year, and so while I think that we'll get good benefits out of just the balance sheet management side, I'm not going to take up the total thoughts that we've had on working capital today. On your other question, sort of how do we think about, I think it was sort of a one and then the other. Do you have to get all the way back to the middle of your range before you accelerate buybacks? I'm in the same place that I was last quarter, which is that I think that we can continue to do buybacks over the course of the rest of the year and still do what we have said that we would do from a leverage perspective. And I don't think of it as do you have to do one and then the other. I'm pretty confident in the trajectory of the business for the second half of the year. And so, I think that we can have sort of good pacing on buybacks and meet what we've said about leverage at the same time. That being said, the capital allocation strategy hasn't changed. We still go after high ROI, organic investment first. We still look then at whether there's a creative M&A opportunity is next. And those come before sort of this balance sheet management and share buybacks that happens as the last set of priorities there. And so, we haven't given a guide around where we think that we'll go in terms of total buybacks. It's because we want to make sure that we maintain that flexibility to do what we think is most important for the business, which is to make the right investments to drive growth of the business going forward."
},
{
"speaker": "Stefan Anninger",
"content": "Operator, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Ben Swinburne with Morgan Stanley."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thanks. Good morning. Chris, I believe you guys took some cost action. I don't know if there were headcount reductions this year at Charter, but I know you guys have had a cost plan you've been working on. I'm wondering if you could just talk about what you guys are doing and how you're approaching that. And I think you had suggested you guys weren't going to touch any sort of customer-facing resources. So just give us a sense of where you are on that and your philosophy as you look through the rest of the year and how we might think about that impacting the financials. And then maybe for Jessica, I don't know if you have any visibility at this point into Q3, ACP impact from that 100,000, but if you do, I'd love to hear it. And try to understand the decline in bad debt. I know you touched on it in your prepared remarks. I don't know if that tells us something about your third quarter ACP expectation, or if you still expect cost of service to be flat for the year, we just want a little more color around those trends. Thank you both."
},
{
"speaker": "Chris Winfrey",
"content": "Hey, Ben. So there's kind of three parts to that, which is, I'll start with the second one you had, is the Q3 ACP. I'll handle that. And Jessica can comment on bad debt and then cost reductions. Jessica can go through and I can tag team there a bit. But from a Q3 ACP outlook, we're not going to be providing any customer net additions guidance today, but for sure there's going to be, as we both mentioned, I think Jessica and I, that there'll be more non-pay disconnect in the third quarter. But there are a lot of other moving parts and we're competing well. I think that maybe the interesting tidbit here is maybe talking a little bit more about recent trends. June was oddly the best loss of the second quarter. And internet net ads trends in July have been similar to what we saw in June. Sounds great. But the reality is the ACP related non-pay disconnect activity hasn't started yet. And we'll know really more about sustainable payment trends than nothing to be scared of today, but sustainable payment trends really through August with the non-pay beginning then and trailing into a little bit into Q4. So when you step back, I know you know this, but ultimately this ACP transitions are onetime event. And so we're very focused on really isolating the ACP impact internally and evaluating not only obviously our performance on retaining those customers because we want to keep them connected. We think it's very valuable and we can, but also what's the underlying trend absent the ACP impact to make sure that we're getting better every day. So Jessica on the ACP does bad debt piece."
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So if you think about what happened in bad debt in the year-over-year, Ben, there's a few things going on. One really with tenure and credit profile in our mobile customer base that's been improving, particularly for customers that have EIP plans with us. And on the ACP front, we took a lot of bad debt along the way, particularly for customers who entered the ACP program and they had outstanding unpaid balances. And so those have really been reserved throughout the ACP program. I mentioned it in the remarks but there also is a portion of the ACP customer base where we have a very low expectation of payment for them and so instead of taking their revenue into revenue and then taking bad debt expenses and offset, we actually didn't recognize revenue for those customers. So when you see that it means that bad debt expense, I think absent that you might have had -- you would have had more bad debt expense if we had put that back in the other direction. And then the last point I mean we did have overall lower resi revenue in 2Q in the year-over-year and some mixed changes and so with other things being equal that also drives a little bit of downward pressure on bad debt. All of that is to say I wouldn't read anything sort of into what is it that you think about Q3 and looking at what happened with bad debt in the year-over-year, I think there are a number of factors going on there. As you think about then what's happening on the overall cost reduction side which I think was your other question. The expense management process is pretty extensive. While we're not doing anything that will impact our sales or service capabilities, we have things that are big things that are small some short some medium some long-term opportunities all across the business. We've made progress with some vendor cost reductions with reduced spend around discretionary categories like real estate and third-party services, some reductions to overhead expenses and implementing some tools to increase our efficiency and actually I think the benefits from those came a little faster into 2Q than what we had anticipated, but we're already realizing the benefits of some of the changes will continue to build on additional opportunities over time. As you look at the rest of the year, I think we had given some thoughts on our outlook for expenses. We had expected programming costs per video customer to grow in the 1% to 2% range year-over-year. I now expect that to be flattish year-over-year. We previously had said that we expected costs to serve to be flat with 2023. I now expect that to decline by 1% to 2% inclusive of bad debt expense. And in sales to marketing, I think we had said 2% to 3% growth. And at this point, I would expect us to be in the low end of that range, if not a bit below. I also, as an aside, just want to clarify something I said earlier. My comments on working capital. I want to be clear that the comments on working capital are on cable working capital. Mobile continues to have the detriment of the EIP notes. And so those will continue to be a drag, though the securitization plan that we did in the quarter does help that."
},
{
"speaker": "Chris Winfrey",
"content": "And on the cost if you just take one a different layer of look, the, so Jessica's right, we're doing lots on vendor savings, overheads, organizational effectiveness lower growth environment, all that's true, but just want to make sure everybody understands that the key focus for us in terms of real permanent lasting and accelerating cost reduction is just to be a better service operator. So continue to invest in our frontline, have better tools, process and systems to make the investments that we've made in tenure. And we see that, and so we are having real results from some of the one time and permanent cost reductions, but we're also probably having bigger success on reducing the amount of service calls, reducing our truck roles, increasing the quality of the service that we provide, that's where the money's at. And then when you think about operating leverage, which is a term that you've used before the best way to have a better operating leverage is to have more customers and to have more products per household and have higher revenue. And that way you can, together, being a better service operator and having higher penetration of your products, you actually lower your cost to serve per customer, you lower your cost of capital per customer as well and you become a better cash flow operator. So all of those things still hold true. And it's why, when we talk about expense management, that we talk about really not doing anything that would impact sales or service, because that's the true efficiency opportunity and that's the opportunity to deliver long-term free cash flow and our views on that and our frontline hasn't changed at all."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Ben. Operator, we'll take our next question, please."
},
{
"speaker": "Operator",
"content": "Our next question will come from Jessica Reif Ehrlich with Bank of America Securities."
},
{
"speaker": "Jessica Ehrlich",
"content": "Question on video, I guess, can you talk about the take-up of direct-to-consumer in these hybrid linear offers? And you've mentioned a couple that are coming, Paramount Plus and Hulu, is there anything else on the horizon? And then secondly, you mentioned political advertising should pick up in the second half. Given the current political environment, can you give us some color and expectations and if that's increasing?"
},
{
"speaker": "Chris Winfrey",
"content": "Sure. On the first one, Jessica, the DTC take-up is going very well. The first one, I know a lot of people think about Disney deals in September, but we launched I think late in January on Disney Plus Basic and it's going well and it's growing every month. We're adding some additional features into it, which will be helpful to even further accelerate the monthly growth that we see. That includes, as I mentioned, in the prepared remarks, the addition of the Disney Plus Premium as an incremental add-on. That will be coming soon, as well as the Disney Duo Basic bundle of plus $2 for Hulu. So that allows you to have a comprehensive package the same way that exists inside of retail and that's helpful, it was always the design. But there's complexity in terms of implementing all of this, also because some of the authentication principles that vary between different operators in terms of credentials and TV everywhere and whatnot. But it's going well and accelerating, ESPN Plus, I didn't mention that on the call, it's also having very good take-up, it's high value into our RSN packages, it's a small portion of the base, but the penetration is going well. And Paramount Plus will launch soon and ViX we just launched and we've always had Max and so that has existed already within the TV everywhere authenticated universe and our expectation is over the next year or so that we'll have a fully baked set of products which really what we're working towards and the more scale we get there the more effective it's going to be. We're not sitting here saying that we're going to arrest completely the loss of video but I think what we are saying is to the extent we're going to put video on our broadband bill, it better have value and if it doesn't have value to the customer then we'd rather they just go take that through the direct-to-consumer applications and we need to be proud of what we're putting on the bill and that's not where the MVPD space has been in a long time as we see a path to being able to be proud of what we're putting on the broadband bill as a video product that it may be expensive but it has a significant amount of value and using that to drive the converge connectivity relationships. So while it may not be growing it's still really important and I think it can be very valuable to our converge connectivity relationships. In terms of what's up next, we're not going to go give a programming renewal schedule but we're optimistic that this has been adopted both from an understanding that the DTCs really do need to be included as part of the full video package. And that's actually better for programmers because of reduced churn and upsell opportunities into the ad-free versions of these products as well. And that look, at the end of the day, if a customer can go out and get the same product at a cheaper price in the marketplace, I think they should. I don't think we should ask them to pay more through us. And so those are some of the core principles that we've had. I'm not committing, but those are some of the bigger ones. And political advertising it's always, as you know, it's always a jump ball as to exactly where it's going to go. And it's evaluated on a state-by-state basis. And so you can't really say that it's an -- it's the same nationally everywhere. So it depends on some of the swing states. Admittedly the events of the past week have jumbled what you thought that might look like. And certainly when you take a look at fundraising and the volatility in what could be swing states, it looks like political advertising net-net nationally is going to be higher than what it probably would have been just a 10 days ago. But it doesn't mean it happens necessarily in the right states for us. And so we're keeping an eye on that. And it's nice when it happens, but it's one time in nature. And so that's why we always try to talk about our results with and without the impacts of political advertising. Because what is this year's windfall will be next year's headwind. And we want to make sure everybody's focused on the right thing, which is the underlying growth profile of the subscription business. Which includes the core advertising, which continues to do well with or without political advertising."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Jessica. Operator, we'll take our last question, please."
},
{
"speaker": "Operator",
"content": "Our final question will come from the line of Peter Cipino with Wolfe Research."
},
{
"speaker": "Peter Cipino",
"content": "Thanks and good morning. I have an ACP question that looks beyond the third quarter. Arguably, ACP has been history's greatest retention program for broadband operators and you took good advantage of it. Looking beyond the wave of involuntary disconnects in Q3 and not to say 2025, does that retention benefit go away? I mean, certainly it does. And then what needs to step up in its place or should we expect a slightly higher underlying churn rate attributable to those four or five million former ACP subs who go from having essentially no churn to maybe having a normal churn rate?"
},
{
"speaker": "Chris Winfrey",
"content": "Sure. Well, look, once upon a time there wasn't an ACP, but it's been a long time. When you think about, we had the, during the pandemic we had the, we were a big participant in the remote education offer, the Keep Americans Connected, the EBB, which evolved and became the Emergency Broadband Benefit, which evolved and became the ACP. And we've been a significant participant in all of those, as has the industry. I think we all have a lot to be proud of for stepping up and really driving those programs, but they didn't exist before. And broadband is a really important product. And from a charter perspective, we have ways to continue to address that marketplace. Before I go there, you asked about the market level activity. I do think that in an environment where ACP or an equivalent doesn't exist, that by definition you have more customers coming in and out of broadband based on affordability. That's rise up transaction volume, both from a non-pay disconnect, as well as from a gross ad sales perspective. When you have better products and better price, that can work towards your advantage. So it's not all bad from our perspective. And but we also have the ability to, at acquisition and for retention, offer unique products. Our Internet 100 is attractively priced. It's not for everybody, but it's affordable. We also, and you can pair that together with Spectrum One, so the ability to have a free mobile line for the first year, and then that line rolls to $30 after a year. If you think about a typical one-line environment or even in a typical two-line environment, the average cost of a line is over $60. And so even at retail rate of $30, we've built in a savings of $30 per month through taking mobile together with our attractively priced, high-powered broadband product. And that's as much, if not more, than the ACP benefit, which means that if you take our products, we can effectively -- we have the built -in ACP savings available to you when you really take full advantage of our product set. And so that is a product and a combination that didn't fully exist prior to all of these programs. And I think we can, by having a wider availability for low income population of these broadband offers, which we have together with our Spectrum 1 offer combined, I think we can save customers as much if not more than they were they're getting through ACP relative to the past. So I think we're in good position to be able to address the base. But the market activity, for sure, is going to be higher than what has been the past couple of years."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, Peter. And that concludes our call. We'll see you next quarter."
},
{
"speaker": "Chris Winfrey",
"content": "Thanks, everyone."
}
] |
chtr | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to Charter Communications First Quarter Investor Call. [Operator Instructions] Also, as a reminder, this conference is being recorded today. If you have any objections, please disconnect at this time."
},
{
"speaker": "",
"content": "I will now turn the call over to Stefan Anninger."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, operator, and welcome, everyone. The presentation that accompanies this call can be found on our website, ir.charter.com."
},
{
"speaker": "",
"content": "I would like to remind you that there are a number of risk factors and other cautionary statements contained in our SEC filings which we encourage you to read carefully. Various remarks that we make on this call concerning expectations, predictions, plans and prospects, constitute forward-looking statements which are subject to risks and uncertainties that may cause actual results to differ from historical or anticipated results. Any forward-looking statements reflect management's current view only, and Charter undertakes no obligation to revise or update such statements."
},
{
"speaker": "",
"content": "On today's call, we have Chris Winfrey, our President and CEO; and Jessica Fischer, our CFO. With that, let's turn the call over to Chris."
},
{
"speaker": "Christopher Winfrey",
"content": "Thanks, Stefan. During the first quarter, we lost 72,000 Internet customers. Despite lower Internet sales, we added nearly 500,000 Spectrum Mobile lines and close to 2.3 million lines year-over-year. We now have more than 8.2 million total mobile lines. With still low mobile penetration of Internet customers and passings, we have a long runway for customer and financial growth with the nation's fastest mobile service at incredible value."
},
{
"speaker": "",
"content": "Revenue was relatively flat in the quarter while adjusted EBITDA grew by 2.8%. And during the first quarter, our Internet customer growth remained challenged by a low-move and generally low-activity environment coupled with continued elevated competition at least in the short term and a small impact from fewer low-income connects due to discontinued ACP availability. Churn remains at historically low levels."
},
{
"speaker": "",
"content": "Telephone Internet continues to compete for gross additions and has expanded its addressable market within our footprint. And we remain confident in our ability to return to healthy long-term growth. Our Internet product is faster and it's more reliable. Our pricing is lower when similarly bundled with mobile. And the cell phone companies will face capacity challenges as customer bandwidth grows."
},
{
"speaker": "",
"content": "In the first quarter, wireline overbuild activity continued at a similar pace. And given the value of our converged products, we resisted chasing some less rational promotional offers from overbuilders."
},
{
"speaker": "",
"content": "As we move forward with our key strategic initiatives, we believe that our differentiated converged connectivity products with superior speeds, that save customers money, and a video product with increasing value and utility to customers, provide us with significant competitive advantages and a platform to grow customers, penetration, EBITDA and free cash flow over time."
},
{
"speaker": "",
"content": "In Internet, data usage continues to grow and demand for faster speeds will grow with it. During the first quarter, Internet customers who do not buy traditional video from us use nearly 800 gigabytes per month. And we now offer 300-meg, 500-meg and 1-gig symmetrical speeds in our first high split market."
},
{
"speaker": "",
"content": "Later this year, we'll begin launching the next wave of markets with distributed access architecture technology. When completed, we'll be able -- we'll be capable of offering 5 by 1 gigabit per second speeds in these markets with even better network performance. The next phase of markets will be upgraded to 10 by 1 gigabit per second speed and the ability to offer fiber on demand."
},
{
"speaker": "",
"content": "And ultimately, we'll see lower contact rates and truck rolls across these upgraded markets, achieving both lower cost and a superior product. We expect to complete our network evolution initiative in 2026, all at an incremental cost to just over -- or just $100 per passing, excluding the benefit of operating and capital savings that result from the project."
},
{
"speaker": "",
"content": "Our mobile offering also continues to evolve and improve. Earlier this month, we began offering Anytime Upgrade to customers within our Unlimited Plus offering. Anytime Upgrade allows new and existing Unlimited Plus customers to upgrade their phones whenever they want, eliminating traditional wait times, upgrade fees and condition requirements. We are the first mobile provider to include this level of freedom within a rate plan. And we also recently launched a new repair-and-replacement plan for just $5 per month. Anytime Upgrade, part of Unlimited Plus, and our repair-and-replacement plan, are each profitable."
},
{
"speaker": "",
"content": "Spectrum One continues to perform well beyond its first anniversary and offers the fastest connectivity with differentiated features like mobile speed boost and seamless connectivity to the Spectrum Mobile network across Android and iOS devices."
},
{
"speaker": "",
"content": "We still have a lot of room to grow our mobile business. Today, less than 8% of our total passings take our converged offering of Internet and mobile. We remain underpenetrated despite having a differentiated and superior offering with market-leading pricing at promotion and retail. And from a dollars perspective, we captured less than 30% share of residential mobile and Internet dollars spent in our footprint today. Mobile will be a meaningful driver of EBITDA and cash flow going forward with what is still an untapped ability to drive overall customer relationship growth."
},
{
"speaker": "",
"content": "Finally, turning to the evolution of our video product. We now offer a unique modern user experience with Xumo, which offers both linear and direct-to-consumer content on one device, combined with packaging and pricing options that offer choice, value and utility across FAST, SVOD, direct-to-consumer apps and linear video services."
},
{
"speaker": "",
"content": "In January, Disney+ became available to all Spectrum TV Select customers nationwide at no additional cost, with ESPN+ launched to Select Plus customers in March. ViX, a Spanish language DTC product, and regional sports DTC products, will also be available to customers at no extra cost within their respective packages."
},
{
"speaker": "",
"content": "We expect our hybrid DTC-linear model to be fully deployed next year. And we'll be able to deliver value for our customers and programming partners through fully bundled hybrid services, genre-based packages, selling DTC a la carte and potentially bundled DTC services to our broadband customers."
},
{
"speaker": "",
"content": "In late January, we launched our Spectrum TV Stream package, a 90-channel non-sports general entertainment package priced at $40 per month. TV Stream provides a compelling content offering at an attractive price from programmers like Paramount, Warner Bros. Discovery, Disney, Fox and A&E."
},
{
"speaker": "",
"content": "And so while the video business is clearly under pressure, we believe that flexible and attractively priced packaging options across all forms of video, channels really, integrated within a modern user interface in a more frictionless environment can recreate value in the ecosystem for our customers, programmers and distributors."
},
{
"speaker": "",
"content": "So when we step back, we clearly recognized some short-term market challenges, and we've embraced the opportunity to become an even better operator, leaving no stone unturned in our go-to-market and our efficiency initiatives. And in the meantime, we're growing a unique converged product at a rapid pace which can grow EBITDA through a competitive investment cycle. In long term, our network and customer demand products, pricing and packaging capabilities, our service infrastructure and the associated investments we're making today position Charter for sustainable growth and value creation."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Jessica."
},
{
"speaker": "Jessica Fischer",
"content": "Thanks, Chris. Let's turn to customer results on Slide 5. Including residential and SMB, we lost 72,000 Internet customers in the first quarter, and video customers declined by 405,000. In mobile, we added 486,000 mobile lines. And wireline voice customers declined by 279,000. Our mobile product continued to perform well. And although we saw lower mobile gross adds year-over-year tied to lower gross Internet additions, we also saw lower overall mobile churn rate year-over-year and sequentially."
},
{
"speaker": "",
"content": "Customers who signed up for our Spectrum One product in the first quarter of 2023 reached their 12-month anniversary this past quarter. Similar to last quarter, those promotional roll-offs did not drive incremental Internet churn. In fact, our Internet churn rate also declined year-over-year. So as we always expected, Spectrum One lines are performing well, and our converged offering drives higher mobile sales and longer customer lifetimes."
},
{
"speaker": "",
"content": "Turning to rural. We ended the quarter with 493,000 subsidized rural passings. And we grew those passings by 324,000 over the last 12 months and 73,000 in the first quarter. It's a bit of a slowdown from Q4, as we noted it would be on our last call, given winter construction seasonality. Penetration growth continues to exceed our expectations, and customer growth in our subsidized rural footprint increased with 35,000 net customer additions in the quarter. We continue to expect to activate approximately 450,000 new subsidized rural passings in 2024, about 50% more than in 2023."
},
{
"speaker": "",
"content": "We also continue to expect our RDOF build to be completed by the end of 2026, 2 years ahead of schedule. The RDOF and ARPA program rules have been successful in driving large-scale private capital builds. With respect to BEAD, most of the state's rules are still working through the NTIA review process. We expect some states will have a regulatory environment conducive to private investment while others will not. And we'll be disciplined in our investment approach with the continued expectation that some opportunities with appropriate ROIs will be available."
},
{
"speaker": "",
"content": "Before turning to our financial results, I wanted to make a few comments regarding the Affordable Connectivity Program. An ACP renewal now appears unlikely for the program's 23 million recipients nationwide and for our 5.0 million Internet customers receiving a subsidy. We will do everything we can to preserve our relationship with the ACP subsidy recipients, and we expect to keep the vast majority of them as customers. We have a number of ways to assist those that may lose their ACP subsidy, including our Spectrum Internet Assist program and Internet 100 product. We're also offering all of our ACP customers a free mobile line for 1 year."
},
{
"speaker": "",
"content": "The success of our Spectrum One offering has shown that we can create long-term converged connectivity customers by saving consumers hundreds or even thousands of dollars on their mobile bill. And even after the initial promotional period ends, we will still be able to save these customers the equivalent or more than the $30 ACP subsidy benefit that they are currently receiving."
},
{
"speaker": "",
"content": "The majority of ACP recipients in our customer base were Internet customers before the start of the ACP program. And the vast majority of our ACP customers also pay something out of pocket for their Internet service. Ultimately, we will lose some customers, and our Internet ARPU and bad debt expense may have onetime pressure, but we expect the impact to Charter to be mostly limited to the second and third quarters of this year. And we will provide transparency for those impacts in our quarterly reporting."
},
{
"speaker": "",
"content": "Moving to the first quarter financial results, starting on Slide 6. Over the last year, residential customers declined by 0.7%, driven by video-only customer churn. Residential revenue per customer relationship declined 0.1% over-year, given a higher mix of non-video customers and growth of lower-priced video packages within our base, mostly offset by promotional rate step-ups, rate adjustments and the growth of Spectrum Mobile. As Slide 6 shows, in total, residential revenue declined by 0.4% year-over-year."
},
{
"speaker": "",
"content": "Turning to commercial. SMB revenue declined by 0.3% year-over-year, reflecting lower monthly SMB revenue per SMB customer primarily due to a higher mix of lower-priced video packages and a lower number of voice lines per SMB customer. These factors were slightly offset by SMB customer growth of 0.2% year-over-year."
},
{
"speaker": "",
"content": "Enterprise revenue grew 3.8% year-over-year driven by enterprise PSU growth of 6.9% year-over-year. Excluding all wholesale revenue, enterprise revenue grew by 5.5%."
},
{
"speaker": "",
"content": "First quarter advertising revenue grew by 10% year-over-year given political revenue growth. And core ad revenue was essentially flat year-over-year."
},
{
"speaker": "",
"content": "Other revenue grew by 2.4% year-over-year primarily driven by higher mobile device sales. And in total, consolidated first quarter revenue was up 0.2% year-over-year and down 0.1% year-over-year when excluding advertising."
},
{
"speaker": "",
"content": "Moving to operating expenses and adjusted EBITDA on Slide 7. In the first quarter, total operating expenses declined by 1.5% year-over-year. Programming costs declined by 8.2% year-over-year due to the decline in video customers of 8% year-over-year and a higher mix of lighter video packages. These factors were partly offset by higher programming rates. And first quarter 2024 programming costs include around $30 million of favorable adjustments versus $50 million of favorable adjustments in the prior year period."
},
{
"speaker": "",
"content": "Other cost of revenue increased by 9.8% primarily driven by mobile service direct costs and higher mobile device sales. Cost to serve customers were essentially flat year-over-year with additional activity to support the growth of Spectrum Mobile and higher bad debt expense, mostly offset by lower service transactions per customers, including productivity from 10-year investments. Sales and marketing costs declined by 2.7% primarily driven by lower labor costs, partly tied to lower connect volume. Finally, other expense grew by 0.5%."
},
{
"speaker": "",
"content": "Adjusted EBITDA grew by 2.8% year-over-year in the quarter. And when excluding advertising, EBITDA grew by 2.2% year-over-year. Looking ahead, our goal is to deliver solid EBITDA growth, and we believe we can do that even as we make significant investments in the business, face a challenging competitive environment and reach the likely end of the ACP program."
},
{
"speaker": "",
"content": "Our residential revenue will be supported by Internet ARPU growth and our growing mobile customer base. In addition, mobile's contribution to EBITDA continues to improve as the business scales. We've also lapped the significant investments that we made in our employee base, so the related EBITDA drag should be mostly behind us."
},
{
"speaker": "",
"content": "And finally, we continue to carefully manage our expenses across the business. And while we're not going to do anything that would impact our sales or service capabilities, this quarter's cost to service customers and sales and marketing expense results demonstrate our ability to drive efficiencies into the business."
},
{
"speaker": "",
"content": "In the second quarter, we will face some tough expense comparisons, particularly in other expense as well as ACP headwinds. So while our second quarter EBITDA growth will be muted, our expense management process is clearly working. And financial growth in the back half of the year should accelerate given our expense management initiatives, Spectrum One promotional roll-off and political advertising revenue."
},
{
"speaker": "",
"content": "Turning to net income on Slide 8. We generated $1.1 billion of net income attributable to Charter shareholders in the first quarter, up from $1 billion last year, driven by higher adjusted EBITDA and a gain on the sale of towers, partly offset by higher income tax and interest expenses."
},
{
"speaker": "",
"content": "Turning to Slide 9. Capital expenditures totaled $2.8 billion in the first quarter, about $325 million above last year's first quarter spend. Line extensions totaled $1 billion, $69 million higher than last year driven by our subsidized rural construction initiative and increased residential and commercial greenfield and market fill-in opportunities."
},
{
"speaker": "",
"content": "First quarter capital expenditures, excluding line extensions, totaled $1.8 billion compared to $1.6 billion in the first quarter of 2023 driven by higher spend on upgrade, rebuild, primarily network evolution, and higher CPE spend due to purchases of Xumo Stream boxes. For the full year 2024, we continue to expect capital expenditures to total between $12.2 billion and $12.4 billion, including line extension spend of approximately $4.5 billion and network evolution spend of approximately $1.6 billion."
},
{
"speaker": "",
"content": "Turning to free cash flow on Slide 10. The cash flow in the first quarter totaled $358 million, a decrease of approximately $300 million compared to last year. The decline was primarily driven by an increase in capital expenditures and a onetime settlement payment in the first quarter of 2024, partly offset by a less unfavorable change in working capital year-over-year and higher adjusted EBITDA."
},
{
"speaker": "",
"content": "We finished the quarter with $97.8 billion in debt principal. Our current run rate annualized cash interest is $5.2 billion. Given our long-dated and 85% fixed rate debt structure, our sensitivity to higher rates is relatively low. If we refinanced all of our debt due in 2025 and 2026 at current rates, the impact to our run rate interest expense would be less than $140 million."
},
{
"speaker": "",
"content": "As of the end of the first quarter, our ratio of net debt to last 12-month adjusted EBITDA was 4.41x, which is lower sequentially and year-over-year. We expect to continue that trend, moving closer to the middle of our 4 to 4.5x target leverage range through the end of this year."
},
{
"speaker": "",
"content": "We remain fully committed to maintaining our split-rated debt structure, including access to the investment-grade market given the significant benefits it offers to all of our providers of capital. And we continue to be confident in the long-term trajectory of the business. We believe that our levered equity strategy, including share buybacks, combined with the investments that we are making in the business, will drive value going forward. During the quarter, we repurchased 1.7 million Charter shares and Charter Holdings common units totaling $567 million at an average price of $339 per share."
},
{
"speaker": "",
"content": "With the continued temporary impact from cell phone Internet competition and the potential headwind from the end of ACP, we will continue to face short-term customer growth headwinds. Despite these short-term challenges, we are competing well. We have a very attractively structured balance sheet, and we're focused on driving healthy EBITDA growth in 2024 through a short-term competitive and investment cycle. So we're well positioned today and for continued future growth."
},
{
"speaker": "",
"content": "With that, I'll turn it over to the operator for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from John Hodulik from UBS."
},
{
"speaker": "John Hodulik",
"content": "If I could follow up on the ACP comments, first of all, just any additional color you guys can provide over the -- on the subscriber and ARPU impacts to that program winding down in the second and third quarter. And it sounds like given the cost-cutting opportunities and the commentary, you still believe you can grow EBITDA for the year. That's number one."
},
{
"speaker": "",
"content": "And then number two, I thought the commentary about the churn on the video side from the Disney renewal was interesting. Chris, is that a trend that you expect to continue, especially as you sort of roll over your existing or you go through more renewals and add more D2C services to your lineup?"
},
{
"speaker": "Christopher Winfrey",
"content": "Sure. Let me try to tackle those, and Jessica may want to chime in here as well. The first one is on ACP and what we estimate. John, the non-renewal of ACP, there's 23 million customers have it today. It's unfortunate. But it's certainly going to have a negative Internet customer growth impact for everyone, including us. And that's going to happen in what's already a seasonal Q2 and probably the third quarter as we work through likely non-pay activity. And so really, as you think about the extent of those losses, it's going to depend on a few things."
},
{
"speaker": "",
"content": "One, first, being the stickiness of our retention offers. That includes us doing a free mobile line as well as for all ACP customers. That allows customers to save as much, if not more money on a monthly basis than the subsidy we already offered by ACP. In some cases, it can be much closer to EBB or maybe even more."
},
{
"speaker": "",
"content": "And we do have a Spectrum Internet Assist. We have Internet 100. So we have products that we can move people to as needed. And so the second thing I would say is it's going to depend on how well we really execute on those retention tactics that matters. And then thirdly, the way that we manage what's going to be likely an elevated non-pay environment and really managing that to the best of our ability for the benefit of customers."
},
{
"speaker": "",
"content": "In terms of specifics, this is an event that's unprecedented. In almost 30 years of cable, I haven't seen something like this before. So the short-term impact, it's difficult to predict. But in the end, I'm really confident we're going to manage through it successfully. It will be a onetime event, both on subscribers and maybe initial suppression of ARPU, but it's not going to impact our long-term growth potential."
},
{
"speaker": "Jessica Fischer",
"content": "Yes. As you think about EBITDA across the year, as we pointed out and I would just highlight it, there are some pressures on EBITDA in Q2 because of the comps to last year as well as likely, if there is non-pay impact, there could be some bad debt pressure inside of Q2 as well. So I would expect our EBITDA growth to be more pressured in Q2."
},
{
"speaker": "",
"content": "But we see the ability for it to accelerate across the rest of the year when you consider the roll-off of Spectrum Mobile, political advertising and our continued expense initiatives in the business as well. And so because of that, in all of the scenarios that we've looked at, we continue to expect EBITDA growth in the year."
},
{
"speaker": "Christopher Winfrey",
"content": "Yes. And so EBITDA, we're very confident on that. Giving a hard estimate on subscriber impact, for all the reasons I mentioned, is difficult. But we're going to outline that quarter by quarter. We'll have the ability to isolate. We'll provide that transparency for people along so they can see what's the underlying growth rate."
},
{
"speaker": "",
"content": "Your other question, John, I want to make sure I understand, was on video churn. We rolled out -- at the beginning of the quarter, we rolled out the Disney+ to all Spectrum Select customers and above and to Select Plus customers, which is our more sports-oriented package on top. We rolled out ESPN+ in March. Very early on, good take-up on that product along the way. But there was nothing that was a rotation of our subscriber base inside there. So there was not a negative contributing factor to adding those in."
},
{
"speaker": "",
"content": "I would highlight, in an environment where video these days really is coming in as an attach rate to Internet, we have lower Internet sales opportunities that has an impact on video. So the video churn rate stays relatively consistent. But the combination of having both lower selling opportunities for Internet and therefore lower attach rates for video, combined with the fact that we did do a programming cost increase pass-through inside of Q1 contributed to the video loss inside the quarter."
},
{
"speaker": "",
"content": "I do think that as we add more bundling of these DTCs in a hybrid linear model over time, I think we have the ability to stem a lot of the churn and actually add back to both the gross addition side coming from potentially new calls coming in, but also higher attach rate to Internet primarily as we provide more value into the package, which offsets the significant programming cost increases that we've been forced to pass through. Does that answer where you're trying to get to?"
},
{
"speaker": "John Hodulik",
"content": "Yes, that's perfect."
},
{
"speaker": "Operator",
"content": "The next question comes from Benjamin Swinburne with Morgan Stanley."
},
{
"speaker": "Benjamin Swinburne",
"content": "Just maybe unpacking the EBITDA outlook a little bit more. Jessica, last quarter, you gave us some helpful guidance on a few expense line items for the year. I think programming, cost to service and marketing come to mind. I don't know if you had any updates on any of those given some of the moving pieces. I just wanted to check on that."
},
{
"speaker": "",
"content": "And then secondly, for either of you or both of you, just on broadband competition. Could you spend a minute just talking about sort of how you see your product competing right now with fixed wireless, which is sort of everywhere or in a lot of markets, and then the wireline overbuild piece? Because fixed wireless net adds at the industry level this quarter, or cell phone Internet just to stay on brand here, were down year-on-year and a bit lighter than at least we were expecting. So it does seem like that product is starting to mature here. But you also called out wireline overbuild sort of pricing at a discount in the market as well. So I'd love to hear your updated thoughts on sort of the competitive framework you're thinking about this year."
},
{
"speaker": "Jessica Fischer",
"content": "So Ben, on the line item expense guidance that we gave earlier in the year, I don't have an update to any of those specific items. But what I would tell you is that, because of some of the work that we're doing around expenses across the business, I think it's possible that we come in lower than what we guided to, to begin with. I don't have a revision, but I think it's possible we come in on the low side."
},
{
"speaker": "Benjamin Swinburne",
"content": "Okay. Even with the bad debt comment you made earlier?"
},
{
"speaker": "Jessica Fischer",
"content": "So that's a fair call out. The exact amount of the bad debt related to ACP is hard to predict because it's a matter of what the mix is between customers that go non-pay and customers that sort of contact you in some other way. So that's fair call out."
},
{
"speaker": "",
"content": "On items other than that, I think the possibility is that we do better."
},
{
"speaker": "Christopher Winfrey",
"content": "You've got a lower transaction environment, plus all the expense management activity that we're doing, and that will have significant impact to cost to serve as well as sales and marketing as well."
},
{
"speaker": "",
"content": "And the broadband competition, maybe just take a step back and talk a little bit more detail about the operating environment and competitive and the results in that context."
},
{
"speaker": "",
"content": "The first thing I think is important to just keep in mind is that our churn, it continues to be at or below historic lows, so very good. And bear with me, but we actually performed a little better in the first quarter in competitive switching versus last year. Which then somebody said, \"Well, wait a second, how does that work?\""
},
{
"speaker": "",
"content": "And the real issue has been selling opportunities for broadband were actually much lower in the marketplace year-over-year, and that's driven by continued lower year-over-year move and household formation rates. There is some reversion to pre-pandemic mobile-only levels the past 2 quarters."
},
{
"speaker": "",
"content": "And at the same time, as you mentioned, there's still some cell phone Internet expansion, and that's competing what is for a much lower opportunity set. So if you add to that, then just a bit of impact from the removal of ACP connects that started in early February, that's really what drove us to the loss of roughly 70,000 Internet."
},
{
"speaker": "",
"content": "Ben, as you know, in this environment, small shifts in gross adds in particular, or even churn, which hasn't been the case, it just really has an outsized impact on net adds. And so that's going to definitely, as I mentioned before, it's going to be the case in the seasonal Q2, also with the end of ACP, all of which is temporary in nature."
},
{
"speaker": "",
"content": "I think the bigger question is what are we doing? And as I mentioned, we still know, and I think everybody agrees, we have the best products. And we have it at the best all-in price, particularly when you're combining broadband and mobile, which is, in a lot of cases, what we're competing against. Our network evolution to symmetrical and multi-gig wireline and wireless capabilities, and we're doing that at a low cost of $100 per passing. And then as I mentioned, we have the expansion of that best-in-class network and converged products to homes with no broadband today."
},
{
"speaker": "",
"content": "So in essence, what we're doing is we're still very competitive saving customers lots of money with fastest products. And we do that with a 100% in-house onshore service structure. And when you put that together with what I mentioned in the prepared remarks is continued increasing customer demand for data, it means we're very well positioned to return to sustainable growth over time."
},
{
"speaker": "",
"content": "And the key for us really is, in the meantime, we're heads down on execution. It doesn't mean that we don't have short-term opportunities. We're leaving no stone unturned on go-to-market. We have great assets and ability to package and price in I think ways that are new and innovative."
},
{
"speaker": "",
"content": "And what we're trying to do in the meantime as well, you mentioned on wireline overbuild in particular, still be very disciplined around the pricing because we know the value of our products. And so we saw a few overbuilders go a little bit downstream during the quarter. And we've resisted the temptation to go there just because we know the value of our both wireline and wireless services and the value that we can bring to customers long term."
},
{
"speaker": "Operator",
"content": "The next question comes from Jonathan Chaplin at New Street."
},
{
"speaker": "Jonathan Chaplin",
"content": "I guess the first one for Jessica, just on the change in your leverage target navigating towards the midpoint of the range. Would love to just get some more context on the thinking behind that. You sort of mentioned earlier in the script that the risk of higher rates isn't a material concern. And so this navigating down in the leverage range just reflect lower confidence in the cash -- the sort of the cash generation in the business given the competitive environment?"
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So Jonathan, I would say our confidence in the business hasn't changed. We remain comfortable with our 4 to 4.5x range based on the outlook that we have. But I think being sort of at the height of the investment cycle, we thought that creating a little bit of headroom was appropriate."
},
{
"speaker": "",
"content": "We constantly reevaluate our position. We'll continue to do that. But we continue to believe in the long-term trajectory of the business. We think the investments that we're making will deliver strong returns. And we know that maintaining the levered equity strategy, including sort of buybacks and leverage levels overall, is important to continuing to drive value."
},
{
"speaker": "Christopher Winfrey",
"content": "I would just add on -- just to add, Jessica said it, 0 lack of confidence. We have good, strong free cash flow today, have even growing free cash flow, and much more so as we get through these onetime investments. It's really -- as Jessica has already said, it's about making sure that we ensure the investment-grade structure we have. And that's important to us, it's important to our debt holders, and it's important to our equity holders as well."
},
{
"speaker": "Jonathan Chaplin",
"content": "And Chris, just a follow-up on that. Were the rating agencies sort of asking you to bring leverage lower in the range? And are there things that you could look -- that we could look for in the business that would make you feel comfortable to go back to the high end of the range over the course of the next few quarters?"
},
{
"speaker": "Jessica Fischer",
"content": "Jonathan, we're in regular contact with all 3 of the ratings agencies. Certainly, I think that there has been some additional conversation across debt holders and the rating agencies, given the higher CapEx that we have in the business and the sort of short-term pressure that, that puts on free cash flow."
},
{
"speaker": "",
"content": "And given sort of the tone of the broader market, you might have seen S&P issued a tearsheet at the end of last week that addressed ACP and the competitive environment. And I think their concerns are similar to those of equity holders, though they noted in there that they don't expect our ratings to change even though they might adjust their triggers somewhat. And even if our corporate family ratings were to change, they didn't expect any impact to the investment-grade rating."
},
{
"speaker": "",
"content": "So we constantly communicate with them. I think that given where we are, it made sense for us to create a little bit of headroom. As I said, we constantly reevaluate. It's certainly possible that we could move back up in the range at some point in time, particularly as you think about sort of free cash flow growth coming back as the investments winds down."
},
{
"speaker": "Christopher Winfrey",
"content": "And so I'd put that one to being responsive, and at the same time, given the current stock price, we want to do as much as we can within that responsiveness."
},
{
"speaker": "Jessica Fischer",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "The next question comes from Craig Moffett at MoffettNathanson."
},
{
"speaker": "Craig Moffett",
"content": "Chris, I want to -- maybe 2 questions. One broader sort of more strategic question and then just one clarification from Jessica. On the first one, you said something to me a while back that I've been thinking about, about the way you think about convergence. And you characterized the Spectrum One offer not really as an offer but sort of as a new product category."
},
{
"speaker": "",
"content": "I wonder if you could just talk about that a little bit and particularly in the context of AT&T talking quite frequently about their converged offering in the portion of their footprint where they have it. T-Mobile now with their Lumos deal yesterday, obviously sort of searching around for a converged offering. How much of the market is actually going in that direction?"
},
{
"speaker": "",
"content": "And then, Jessica, just one minor clarification. Could you just let us know how much is left of wholesale in the business services market? So that we can understand when we might start to see the overall growth rate start to look more like the non-wholesale part of your business?"
},
{
"speaker": "Christopher Winfrey",
"content": "So Craig, I'll start on the first one on convergence. And I think the best way to do this is I spend a lot of time internally talking about it as well, is if I asked you 15 years ago, what's the speed of your Internet connection? You would have connected to the back of the computer in your kitchen, and that would have been it. And 10 years ago, it might have been, here it is on WiFi on my couch or out on the terrace."
},
{
"speaker": "",
"content": "And today, if you're pulling out of the driveway and driving out and I say, \"Who's your Internet provider right now?\" You'd say, \"I don't know, I don't care. It just has to work and it has to be fast.\" And if that's people's definition increasingly of what's broadband connectivity, then we're the only provider in our footprint that can provide that uniform, ubiquitous broadband Internet in a seamless connectivity way."
},
{
"speaker": "",
"content": "And so we have the Internet. We have the WiFi. Our 5G cellular is a backup service when Internet and WiFi isn't available. And over -- last we reported, it was 87% of our traffic was going over our WiFi and increasingly with CBRS."
},
{
"speaker": "",
"content": "So 5G, interestingly, it's the backup radio. It's the slowest portion of our network. And when you put that all together in a way that I think we're uniquely capable of doing, we have the ability to offer something in the marketplace."
},
{
"speaker": "",
"content": "Now the challenge is that's not the way that it's been sold. It's not the way that customers think about it explicitly today in terms of how they purchase service. So there's an education challenge that's there in the way that we package, price and market that along the way. We'll have a meaningful impact."
},
{
"speaker": "",
"content": "Another way of thinking about it is that mobile today, and in fact I would argue, always has been, is just an extension of an Internet connection. And is it really a product? Is mobile a product? Or is it just an extension? Because even in 15 years ago, it's really a wireline service going to a tower, and that was just extending the broadband connection. And today, we're doing that from WiFi inside the home, out on strand. And we have the ability to provide that service in a ubiquitous way that is competitive."
},
{
"speaker": "",
"content": "And so Spectrum One, the idea is how do you educate the market and try to get the purchase habits to change in a different way. And over time, is mobile really a product? And testing and pushing the limits in the market, I think we have something here that's a competitive advantage, and it just may take a little bit of time to fully flesh its way out."
},
{
"speaker": "",
"content": "But we are that service provider today, not only to ourselves, but we're actually providing that backhaul service to foreign cellular devices on our WiFi routers today. And we are the backhaul and the backbone of almost all cellular traffic. So it just puts a unique opportunity for us to capitalize on that in the future."
},
{
"speaker": "Jessica Fischer",
"content": "Craig, on the other side, wholesale is a little less than 20% of overall enterprise revenues."
},
{
"speaker": "Christopher Winfrey",
"content": "And the piece of that, the piece that's pulling that is really cell tower backhaul..."
},
{
"speaker": "Jessica Fischer",
"content": "Yes, and that's really a little less than half of that piece."
},
{
"speaker": "Christopher Winfrey",
"content": "Right. So the traditional wholesale is relatively steady, and it's the cell tower backhaul that's in systemic decline, if you will."
},
{
"speaker": "Operator",
"content": "The next question comes from Bryan Kraft with Deutsche Bank."
},
{
"speaker": "Bryan Kraft",
"content": "I had 2 if I could. First, Jessica, related to free cash flow. I was wondering if you could size for us the onetime payment in the first quarter that impacted free cash flow. And also if you could help us understand how you're thinking about working capital usage this year."
},
{
"speaker": "",
"content": "And then, Chris, just on network neutrality. I was wondering if you could share your thoughts on the SEC's recent reinstituting of net neutrality rules. Any concerns with the rules? Do they impact the way you're running the business in any way, whether it's on the home broadband or on mobile side?"
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So Bryan, the onetime payment that impacted free cash flow on the order of $150 million to $180 million, in that range. And then from a working capital perspective, Q1 is always for us a negative working capital quarter. And I fully expect that we'll sort of make back to close to flat over the course of the year the negative working capital that we had. Excluding working capital, excluding the mobile device or the mobile side in the first quarter. Obviously, mobile continues to be a drag on working capital because of the device sales, and so you should expect that piece to continue."
},
{
"speaker": "Christopher Winfrey",
"content": "Bryan, on the net neutrality, I'd start from the get go. We don't -- the key concern isn't net neutrality. The concern is the Title II regime. We've -- we don't block. We don't do paid prioritization. We don't throttle, and we don't even have data caps. We believe that customers should have unlimited usage of the service that they're paying for."
},
{
"speaker": "",
"content": "The question has really been around Title II and what that brings, things around forbearance on rate regulation, the additional unintended consequences of where that can lead to on regulation for a product that, without regulation, is that type of regulation has been very successful to delivering tremendous value for consumers over a couple of decades now."
},
{
"speaker": "",
"content": "I would say that where we're at in the Title II debate with the FCC, there's 0 surprise. It's exactly where everybody thought we would be, and we're going to continue to go through that process. Unfortunately, it seems like over many years as this kind of works its way probably back to a court at this stage. And then hopefully, over time, we can get a standard set by Congress that puts this to bed once and for all. That's always been the hope. But I don't think Title II is the right way to regulate the things that we're already doing well."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Rollins at Citi."
},
{
"speaker": "Michael Rollins",
"content": "Two questions. First, with respect to the residential broadband ARPU performance, can you unpack the benefit in the quarter from the Spectrum One promotions rolling off? And how the potential benefit of this in terms of size can move through the year as more customers start getting back to maybe the normal course rate levels?"
},
{
"speaker": "",
"content": "And then just secondly, in the press release for quite some time now, you noted customers, and I hope I'm framing this right, that are broadband subscribers where there may have been some suspension of collections for other Charter services. And I'm curious what happens to those customers if ACP is discontinued? And do those disclosures provide any insight on how to quantify potential customer risk or churn risk if this program is discontinued?"
},
{
"speaker": "Jessica Fischer",
"content": "Yes. So starting on the first one on the Internet ARPU. The Spectrum One allocation was 70 basis points of drag year-over-year on our net ARPU growth in the quarter. So the GAAP Internet ARPU increased by 1.7%. It would have been 2.4% excluding the mobile allocation for free lines. Generally, I would expect that the gap in those 2 growth rates should narrow over the course of the year because the base of free lines becomes more stable given promotional roll-off."
},
{
"speaker": "",
"content": "However, I talked about that we are offering all of our ACP customers a free mobile line for a year. And depending on the level of success of that program, if we did see a reacceleration in the number of free lines, the gap between those 2 things could widen again."
},
{
"speaker": "",
"content": "Talking about what you see inside of the footnote and the aging. So we have had a process over time where we save customers into ACP. So if there was a customer who took multiple lines of business, say they were an Internet and video customer, and they were paying us. And then went into a non-pay status but they were eligible for ACP."
},
{
"speaker": "Christopher Winfrey",
"content": "Or in it, in most cases."
},
{
"speaker": "Jessica Fischer",
"content": "Or already in ACP. What we would do would be to downgrade the customer to an Internet-only product that was fully covered by the ACP subsidy, which enabled them to continue their Internet service. But then they would no longer have whatever the additional services were that were on their accounts. We have held those balances, though they're fully reserved. So they're sitting in receivables, but they're also sort of fully written off already in the bad debt reserve process."
},
{
"speaker": "",
"content": "But you're correct that numerically inside of the footnote, then you can see the base of customers who at some point in the past went into a non-pay process but have had their bill fully subsidized by ACP for some period of time."
},
{
"speaker": "Christopher Winfrey",
"content": "And if you think about it just from a customer perspective and how we were trying to be responsive to the government request, we wanted to make sure that these customers entering into collection cycle on video or phone didn't somehow suppress their ability to continue to receive the ACP benefit and continue to receive connectivity. And it's -- that's a classic example of the base of customers that we're going to work through, as I talked about from a collection cycle. And do the right thing for those customers to do everything we can to make sure that they stay connected to Internet over time. But there's challenges there."
},
{
"speaker": "Michael Rollins",
"content": "And are you choosing to implement the ACP wind-down at the end of April? Or are you planning to go through mid-May with your customers?"
},
{
"speaker": "Christopher Winfrey",
"content": "We'll go through the month of May with a partial ACP in accordance with what the government outlined. It's going to be a partial credit of $14, and we've agreed to make it $15 just to round it and make it clear to -- and fair to customers. So that's what we'll do inside of May."
},
{
"speaker": "Operator",
"content": "The next question comes from Vijay Jayant with Evercore."
},
{
"speaker": "Vijay Jayant",
"content": "Chris, given your focus on improving the video consumer proposition, I think you have a pretty substantial programming contract coming up very shortly. And what [ you sort of saw ] with the Disney agreement. Can you just talk about, is there a big [ opportunity ] there to sort of resize your programming costs associated with that sort of portfolio of channels?"
},
{
"speaker": "",
"content": "And second, I saw that your buyback authorization is somewhere around the $260 million. Is that something that's going to be re-upped?"
},
{
"speaker": "Christopher Winfrey",
"content": "So on the first question, the connection was a little off, and so we're going to sell you a Spectrum Mobile after this call here."
},
{
"speaker": "",
"content": "But the -- so I'm going to want to take the liberty of answering the question I think you asked. Look, we don't get into detail on individual programming renewals, and we've been generally very successful at getting renewals throughout the years. That's always our goal."
},
{
"speaker": "",
"content": "Our goal, though, is to really make sure that, first and foremost, that we really change the model so that we, once again, create value for customers. That starts with not asking them to pay twice for the same product, which is the debate that we've had historically and where we set a new model."
},
{
"speaker": "",
"content": "But it also means approaching the marketplace in all of our deal renewals and saying, \"Look, we've got to fight for the customer.\" And if they have a path to get a product that's equivalent or in some cases, even better for a lower price, we should just be selling that product, and that's the way that we should go to market."
},
{
"speaker": "",
"content": "And we can have that ability to do traditional linear hybrid. We can sell DTCs. We can sell them in a bundle. We have 25,000 in-house sales representatives in sales and retention. And so we have a workforce that's very capable of being a distribution engine for linear hybrid, DTC. And we have a large base of broadband customers, none surpassing us, that we can use that's unique. And we want to do that in a way that creates value for consumers."
},
{
"speaker": "",
"content": "I think as we've approached the marketplace in what is a different way, it creates consternation because it's something very different. But our goal here is really to create a video ecosystem that works for customers and providing utility and value. Again, utility through Xumo and value through our ability to package in different ways that meets the customers' needs at a fair price. And ultimately, while it may be painful along the way, actually creates value again for programmers and distributors and recreates a video ecosystem that works for everybody."
},
{
"speaker": "",
"content": "And so we're not approaching this from a way of just trying to save money. We're just trying to actually create value for customers by either adding more product so that the price they pay is worth it or saving them money because they wanted to package anyway. And we can do that in a way in a lower churn environment for the benefit of programmers, and that just takes a little bit to get through."
},
{
"speaker": "",
"content": "But our goals here are really to recreate a video ecosystem that works for everybody. Today, it doesn't. It's been broken, and it's been broken for a while. And I think that we had the first time in maybe 2 decades where we can do something where we have a product that we're proud to put on our Internet bill at some point soon."
},
{
"speaker": "",
"content": "And that really is, when we talked about it last year, is the balance of, on one hand, our bundled customers churn less. And so a high-quality video product has always been an asset. But when the rate continues to go up and the value goes down and it's being sold around customers and ask them to pay twice, then it becomes a liability on the Internet broadband bill. And then I think we need to rethink the way that what we're selling for video and how it actually creates value for customers or not."
},
{
"speaker": "",
"content": "So that's where we've been. And I'm confident we're going to continue to make progress in this space."
},
{
"speaker": "Jessica Fischer",
"content": "On the buyback authorization side. I'm going to make sure we answer that question. The authorization as of the end of the quarter, as you pointed out, is a little bit lower than what you would typically see. There are multiple mechanisms by which that gets renewed, and we have increased the buyback authorization since that point in time. And just because of the readthrough to that, I want to be really clear that we expect to be able to maintain our buybacks over the course of the year even as we delever. So you should not read that through as any sort of sign about the direction of the program."
},
{
"speaker": "Stefan Anninger",
"content": "Operator, we'll take our last question, please."
},
{
"speaker": "Operator",
"content": "The last question will come from Steven Cahall with Wells Fargo."
},
{
"speaker": "Steven Cahall",
"content": "So Chris, earlier, you said you're confident in returning to long-term growth, and you spoke a lot about the overbuilding activity that you're seeing. I think the challenge many of us have is when we pencil that out and kind of think about penetration of fiber and then we look at your passings growth and think about penetration as well, it's just tough to see when things return to growth on the subscriber side, maybe ex rural. So I was wondering if you could just give us any thinking as to your color and timing when we might start to see subscriber growth reaccelerate to a positive level."
},
{
"speaker": "",
"content": "And then Jessica, just picking up on Bryan's question. You talked about maybe mobile being a bit of drag in working capital this year. So as you start to do the ACP lines for mobile, could that accelerate the drag for mobile working capital on handsets? Or do you not expect the customers to necessarily be acquiring new handsets?"
},
{
"speaker": "Christopher Winfrey",
"content": "So I'm not going to provide a detailed timeline for the timing to reaccelerate, just because I want to be conservative and recognize that it's a very fluid space. I mean, clearly, we have ACP going on right now, which is going to be a onetime hit. You have cell phone Internet where they will reach capacity, and the timing of that isn't entirely clear. And then there's fiber upgrades, which have been announced and are pretty far along from what was actually announced."
},
{
"speaker": "",
"content": "So I think if you put that all together, though, and flip it and say, well, get past ACP, and the pace of fiber upgrades is relatively stable, and I think over time should actually start to decline. Cell phone Internet will run out of capacity, and you're already starting to see some signs of some of that paring back, all of which bodes well."
},
{
"speaker": "",
"content": "And then you combine that with the fact that when you look at our -- the quality of our Internet product, in 100% of the market, particularly and even more so in those that don't have a gig overlap, which is about half. And then you combine that with the unique ability to provide a very attractively priced mobile product that's actually the fastest mobile product in the business simply because it largely rides on our gigabit wireless infrastructure, we have a structural advantage for now and many years to come, not only just on quality, but the ability to save customers hundreds and even thousands of dollars."
},
{
"speaker": "",
"content": "And so I sit back and look at that and say, it isn't a question of if. It's just a question of when. And as some of these short-term pressures pare back, that's when you'll start to see it turn."
},
{
"speaker": "",
"content": "Honestly, we haven't been the best at predicting the exact timing of that. And so I said last quarter, we owned that. And so I want to be careful that I'm not overextending ourselves here either. But I think it's more important just to take a step back and look at what is the product we have, what's the network capabilities we have. It's only getting better."
},
{
"speaker": "",
"content": "If you then tack on to that the rural passings, that you mentioned ex rural, so I did that ex rural. But if you add on to that the subsidized rural passings where it's just math in terms of the penetration, the net additions that we're going to get on the back of that investment, I still think the future's very, very bright for Charter."
},
{
"speaker": "Jessica Fischer",
"content": "On the mobile working capital side, so you point out, without a doubt, the drag on working capital is driven by the number of phones or other mobile devices that you sell subject to EIP notes. And so if we were to end up with additional devices because of having additional mobile customers as a result of our work on ACP or if we end up with some additional devices because of the Anytime Upgrade program, which is also possible, there could be some acceleration in that drag."
},
{
"speaker": "",
"content": "What I would tell you on the other side of that is, as we've been building our mobile business, we haven't taken advantage of some of the financing options that are available for us related to having those EIP notes as part of our overall asset stack. And it hasn't yet made sense for a wide variety of reasons, including just sort of building the scale for a program like that to make sense."
},
{
"speaker": "",
"content": "So I think it's also possible that we could offset some of that drag in working capital by working through some of those financing mechanisms. And certainly, as we've been building, I think we're reaching a size at which that becomes a more viable option."
},
{
"speaker": "Christopher Winfrey",
"content": "Good. Well, thank you, everyone, for joining the call. And look forward to talking to you again on the next one."
},
{
"speaker": "Stefan Anninger",
"content": "Thanks, operator."
}
] |
ci | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for standing by for the Cigna Group’s Fourth Quarter 2024 Results Review. At this time all callers are in a listen-only mode. We will conduct a question-and-answer session later during the conference and review procedures on how to enter the queue to ask question at that time. [Operator Instructions] As a reminder ladies and gentlemen, this conference, including the Q&A session, is being recorded. We'll begin by turning the conference over to Ralph Giacobbe. Please go ahead."
},
{
"speaker": "Ralph Giacobbe",
"content": "Thank you. Good morning, everyone. Thanks for joining today's call. I'm Ralph Giacobbe, Senior Vice President of Investor Relations. With me on the line this morning are David Cordani, the Cigna Group's Chairman and Chief Executive Officer; Brian Evanko, Chief Financial Officer of the Cigna Group, and President and Chief Executive Officer of Cigna Healthcare; and Eric Palmer, President and Chief Executive Officer of Evernorth Health Services. In our remarks today, David and Brian will cover a number of topics, including our fourth quarter and full year 2024 financial results and our financial outlook for 2025. Following their prepared remarks, David, Brian, and Eric will be available for Q&A. As noted in our earnings release, when describing our financial results, we use certain financial measures, including adjusted income from operations and adjusted revenues, which are not determined in accordance with accounting principles generally accepted in the United States, otherwise known as GAAP. A reconciliation of these measures to the most directly comparable GAAP measures, shareholders' net income and total revenues, respectively, is contained in today's earnings release, which is posted in the Investor Relations section of the CignaGroup.com. We use the term labeled adjusted income from operations and adjusted earnings per share on the same basis as our principal measures of financial performance. In our remarks today, we will be making some forward-looking statements, including statements regarding our outlook for 2025 and future performance. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. A description of these risks and uncertainties is contained in the cautionary note to today's earnings release and in our most recent reports filed with the SEC. Regarding our results, in the fourth quarter, we recorded net after-tax special item charges of $64 million, or $0.23 per share. Details of the special items are included in our quarterly financial supplement. Additionally, please note that when we make prospective comments regarding financial performance, including our full year 2025 outlook, we'll do so on a basis that includes the potential impact of future share repurchases and anticipated 2025 dividends. With that, I'll turn the call over to David."
},
{
"speaker": "David Cordani",
"content": "Thanks, Ralph. Good morning, everyone, and thank you for joining our call. Today, I'll discuss key headlines from the quarter and our full year 2024 performance. I'll also share more on the actions we are accelerating to build a better and more sustainable healthcare model. And then Brian will provide additional details on our financial results in our 2025 outlook, and we'll take your questions. Before I get into our earnings, I want to start by sharing a few comments on the current environment. During my tenure as a leader of the Cigna Group, there have been a number of periods in our industry where we faced unique challenges, whether the financial crisis, the introduction of the ACA, the global pandemic, or several significant shifts in political, regulatory, and societal landscape. At the Cigna Group, our resilience and the durability of our business model have allowed us not only to overcome obstacles, but to lead through change while focusing on achieving our long-term objectives for sustainable growth. In early December we all witnessed the tragic murder of Brian Thompson, a leader at the UnitedHealth Group. The past several weeks have further challenged us to even more intensely listen to the public narrative about our industry. At the Cigna Group, we are further accelerating improvements and innovations to increase transparency, expand support, and drive even greater accountability. I'll come back to this important topic in a few moments. With that, let me start with a summary of our 2024 results. We delivered full-year revenue growth of 27% to approximately $247 billion. Full-year adjusted earnings per share of $27.33, representing an increase of 9% year-over-year, but short of our expectations. We returned $8.6 billion to shareholders through dividends and share repurchase. And our Board of Directors declared an 8% increase to our quarterly dividend to $1.51 per share, and increased our share repurchase authority to $10.3 billion. The Cigna Group also maintained a strong capital position in 2024. We're also nearly complete with the sale of our Cigna Healthcare Medicare business to HCSC, and we continue to expect to close in the first quarter and plan to use the majority of the proceeds for share repurchase. Now turning to our business results and actions, I want to cover just a few headlines. First, our fourth quarter results were below expectations due to higher than expected medical costs in our stop loss product within Cigna Healthcare. We are taking corrective actions on this near-term pressure and expect to recapture margin over the next two years. This is a specific issue we identified and are mitigating, and I'll reinforce that we believe our U.S. employer and Cigna Healthcare businesses are strong and remain well positioned, and we're confident in our long-term growth strategy. Brian will discuss this in greater detail in his remarks. The second headline for the quarter is that Evernorth continues to drive strong results in line with our expectations, primarily driven by our specialty and care services segment. Our continued leadership of biosimilars is a good example of how we are addressing some of the biggest challenges facing clients and patients today. We began dispensing our Humira interchangeable biosimilar last summer to eligible Accredo patients with $0 cost to our patients. We are pleased that biosimilar use for eligible Humira scripts reached nearly 50% by year-end 2024. We took another step forward as we announced that we’ll begin offering an interchangeable Stelara Biosimilar, again for $0 cost to our patients. Looking forward, we expect approximately $100 billion of specialty drug spend in the U.S. will be subject to biosimilar and generic competition over the next five years. Our Humira and Stelara Biosimilar offerings are just the start of this opportunity, and Accredo is well positioned to lead and continue to deliver real savings for clients, customers, and patients. Now, stepping back, prescription drug coverage is the most frequently used healthcare benefit. On average, it's used about 15x per year per person, and how our nation and industry captures the full promise of prescription drug innovation, while addressing affordability has been subject to continued debate. Pharmacy benefit managers are essential in helping patients’ access medications at fair and affordable prices. In fact, approximately 80% of Express Scripts patients spend less than $100 out-of-pocket per year for their prescriptions. Yet, we recognize for those Express Scripts patients who pay more than $100. For some, it's too high. For example, consider the increased use of GLP-1s in the United States. It is the number one driver of drug trend across employers of all sizes since 2024. Despite these medications being relatively cheap to produce, Americans are paying prices that are multiples higher for GLP-1s compared to other countries, even with full pass-through of rebates. Said otherwise, even including all discounts and rebates, the end result is that the U.S. costs are multiples higher than other OECD countries. This is not acceptable nor sustainable. As for innovations, led by Evernorth and Express Scripts, we are proud that last year our EnCircle Rx solution grew to approximately 8 million lives enrolled. We are supporting the best possible patient outcomes by providing those on GLP-1s, additional lifestyle support and tools to help sustain long-term improvement. Now, the next headline I want to touch on a bit more is the current environment. We have long been on a path to evolve and drive continuous improvement. As we step into 2025, we have further strengthened our urgency and resolve on this path. That means we are accelerating investments that will positively impact the way our customers and patients experience healthcare. To that end, this week we announced actions we are taking in Express Scripts, our pharmacy benefit service business within Evernorth. Our commitment will help patients directly benefit further from the negotiations we drive to lower out-of-pocket costs, as well as work to further enhance transparency. Let me briefly recap the announcements. Going forward, our standard products will provide patients lower prices at the pharmacy counter, protecting them from paying full list prices for drugs, and they will fully benefit from our lower net negotiated prices. Next, patients will also have improved predictability, especially and importantly in their deductible phase, by receiving the benefit of Express Scripts negotiated savings like their employer does. We will also expand the benefit summaries and disclosures we provide. Patients will receive a personalized summary that details their annual total prescription drug costs, plan paid amounts, and the savings we deliver. And planned sponsors will also receive an enhanced report beyond what Express Scripts already provides, including additional transparency on costs and pharmacy claim level insights. We know that more can be done within our health plan offering as well, for customers and patients as well as clinical partners, to further ease access to care timeliness and expand support programs. More specifically, Cigna Healthcare will soon be announcing steps to improve value and address patient points of friction. Our focus is on making prior authorizations faster and simpler and expanding access to advocates for those facing complex health conditions to help them navigate every stage of their care journey. These initiatives will require that we incur additional costs, but we firmly believe these are critical actions for the benefit of customers and patients. We will continue to take a prudent approach to these and future Cigna Healthcare and Evernorth actions in the weeks and months ahead, as we are determined to continue to evolve for the benefit of those we serve and build a more sustainable healthcare model. Now let me briefly summarize. Against the backdrop of a dynamic and challenging environment, in 2024, we delivered full-year adjusted earnings per share of $27.33. And we returned $8.6 billion to shareholders through dividends and share repurchase. Looking ahead to 2025, our EPS outlook of at least $29.50 reinforces the sustained growth and strength of our company, and we are focused on taking the prudent steps necessary to ensure our company is well-positioned for future growth. And we remain confident in our long-term 10% to 14% growth target, fueled by our differentiated capabilities and portfolio of businesses. Finally, we recognize the need for accelerated positive change in our healthcare system to make it simpler and more affordable for everyone. And the Cigna Group is committed to continuing to take actions to drive further accountability and transparency as well. With that, I'll turn the call over to Brian."
},
{
"speaker": "Brian Evanko",
"content": "Thank you, David. Good morning, everyone. Today I'll review Cigna's fourth quarter and full-year 2024 results, and I'll provide our outlook for 2025. For full-year 2024, we reported consolidated adjusted revenues of $247.1 billion, adjusted after-tax earnings of $7.7 billion, and adjusted earnings per share of $27.33. Our performance within the Evernorth Health Services segment ended the year strong with particular momentum in specialty and care services. Despite this, our enterprise earnings results fell short of our expectations, driven by higher than expected medical costs in our stop loss products within the Cigna Healthcare segment. This resulted in a full-year medical care ratio of 83.2%, which was above our guidance range. We are taking corrective action to recapture margin, and we remain confident in the long-term strength of our business despite this short-term pressure. Now more specific to Cigna Healthcare's fourth quarter results, fourth quarter 2024 revenues were $13.3 billion, pre-tax adjusted earnings were $511 million, and the medical care ratio was 87.9%. As I noted, fourth quarter earnings fell below our expectations as we observed elevated medical costs in stop loss. Results of our other products were in line with expectations, exhibiting a continuation of elevated trends that we had seen throughout the year. Taking a step back, it's important to note that stop loss is a unique product within our portfolio where employers limit their risk from unexpected high-cost claims by transferring that risk for medical costs above a specific individual or aggregate employer dollar amount. We can see variability in this product at times, but we've generated and continue to expect attractive margins over the long term. This year, variability was more pronounced in the fourth quarter as we had an increase in the number of high-cost claimants related to cost pressures from the continued acceleration in the prescribing and use of specialty medications, as well as elevated high-acuity surgical activity. The fourth quarter also tends to be when more client settlements transpire, including true-ups for the full calendar year of activity. We had seen some of these trends emerge in the third quarter and began pricing for higher trend on high-dollar claims, but did not capture the full extent of this trend acceleration that materialized in the fourth quarter. And as a result, we expect a slightly higher MCR for stop loss in 2025. While this negatively impacts near-term margin, we expect to recapture approximately 100 basis points of margin in the overall Cigna Healthcare segment over the next two years, with the majority in 2026 and the remaining in 2027. We will do this by balancing pricing action, affordability initiatives, operating cost efficiency, and continued investments. Now turning to Evernorth, 2024 highlighted another year of sustained growth, particularly within the specialty and care segment, highlighting the attractiveness of our market-leading clinical capabilities and innovative solutions that create affordability for customers and patients amidst the growing trend of pharmacological innovation. Adjusted revenues for fourth quarter 2024 grew 33% to $53.7 billion, and pre-tax adjusted earnings grew 14% to $2.1 billion, in line with expectations. Moving to our businesses within Evernorth, specialty and care services adjusted revenue grew 18% to $23.5 billion, and adjusted earnings grew 27% to $948 million. This continues the pattern observed from last quarter, which reflects growth across our specialty businesses, driven by higher utilization of specialty medications, as well as a continued increase in the adoption of Humira biosimilars. By the end of the fourth quarter, we saw almost half of eligible Humira scripts transition to biosimilars. Pharmacy benefit services also posted robust growth, reflecting client wins and the continued demand for new drugs through our innovative products and solutions. Pre-tax adjusted earnings increased to $1.2 billion, as our differentiated capabilities continue to drive affordability and value to our patients, customers and clients. Overall, the fourth quarter capped another strong year for Evernorth, with full-year pre-tax adjusted earnings growing 9% for the year. We are the industry leader in pharmacy benefit services and in specialty pharmacy, and our strong 2024 performance gives us confidence for sustained attractive growth over the long term. Now, turning to our 2025 outlook. First, I'd note that the divestiture of our Medicare businesses to HCSC remains on track to close in the first quarter, and this is contemplated in our outlook. We expect full year 2025 consolidated adjusted revenues of at least $252 billion, and we expect full year 2025 consolidated adjusted income from operations to be at least $7.9 billion or at least $29.50 per share. As David mentioned, we are accelerating investments that will positively impact the way our customers and patients experience healthcare. Our outlook reflects up to $150 million in costs for these initiatives, split between Evernorth and Cigna Healthcare. When considering earnings seasonality, 2024 is not representative of typical patterns, given the dynamics I referenced with our stop loss products. As such, we would expect the adjusted earnings per share pattern for 2025 to be more similar to 2023's pattern. Now, turning to our 2025 outlook for each of our segments. In Evernorth, we expect full-year 2025 adjusted earnings of at least $7.2 billion. This represents year-over-year growth within our long-term growth target range on a normalized basis. Within Evernorth, we expect first quarter earnings to contribute slightly below 20% of full year Evernorth earnings. For Cigna Healthcare, we expect full year 2025 adjusted earnings of at least $4.1 billion. This represents mid-single digit year-over-year growth on a normalized basis. Within Cigna Healthcare, we expect approximately 55% of full-year earnings to be in the first half of the year, slightly more weighted to the first quarter. Assumptions in our Cigna Healthcare outlook for 2025 include our medical care ratio to be in the range of 83.2% to 84.2%. This reflects the expectation that our stop loss MCR continues to be above target levels for full year 2025. We expect the first quarter 2025 medical care ratio to be below the low end of the full year guidance range to reflect typical seasonal patterns. We expect approximately 18.1 million total medical customers at year-end, reflecting the divestiture of our Medicare businesses to HCSC, a reduction in individual exchange customers, and growth within our U.S. employer select and middle market segments. For the enterprise, we project an adjusted SG&A ratio of approximately 5.4% for 2025. This percentage is lower in 2025, largely reflecting mix due to the absence of our Medicare businesses, which carried a higher SG&A ratio compared to the consolidated average, and we expect the consolidated adjusted tax rate to be approximately 19%. Now, moving to our 2024 capital management position and 2025 capital outlook. Our fourth-quarter cash flow is quite strong, and we finished full year by delivering $10.4 billion of cash flow from operations. In 2024, we repurchased 20.9 million shares of common stock for approximately $7 billion. In addition, the Board of Directors recently approved an increase of $6 billion in incremental share repurchase authorization, bringing the company's total share repurchase authorization to $10.3 billion as of December 31, 2024. Finally, we returned $1.6 billion to shareholders via dividends in 2024. Now framing our 2025 capital outlook, we expect to deliver approximately $10 billion of cash flow from operations with the strength of our efficient service-based model. We expect to deploy approximately $1.4 billion to capital expenditures, and we expect to deploy approximately $1.6 billion to shareholder dividends, reflecting our quarterly dividend of $1.51 per share, an 8% increase on a per-share basis. Our guidance assumes full-year weighted average shares outstanding to be in the range of 266 million to 270 million shares. Our capital deployment priorities remain consistent with our long-term framework. We expect some debt paydown in 2025 as we look to bring our leverage ratio closer to our 40% target. As it relates to the sale of our Medicare businesses, we continue to expect a majority of proceeds will go toward share repurchase. Now, to close. As we look to 2025 and beyond, we remain confident in our long-term strategy and our ability to deliver sustainable growth through a differentiated portfolio of businesses. As David mentioned, we're operating in a highly dynamic environment. But as we've demonstrated in the past, we have a proven track record of meeting challenges and taking the actions to deliver affordable and innovative solutions for our customers and patients. We're confident in our ability to deliver full-year 2025 adjusted earnings of at least $29.50 per share, which we believe is prudent at this time, given the dynamic environment. And with that, we'll turn it over to the operator for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Justin Lake with Wolf Research. Your line is open. You may ask your question."
},
{
"speaker": "Justin Lake",
"content": "Thanks. Good morning. I wanted to ask a couple of things on the stop loss business. First on the $7 billion of premium, I was hoping you can give us some split between the aggregate versus specific stop loss premiums, and then maybe tell us if there was any more margin pressure in one segment versus the other in the fourth quarter. I then wanted to just make sure I'm understanding the magnitude of the miss correctly here. You talked about the fourth quarter miss being all stop loss, so I'm getting to like 1,500 basis points in the fourth quarter, because that’s in the ballpark. And I think you said your margins overall are 100 basis points higher because of this or lower that you'll recapture, which would seem to indicate stop loss is off by about 5% given the percentage of revenue. Just trying to make sure – I was just making sure I understand all of that correctly. Any help appreciated. Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Justin. It's Brian. A number of components to your question, so I'll do my best to capture as much of that as possible. Let me just start with a little bit of context on the stop loss business, and then I'll try to get to your very specific questions there on my way through here. So obviously we're disappointed by the shortfall that we reported in the fourth quarter. As I mentioned in my prepared comments earlier, the vast majority of the shortfall was driven by our stop loss products within Cigna Healthcare, and the rest of the company performed broadly as we expected. Now, it's important to keep in mind that our stop loss product performance in the quarter is really more representative of the full-year impact, because it's an accumulation product reflecting 12 months of healthcare activity for a given individual or an employer. And we continue to feel very good about the long-term fundamentals of our U.S. employer portfolio and the stop loss product specifically, and the shortfall that we're currently experiencing represents an embedded earnings opportunity for the future. As we look back at 2024, the aggregate healthcare costs within the Cigna Healthcare portfolio were broadly in line with our expectations, reflecting the persistently elevated cost trend environment that I referenced. But the mix of those costs shifted more toward high-cost claimants than we had expected, which has a disproportionate impact on the stop loss products. And given when we identified the magnitude of the 2024 stop loss pressure, we were not able to fully recognize this in our January 2025 renewal pricing, as much of that pricing work was completed in the fall. Now, some of the later 2025 renewals will reflect the updated estimates, but the majority of the 2025 stop loss pricing will not capture that elevated cost structure. So when you put all those pieces together, we would expect to see 100 basis points of margin improvement across the Cigna Healthcare portfolio by 2027, with the majority of that to be captured in 2026. Now, more specifically to your questions, when you think about the $6.7 billion of premium in our stop loss book of business, there's a mix of individual and aggregate stop loss in there, and there are a variety of attachment points and different client choices embedded in there. You can think of it as more tilted toward the individual versus the aggregate, but we have a wide range of stop loss offerings that are out there. And for full year 2024, the overall stop loss MCR ran in the low 90’s in terms of the percentage, which you can think of as being a mid-single digit percentage amount, worse than our expectations had been in 2024. So again, that $6.7 billion of premium multiplied by a mid-single digit percentage miss gets you about the earnings impact that we're seeking to recover over time on the stop loss portion of the portfolio. But importantly, the balance of the Cigna Healthcare portfolio ran broadly in line with expectations. Thanks for your question."
},
{
"speaker": "Justin Lake",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Stephen Baxter with Wells Fargo. Your line is open. You may ask your question."
},
{
"speaker": "Stephen Baxter",
"content": "Hi. Thanks for the question. I'm going to ask another one on stop loss. I guess when you've gone through these cycles in the past, can you talk a little bit about how it's impacted retention and membership for the impacted accounts that have seen these kind of larger above-trend increases for stop loss? And you know, I can definitely appreciate why it takes until at least 2026 to get meaningful improvement. But when you are talking about some of this improvement leaking out into 2027 potentially, could you just help us understand a little bit why it could become, you know, even that far extended? Thank you."
},
{
"speaker": "Brian Evanko",
"content": "Hi, Stephen. It's Brian again. So, one thing that's critical to keep in mind as it relates to our stop loss portfolio is that we don't write standalone stop loss coverage. So our entire book of business reflects an integrated employer offering where we're providing the first-dollar coverage alongside. So as a result, our overall relationship with the employer is multifaceted in nature and it involves many products and solutions, which ends up creating numerous opportunities for value creation and the associated value capture. And even with the stop loss claims pressure that we experienced in our 2024 results, our overall client level relationships are profitable for those employers who choose our stop loss offerings. When we look back historically over many years, decades in fact, we've been able to overcome the short-term ups and downs of our stop loss portfolio and generate attractive long-term returns. And our clients value these long-term relationships and the associated budget certainty that our offerings can provide to them, which really is evidenced by the fact that well over 50% of our employer clients who choose our stop loss products have been clients of Cigna Healthcare for five years or more. So, the shortfall in our 2024 results offers a substantial embedded earnings opportunity for the company, and we're confident in our ability to execute against this, balancing the timing of margin recovery with client persistency."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Charles Rhyee with TD Cowen. Your line is open. You may ask your question."
},
{
"speaker": "Charles Rhyee",
"content": "Yeah, thanks for taking the question. Just related to sort of the stop loss again a little bit, you called out specialty NEDs at the start contributing to that. Is that related to GLP-1s at all? And related to that, as we think about the Evernorth guide going forward, you are starting at a 3% operating income growth starting point. But you finish ‘24 up 9%, which if I remember correctly, right, included onboarding costs related to the same team in the first half of the year. Anything to call out relative to ’25, because otherwise it seems -- you know this part of the guidance seems pretty conservative, particularly given the growth you saw in specialty in the back half of ‘24. Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Charles. This is Brian. So, as it relates to the stop loss specific drivers, which I think was the core of your first question, you can think of this as being at a situation where we had a greater frequency of high-dollar claimants than we had been expecting, particularly driven by high-cost specialty pharmaceuticals and by high-acuity surgical activity. Now, within the specialty drugs, I would not point to GLP-1s as a driver of this. Think of it as more specialty injectables. So when you look at the nature of that, particularly for the stop loss books, its drugs like Keytruda or Ocrevus, those sorts of specialty injectables that drove some of the upward pressure. And then on the high-acuity surgical side, think of that as more tilted to inpatient procedures, for example, oncology and cardiac-oriented procedures. So that was really the core of the upward pressure on the stop loss products. Now, as it relates to Evernorth's 2025 income outlook, I'd start by saying how pleased we are with the overall performance of that portion of the company. We delivered a strong result in ‘24, as you noted in your question. As it relates to 2025 specifically, our outlook for the income growth is within our long-term growth rate range of 5% to 8% when a few adjustments are made, so specifically the absence of Village MD net investment income, which was recorded in 2024, as well as the Evernorth share of stranded overhead from the Medicare divestiture. And then as I noted in my prepared comments, we have earmarked up to $150 million across the company for incremental 2025 investments in patient and provider-facing initiatives, and our guidance reflects a portion of that spending in the Evernorth segment. So adjusting for these factors, we look forward to Evernorth delivering income growth within our long-term average annual growth rate range. So overall, Evernorth is performing well. We're positioned for another good year."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Lisa Gill with JP Morgan. Your line is open. You may ask your question."
},
{
"speaker": "Lisa Gill",
"content": "All right. Thanks very much, and good morning. David, I wanted to go back to the comments that you made around express strips and some of the offerings that you now have, lowering the price at the counter, etc., and really tie that back to comments you've made in the past around roughly 20% of total profits coming from rebate retention. Can you talk about two things? One, are clients shifting more where they want, more of the rebate retention, and if so, how do we think about that impact of profitability over time? And then secondly, the programs that you talked about, are those more of an opt-in, so you are selling those into the marketplace. And I'm just curious around, what you're seeing on the uptake side. So really two questions here, how I think about the future, and if we have changes, what that could do to the profit of the model, and then secondly, the uptake around this."
},
{
"speaker": "David Cordani",
"content": "Morning, Lisa. It's David. I'll start and I'm going to ask Eric to expand. I think your latter part of your comment and question was the summary you are seeking. At the enterprise level, we do not see this as a change to our profit model. So I'll come back to that headline in a moment. We've worked for an elongated period of time through innovation, through ongoing efficiency, to continue to deliver more value while maintaining an attractive margin, and by maintaining it a stable low single digit margin, which we think is responsible given the nature of this book of business. Coming back up to the top, I'd ask you to not think that your statement was 20% of the profit is correlated to rebate retention. The vast majority of rebates are passed through today. The model has evolved rather rapidly for the vast majority of all rebates being passed through. We continue to offer choice in the marketplace. There are instances where employers, large sophisticated employers, or collective bargaining arrangement unions want to continue to use rebates a little differently in their overall benefit program. And then to the core of the center part of your question, we're really excited about, and I couldn't be more appreciative and proud of the innovation of our team with the most recent innovations we announced this week, which take even more precision to identify those patients who due to deductible phases or otherwise have some financial dislocation. As I noted, 80% of all Express Scripts customers have less than $100 cumulative out of pocket through the course of the entire year. However, we recognize some have more, and we need to bring more precision there, and that's where some of the new innovations are targeted. So I'll ask Eric to expand a little bit more on those exciting innovations."
},
{
"speaker": "Eric Palmer",
"content": "Great. Thanks David and good morning Lisa. As David noted, as you noted, we announced yesterday a couple of additional enhancements that just build on our track record of innovations to make medicines more affordable. So first, we announced that customers will not have to pay less price at the pharmacy counter, and regardless of where they are at with deductibles, our go forward approach will be to ensure that they get the benefits of the discounts we negotiate. Second, for customers who are in a phase of a deductible or a coinsurance plan, we'll work to ensure that they receive the same price as their underlying plan would pay, and we also announced an additional series of patient and plan sponsor level reporting enhancements building on the transparency we deliver. So taken together, those are just another example, set of examples in our track record and our history of continuing to bring innovations to market. And then the kind of last piece of your question, I'd expect this will be the default way that we bring these solutions to market for employers and the like. As David noted, our clients undertake significant work to structure their benefits in a deliberate way, and we offer them choice in how they wish to structure them. But as the years passed, rebate value that we share with our clients is continuing to increase, and we're proud of the choices we're able to offer and the work that we do to bring improved affordability to medicines to the millions of people we serve."
},
{
"speaker": "Lisa Gill",
"content": "Great, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from AJ Rice with UBS. Your line is open. You may ask your question."
},
{
"speaker": "AJ Rice",
"content": "Hi, everybody. Just to maybe get a little bit of clarification on a couple of points with respect to the 2025 guidance. I think now, and when you gave some preliminary comments on third quarter, I don't think you had incorporated this, but now you're incorporating the sale of the MA book by the end of the first quarter in the outlook as well as presumably some redeployment of that capital. I'm trying to figure out how much, what is the underlying assumption around what that does to the earnings outlook of the company when you start to factor that in. Also, I think the other aspect of the 2025 outlook was there was some pressure on the Evernorth margin at ‘24 related to the big new contract wins that you are absorbing, and that there was presumably going to be some favorable step up in ‘25 as that contract, that one big contract, in fact, matured a little bit. Are you assuming some level of step up on that or are you now sort of assuming it's sort of steady state margin?"
},
{
"speaker": "Brian Evanko",
"content": "Morning, AJ. It's Brian. So let me do my best with your questions here. The former, in terms of the Medicare divestiture, as I mentioned earlier, on track to close in the first quarter. We reflected that in the revenue and the income guide, as well as the capital deployment expectations here for the year. And you can think of it as about $12 billion of revenue from 2024. That will be obviously removed with the divestiture. We'll recognize a stub year here with one month of January revenue and then whenever the closing date happens to be in February or March. As it relates to capital deployment, as I mentioned earlier, we expect to use the majority of the proceeds for share repurchase. That's reflected in our share count guide. And then relative to the other contributions, when you think about the Cigna Healthcare income guide, the removal of Medicare is reflected in that. So maybe just to put a finer point on that, if you look at our segment income guide for Cigna Healthcare this year and you compare it to 2024, if you look at 2024's actual income and remove the contribution from the Medicare financials, remove the stranded overhead from the divestiture, and remove the favorable prior year development that we saw in 2024, the normalized Cigna Healthcare earnings would have been slightly below $4 billion in 2024. So that just gives you a basis to compare our 2025 outlook, reflecting the removal of Medicare and the removal of the prior year development, and we do not forecast a future prior year development. As it relates to the client contribution in Evernorth and the guide that I walked through to the earlier question that Charles asked me, the implied normalized growth rate that I referenced being within our 5% to 8% long-term growth rate range reflects the continued maturation of our large client contracts. So it's in there. The relationship continues to be very strong across the teams and we're pleased with the overall financial contribution of that relationship."
},
{
"speaker": "AJ Rice",
"content": "Okay, thanks a lot."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Scott Fidel with Stephens. Your line is open. You may ask your question."
},
{
"speaker": "Scott Fidel",
"content": "Hi, thanks. Good morning. I just wanted to sort of put the stop loss repricing efforts into some context. You know, first just curious around the fact that we know that the stop loss pressures were not unique to Cigna. We did see data points during the quarter from other large stop loss carriers, also discussing very similar effects. So the first piece would be as you reprice the business in ‘25 and into ’26. Do you think that the persistency of the clients may benefit from the fact that others in the market will also be needing to take similar pricing actions? And then, when we think about the sort of the renewal cycle of the clients that typically take stop loss for Cigna, which has always been a bit more weighted towards selected in middle market, there's a different renewal cycle for those clients. They're not as entirely weighted to sort of Gen 1, for example. So basically, also if you could remind us, for ‘25 basically, walk us through how much of the business you still have an opportunity to reprice on where you've seen these higher stop loss costs. Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Scott. It's Brian. So as it relates to your first question in terms of the client relationships, the timing to recover, etc., and putting that into context, as I mentioned to the earlier question I think Stephen had asked me, it’s important to keep in mind, these are all integrated client relationships where we have both, the first dollar and the stop loss coverage. And if you look across the totality of the relationships, on average, about 20% of a given client's cost is stop loss oriented in terms of the clients that choose to work with us on stop loss. About on average, 20% of it is stop loss. Some are higher, some are lower, depending on how much risk appetite they have, how much risk they seek to transfer. So the point being, a point of overall claim cost is only 20% of that on the stop loss. So there's a little bit more of a buffer here as it relates to repricing in terms of the overall client persistency, which in our estimation gives us an advantage being an integrated stop loss carrier compared to the standalone stop loss carriers who might be competing up against this. Now, your question on the renewal cycles, the way that our stop loss products happen to work, it's actually a little bit more tilted toward the beginning of the year. So we have about two-thirds of our stop loss premium that renews in the first quarter, given that we also have large clients who purchase stop loss from us. So it's not quite as uniformly distributed throughout the calendar year as our select segment happens to be. And as a result of that, that's one of the primary reasons why we're not able to recapture more in 2025. Again, we have the confidence that we'll capture a majority of that 100 basis points at Cigna Healthcare margin expansion in 2026 with any residual in 2027."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Erin Wright with Morgan Stanley. You may ask your question. Your line is open."
},
{
"speaker": "Erin Wright",
"content": "Great, thanks. So you spoke to the buyback authorization increase, but how are you thinking about, I guess capital deployment from an acquisition standpoint, and just any sort of change in your thought process around the regulatory environment on that front or just your broader framework and thought process around acquisitions, I guess, has anything changed there? Thanks."
},
{
"speaker": "David Cordani",
"content": "Erin, good morning. It's David. First, to frame the M&A question, our capital priorities remain intact and consistent in terms of how we deploy our capital in terms of supporting the ongoing growth of the business, including our CapEx, which we have a disciplined process attached to that, and then evaluating both, strategic M&A and ongoing deployment of targeted M&A activities, which I'll come back to in a moment. And as both Brian and I noted, an attractive dividend sits in there as a part of it that continues to grow. Now, specific to M&A, first, our three growth platforms continue to perform well, and we just highlight and amplify how pleased we are overall with the sustained performance there and call out the specific significant growth opportunity we continue to see in the specialty and care platform. By way of just our actions and our words lining up, as we noted, we deployed in excess of $8.5 billion in 2024, mostly for share repurchase, as well as with dividend payments, and our capital outlook and our cash flow outlook of greater than 10% cash yield for 2025 remains attractive. So as we look forward, we will continue to evaluate strategic, what we consider bolt-on acquisitions that will advance our portfolio, but our ongoing growth of our core platforms will be the underlying driver, and we will support that with ongoing share repurchase, as we believe that is a prudent ongoing investment back into the organization, and we'll evaluate those targeted bolt-on acquisitions as they make good strategic sense for us."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Andrew Mok with Barclays. Your line is opening. You may ask your question."
},
{
"speaker": "Andrew Mok",
"content": "Hi. I understand the different mechanics of the stop loss business, but if you're seeing pressure in that part of the business related to higher specialty cost trends, I'm a little confused why you are not seeing that pressure on the fully insured part of the business. Maybe you can help clarify that. Thank you."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Andrew. It's Brian. So as it relates to your question on the different pockets of the Cigna healthcare portfolio, maybe I'll expand a little bit on the MCR performance for the different components. But again, I'd come back to something I said earlier, where the all-in cost structure that we saw in 2024 was comparable to what we expected it to be, an elevated cost structure, but comparable to what we had planned in price for in totality. But the mix of those costs shifted more toward high-cost claimants than what we had been anticipating coming into the year. If you think about the Cigna healthcare portfolio in aggregate, you can think of it as three broad components. So the largest portion of Cigna Healthcare, which represents about 60% of the Cigna healthcare premium and is unrelated to stop loss, unrelated to Medicare, so think of everything else, broadly in line with expectations. And we ended the 2024 full year with an MCR of around 80% on that block of business. So that 60% ran at about 80% MCR. And we're projecting a roughly similar MCR performance in 2025 for that portion of the book, as our pricing yields are expected to track cost trends on that portion. The second component is our Medicare business, which represents about 25% of the Cigna healthcare premium and ran broadly in line with expectations in 2024. And then the final 15% is the stop loss products, the stop loss products. So for 2024, as I mentioned in Justin's earlier question, the overall stop loss ran in the low 90s on that 15% portion of the book. So we ended up seeing, within the total healthcare pie, a shift toward more high-cost individual claimants, putting pressure on the stop loss line, but the all-in fully insured products ran broadly in line with expectations. David, do you want to add anything?"
},
{
"speaker": "David Cordani",
"content": "Sure. Thanks Brian. And Andrew, maybe just to give you an illustration to click that down a notch, as you are rightfully thinking about the aggregate cost structure versus stop loss. For example, if you take facility costs for 2024, we saw a bit more moderation in lower-dollar inpatient events, but an acceleration of higher-dollar inpatient events. And you can think about those as cardiac surgical events or oncological events. In the oncological events, aided by specialty pharmaceuticals as they correlate against oncological programs. So that's an example where the aggregate inpatient may be closer to what we thought it would be throughout the course of the year, because of the deceleration or the less growth on the lower dollar inpatient costs versus the higher dollar, it aggregates more in the stop loss component. That's an illustration of what Brian was articulating. Thanks."
},
{
"speaker": "Andrew Mok",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Josh Raskin with Nephron Research. Your line is open. You may ask your question."
},
{
"speaker": "Josh Raskin",
"content": "Hi, thanks. Good morning. Just on the pending Medicare sale, asset sale to Healthcare Service Corp., are there any potential adjustments to the purchase price based on revenues, membership, MLR, and maybe a comment on the strong membership to start 2025? And then any pending approvals or any sort of last-minute things you are looking for?"
},
{
"speaker": "David Cordani",
"content": "Good morning, Josh. Its Brian. So overall, I'd just start by saying the Medicare businesses perform broadly in line with expectations in 2024, and we're on track to close the divestiture in the first quarter as I mentioned earlier. We have a very collaborative, constructive relationship with HCFC. We've completed all federal antitrust approvals and nearly all state approvals, just one more state to get through. We have typical financial adjustments to the final purchase price in terms of subsidiary capitalization and things along those lines, but nothing else that I would note that's particularly relevant to the core of your question. Now, as we approach 2025 as we always do, we employed a local market county-level bid approach, and based upon our final product positioning, we did see attractive growth in this business, specifically in the geographies and the products where we were targeting. In particular, we were pleased to see net growth coming primarily from HMO products in our more mature markets where we have years of experience and strong provider relationships. So the business is on a solid footing. We're tracking for attractive growth in 2025, and we're ready to hand it off to HCFC."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Adam Ron with Bank of America. Your line is open. You may ask your question."
},
{
"speaker": "Adam Ron",
"content": "Hey. I'd like to dig a little deeper into the Evernorth guidance. I know we somewhat touched on it already, but if you could distill it down into a couple more specific items. So just curious, like this time last year, what gave you the confidence to raise the growth rate in the segment that has now come in worse than those at higher expectations? It sounds like specialty growth in particular is coming in better, if anything. So are there any specific items like VillageMD or on-trend guarantees that you gave customers that are driving the underperformance for 2025 in the outlook? Thanks."
},
{
"speaker": "David Cordani",
"content": "Adam, let me ask Eric just to start to talk about the strategic positioning of the business and the ongoing sustained growth of the components in the business with our sustained strong performance of our PBS, and to talk a little bit about the retention rates and the growth profile, as well as the ongoing focus on the innovations within our specialty business. And then, Brian, if you can take it from Eric and just talk a little bit further around the number aspect of where Adam's question comes back to. Eric?"
},
{
"speaker": "Eric Palmer",
"content": "Adam, it's Eric. Thanks. Good morning. I'd start at the headline. We're really proud of the growth rate and the track record that we've had here. In fact, we've increased the growth rate for Evernorth a number of times over the course of the last number of years and are committed to and excited about the long-term growth rate of 5% to 8% that we see for the Evernorth portfolio overall. And I wouldn't call out anything that's changed relative to that as the long-term growth rate for the segment. We are continued and committed to delivering that. Brian walked through a couple of the specific kind of tactical items that were incorporated as we built up our 2025 specific guidance, and I think about those in the short term. But the long-term tailwinds and our positioning for innovation across both, the pharmacy benefit services and the specialty and care services portfolio continue to be set up really well. We're leaders in both of these spaces, and we think there are real opportunities for us to continue to grow and thrive there. Brian?"
},
{
"speaker": "Brian Evanko",
"content": "Thanks, Eric. And just to reiterate, there are three unique items as you look at the ‘25 over ‘24 Evernorth income growth rate. The VillageMD recognition of the dividend, that was in ‘24 and will not be there in ‘25. Stranded overhead from the Medicare divestiture, a portion of that will sit in the Evernorth P&L in 2025. And then finally, the investments that I made reference to that David covered earlier, we've earmarked at the enterprise level up to $150 million, split between the Evernorth and Cigna Healthcare segments that will hit the 2025 P&L. So those three items are discrete ‘25 over ‘24 items, but the long-term megatrends remain very intact, as Eric mentioned earlier."
},
{
"speaker": "Adam Ron",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Ann Hynes with Mizuho Security. Your line is open. You may ask your question."
},
{
"speaker": "Ann Hynes",
"content": "Hi. Good morning. I just want some more clarity on 2025 MLR. So I think you said earlier that office 6.7 billion basis stop loss was off mid-single digit. So if I do the calculation, that's maybe like around a $335 million or $340 million dollar hit versus expectation. But when I look at the 2025 healthcare EBITDA, it's about $800 million below the street. So I'm just trying to figure out what the difference is versus our expectations. Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Ann. It's Brian. So as it relates to the stop loss dynamic we were discussing earlier, that was a 2024 reference when I described the low 90s MCR on the stop loss book on the $6.7 billion of premium. For ‘25, we're expecting a slightly higher MCR on the stop loss book, because of the timing of every pricing cycle. And as I made reference, we're unable to capture all of the elevated cost trend on the stop loss for 2025. So we expect a slightly higher MCR on stop loss in 2025, and that'll be on a higher premium base, because that $6.7 billion will grow at an attractive rate again. So that dollar amount will grow in ‘25. In addition, as I made reference earlier, we do not forecast future prior year development, which was a benefit to 2024, and we have earmarked up to $150 million at the enterprise level for the provider and patient facing initiatives that David described, and a portion of that will be reflected in the Cigna Healthcare P&L. So those dynamics help to bridge, I think where you were going with the 2025 prior expectations to our 2025 guidance we've initiated today."
},
{
"speaker": "Ann Hynes",
"content": "All right. Thanks. Very helpful."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Sarah James with Cantor Fitzgerald. You may ask your question. Your line is open."
},
{
"speaker": "Sarah James",
"content": "Thank you. Since you started seeing the stop loss claims pressure into 3Q, was some of that pressure already included in the 3Q guide as more than 10% growth, and was any of the 150 investment spend included in that? Because I'm trying to run the math bridging the 8% to the more than 10%, and I kind of feel like I'm missing a few good guides. So I'm wondering if your outlook improved on some of your other businesses. Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Sarah. It's Brian. So the third quarter commentary that we made again, was not meant to be formal guidance. It was meant to be just directional guidance, and at the time we had said at least 10%, which we felt was at a prudent growth rate range at that point in time. You may also recall we had moved the MCR guide for the full year at that point in time toward the upper end of the range, because we've started to see some indications of some pressure on the stop loss, but not to the degree that ultimately manifested across the full year. So as you think about trying to do that bridge, the couple of things that I'd call out would be, we have now factored in the up to $150 million of investment spend for the provider and patient facing initiatives that David walked through, that's not new. The degree of the stop loss pressure for the full year ‘24 was greater than what we had anticipated three months ago, that's not new. And then to your point, are there other things going better than expected across the company? Directionally, you should think of the growth is strong yet again. So if you remove the Medicare business, we expect top line for the company will grow in the call it 6% range. So we expect to have another year of good growth across the enterprise. So broadly speaking, I would think of it in those different buckets. But again, the third quarter commentary was not meant to be formal guidance. It's just trying to give you some directional sense."
},
{
"speaker": "Sarah James",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Ben Hendrix with RBC Capital Markets. Your line is open. You may ask your question."
},
{
"speaker": "Ben Hendrix",
"content": "Great. Thank you for squeezing me in here. I just was hoping you could put a finer point on your 2025 earnings cadence comments. I appreciate the commentary that you would expect earnings to look a little bit more like 2023 patterns versus 2024, but knowing that we're going to be recapturing the stop loss margins over a number of years, any reason not to expect elevated 4Q cost trend in 2025 as well? Just any comments on that seasonality? Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Ben. It's Brian. So, just the nature of the stop loss products as I was referencing earlier are really full year products. And so each quarter, we're making estimates of where the final full year MCR will land for stop loss. In 2024, when the pressure was identified, it was late in the year, which is why the earnings impact showed up predominantly in the fourth quarter. But you should take that earnings impact and kind of spread it over the course of the full year 2024, which is why we're saying that ‘24 seasonality is not reflective of what a typical year should look like. So 2025, for that reason, you should think of it as more of a normal year, if you will, where typical cost-sharing seasonality will drive lower MCRs in the first half of the year and higher MCRs in the back half of the year. And we would expect the stop loss MCRs to have more of a level cadence over the course of 2025. In addition to that, there are some dynamics unique to Evernorth. For example, the VillageMD and the stranded overhead that I made reference to are more first half weighted. So they serve to depress the Evernorth income a bit on a year-over-year basis compared to the 2024 pattern. But again, the stop loss dynamic, I think is the most important point as you reflect on the seasonality of our expected earnings."
},
{
"speaker": "Ben Hendrix",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from George Hill with Deutsche Bank. Your line is open. You may ask your question."
},
{
"speaker": "George Hill",
"content": "Yeah, good morning guys. Two more quick ones, I guess, to close it out on stop loss. Number one, Brian, are there any other considerations on the stop loss margin recovery besides price, as it relates looking at the ‘26 or ‘27 that we should be meaningfully thinking about? Like, are there benefit design or kind of breakpoint levers that get pulled here that get you guys back? And then the second one is, you talked about high acuity surgical activity. I'd be interested if you could comment on whether this is elective versus non-elective, and if there's any particular procedure types you would call out."
},
{
"speaker": "A - Brian Evanko",
"content": "Morning, George. It's Brian. So on the first question in terms of the stop loss recovery and are there other factors, to the comment I made earlier, given these are integrated client offerings, the stop loss is just one component of the conversation that we have when we go and renew with clients. And as a result of that, it is not just a price conversation. It's a total relationship conversation that we tend to have. And it's not uncommon for a client to say I want to move my pooling points or my attachment points up to reflect the cost inflation that's happened over time, which helps to mitigate the budget outlay for the employer client. So those types of dynamics often do work their way into the renewal conversations. And I made reference to earlier, we have decades of experience with this business and have shown during times of both good and bad, the ability to keep persistency at strong levels with the employer clients that choose our stop loss offerings. On the high acuity surgical activity that we saw specifically, it was a little more tilted toward inpatient. And as David and I both commented, a little bit more cancer driven and cardiac driven, which we don't necessarily see correlating with elective procedures. And broadly speaking, our planning assumptions for 2025 are for the high cost claimant activity we saw in ‘24 to continue. So we see it as more of a structural shift than something that's temporary. And in the scenario where that assumption is incorrect and it is temporary, then that will offer some upside to the outlook that we've provided here this morning. But we don't see it as heavily correlated to electives."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, I'll turn the call back over to David Cordani for closing remarks."
},
{
"speaker": "David Cordani",
"content": "Thanks. I'll be brief. First and foremost, thanks for joining our call and, of course, for your questions today. A few headlines just to reinforce as we wrap up. Against the backdrop of what is indisputably a dynamic and challenging environment, we're confident in our ability to deliver EPS commitment for 2025 of at least $29.50 and remain convicted and committed to our long term growth algorithm of 10% to 14%. We also continue to focus with our specific actions on further improving the healthcare ecosystem and delivery system, and supporting our customers and patients with greater value, greater support, and expanding transparency for the benefit of all we serve. And lastly, before I close, I want to express my personal appreciation and recognition to our colleagues across the globe. We have about 70,000 colleagues that wake up every day to make a positive difference in customers' and patients' lives and, by and large, do that each and every day. And we're going to further strengthen our ability to make a difference for those who have yet even higher needs or at times we may fall short on, but a sincere appreciation to our colleagues. Thank you, and we look forward to furthering our conversation in the future."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes the Cigna Group's fourth quarter 2024 results review. Cigna Investor Relations will be available to respond to additional questions shortly. A recording of this conference will be available for 10 business days following this call. You may access the recorded conference by dialing 800-819-5739 or 203-369-3350. There is no passcode required for this replay. Thank you for participating. We will now disconnect."
}
] |
ci | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for standing by for the Cigna Group’s Third Quarter 2024 Results Review. At this time all callers are in a listen-only mode. We will conduct a question-and-answer session later during the conference and review procedure on how to enter the queue to ask question at that time. [Operator Instructions] As a reminder, ladies and gentlemen, this conference, including the Q&A session, is being recorded. We'll begin by turning the call over to Ralph Giacobbe. Please go ahead."
},
{
"speaker": "Ralph Giacobbe",
"content": "Thanks, operator. Good morning, everyone. Thank you for joining today's call. I'm Ralph Giacobbe, Senior Vice President of Investor Relations. With me on the line this morning are David Cordani, the Cigna Group's Chairman and Chief Executive Officer; Brian Evanko, Chief Financial Officer of the Cigna Group and President and Chief Executive Officer of Cigna Healthcare; and Eric Palmer, President and Chief Executive Officer of Evernorth Health Services. In our remarks today, David and Brian will cover a number of topics, including our third quarter financial results and our financial outlook for 2024. Following their prepared remarks, David, Brian and Eric will be available for Q&A. As noted in our earnings release, when describing our financial results, we use certain financial measures, including adjusted income from operations and adjusted revenues, which are not determined in accordance with accounting principles generally, accepted in the United States, otherwise known as GAAP. A reconciliation of these measures to the most directly comparable GAAP measures, shareholders net income and total revenues, respectively, is contained in today's earnings release, which is posted in the Investor Relations section of the cignagroup.com. We use the term labeled adjusted income from operations and adjusted earnings per share on the same basis as our principal measures of financial performance. In our remarks today, we will be making some forward-looking statements, including statements regarding our outlook for 2024 and future performance. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. A description of these risks and uncertainties is contained in the cautionary note to today's earnings release and in our most recent reports filed with the SEC. Before turning the call over, I will cover a couple items pertaining to our GAAP financial results. In the third quarter, we recorded shareholders' net income of $739 million or $2.63 per share. This is driven by a non-cash, after-tax, net realized investment loss of $1 billion or $3.69 per share related to VillageMD. This includes both the write-down of the remaining carrying value of the asset, as well as the impairment of the dividend, which is recognized as a special item in the quarter. This is excluded from adjusted income from operations and adjusted earnings per share in our discussion of financial results. In the third quarter, we also recorded other after-tax net special item charges of $162 million or $0.58 per share. Details of the special items are included in our quarterly financial supplement. Additionally, please note that when we make prospective comments regarding financial performance, including our full-year 2024 outlook, we will do so on a basis that includes the potential impact of future share of purchases and anticipated 2024 dividends. With that, I'll turn the call over to David."
},
{
"speaker": "David Cordani",
"content": "Thanks Ralph. Good morning, everyone and thank you for joining today's call. Today I'll spend a few minutes talking about our strong results in the third quarter and how we're advancing our growth strategy. I'll also provide some initial perspective relative to 2025, including some of the expected tailwinds and headwinds. Then Brian will share more detail about our results and our outlook for the rest of the year and we'll take your questions. So let's get started. Building on a track record of competitively differentiated performance, I'm pleased to report that in the third quarter the Cigna group delivered total revenue of $63.7 billion and adjusted earnings per share of $7.51. Our results are a testament to the collective depth and strength of our people and commitment, hard work and focus they bring to everything we do. We have deep continuity and the most experienced leadership team in the industry with more than 16-years average tenure across our growth platforms. And we continue to infuse new talent into the company from across many sectors and industries to round out our enterprise perspective. Our third quarter performance demonstrates how we harness the complementary capabilities of our two growth platforms: Evernorth Health Services and Cigna Healthcare to drive attractive growth. This quarter Evernorth anchored our results by delivering strong top and bottom line contributions generated by market leading innovation and affordability initiatives, particularly within our specialty and care services portfolio, as well as our pharmacy benefit service business. Evernorth’s strong overall growth reflects the continued demand for our services as we continue investing in broadening our offerings and expanding our reach. Cigna Healthcare was also continuing their momentum in the quarter. U.S. employer business draws on enterprise capabilities to deliver greater affordability and support healthy outcomes for the benefit of our clients and their employees and families. Of note, we are driving continued solid growth in our select customer segment. Our results demonstrate focus execution and momentum during our peak selling season and continued opportunity for growth in the years ahead. Touching on our Medicare Advantage business, we remain on track to close on our sale of our Medicare business to HCSC in the first quarter of 2025. We continue to expect to use the majority of the proceeds for share repurchase. I would note that our Medicare business is performing in line with expectations and we're pleased with the overall value of our offerings, including our nationwide enrollment weighted average will again be four stars for 2025. Going forward, our focus will be on further growing our Evernorth chassis to continue to serve Medicare lives. Overall, our quarterly results reflect clear strategy and strong execution resulting in attractive results. Now stepping back, I want to take a moment to comment on recent headlines and speculation around our company. And while we don't comment on media rumors, we believe that it is important to provide additional context during these unprecedented times. First, there is no question that the industry is highly disrupted. For example, the Medicare Advantage market is particularly challenged given a number of factors, including elevated medical costs, a significant change in SARS ratings for many, and a reset of the risk-adjusted revenue streams. These and other forces are contributing to operational disruption for some as well. As I noted, we don't comment on rumors. But what I will do is be very clear on the actions we are pursuing. We continue to deploy our excess free cash flow for share repurchase, with repurchases totaling $5.7 billion year-to-date, including over $715 million in October. Looking forward, we expect to continue to actively repurchase our shares in the fourth quarter, further leveraging our remaining repurchase capacity, which stands at $5.6 billion. Now I want to transition and cover several actions we are driving in the third quarter and throughout 2024 that address the forces of change that are reshaping the face of healthcare, while we continue to position our company for growth for the benefit of our clients, our customers, and our patients. The first is the pace and rate of pharmacological innovation, and it continues to surge. Many of the treatments coming to market are meaningful in extending and improving quality of lives, for example, through new gene therapies and breakthrough treatments, but they are pressuring affordability given the high list price for manufacturers. Evernorth’s specialty pharmacy business, Accredo, is continuing its strong growth trajectory given both the secular tailwinds and our differentiated strengths, which make us the market leader in the space. The opportunity in biosimilars is a good example of how we are leading the way in providing more value. At the end of June, we began dispensing our interchangeable biosimilar for Humira. And we're pleased that biosimilar penetration was approximately one-third among eligible accredited patients in the quarter. Building on that success, several weeks ago we announced that we will begin offering an interchangeable to Stelara Biosimilar in 2025. Like Humira Biosimilar, it will be available for a $0 out of pocket for eligible Accredo patients, which drives savings for individuals as well as clients. Another example of our leadership is the GLP-1 drug class, which is on pace to be the number one drug trend driver for plants this year. Now, they're expensive with manufacturers' list price of approximately $15,000 a year. Express Scripts, our pharmacy benefit service business, the EnCircle Rx solution provides a clinical program wrapper around the medication to help to support sustainable and positive lifestyle changes for patients, as well as improve affordability and access for clients. I'm pleased to share that in the quarter, EnCircle has already grown to almost 8 million lives now enrolled. The pace of change in the pharmacological industry is also why we continue to proactively address misconceptions and misinformation around the pharmacy benefits industry. This is vital to ensure that patients and individuals continue to maintain access to affordable, high-quality prescriptions. Earlier this month, Dr. Dennis Carlton, Professor of Economics Emeritus from the University of Chicago and former DOJ economists released a comprehensive review of the PVM industry. Dr. Carlton's research was conducted over 16-months and drew from multiple sources, including analysis of approximately 20 billion 30-day equivalent prescriptions. The finding of Dr. Carlton’s research in direct contradiction with the FTC's report concludes that PBMs lower high drug prices by fostering competition among [tribal] (ph) drug manufacturers and pharmacies. PBMs facilitate broader access to generic medications in addition to name brand alternatives, which lower costs. And importantly, PBM support independent pharmacies with higher reimbursement rates than chains. And the number of independent pharmacies is increasing. We will leverage Dr. Carlton's study as we continue to engage in fact-based discussions about these critical issues. Moving to the second rapidly changing trend, the increased need for quality behavioral services, which is in part driven by geopolitical, economic, social dynamic tensions that are unfolding around the globe. For context, in the past five years, we've seen overhaul behavioral therapy utilization nearly double. Now in the same period, we worked to increase services and access, for example, adding almost 270,000 providers to our network, assessing the needs of those with lower complexity issues and offering new coaching programs, and implementing online scheduling and access with appointments guaranteed within 72 hours, which millions of Cigna Healthcare customers can now pursue. This is another example of how our businesses have complementary capabilities as we leverage behavioral health innovations and services from Evernorth and embed them into Cigna Healthcare Solutions. The final trend that I will touch on is technology-enabled innovations. We're only beginning to see the start of profound changes as emerging technologies such as AI-powered diagnostics and treatments will drive vast improvements including more personalized care. Another example is the ongoing adoption of virtual services which is rapidly rising with about 25% of patients accessing care through telehealth services last year in the U.S. This far exceeds the 5% or fewer who accessed care this way prior to the pandemic. We continue to advance in this area with our telehealth platform MDLIVE. We have offered MDLIVE for our customers since its acquisition in 2021. And last month we took another step forward with patients that have lower health risk issues enabling them to get fast, flexible care without a phone call or video call, whenever and wherever they want, with MDLIVE physicians via an online portal. And patients typically are able to receive treatment within one hour. At the Cigna Group, we're built to create and capture value from these forces of change for the benefit of those we serve. Next, I'll transition to provide some context relative to the tailwinds and headwinds we anticipate for 2025. Now we'll provide detailed guidance as we always do during our fourth quarter call. With the strength of our Evernorth and Cigna Healthcare platforms, we expect to both finish 2024 strong and for 2025 to have another year of competitively attractive performance. Some notable tailwinds include our continued ramp-up of biosimilar offerings, continued advancement of new client relationships, and EPS accretion from the divestiture of our Medicare business, specifically the impact of share repurchase from the sales proceeds. Now turning to headwinds, we expect lower net investment income as we will no longer recognize the dividend from our VillageMD investment. We anticipate some stranded overhead from the sale of our Medicare Advantage business, which we will mitigate over time. And we will make continued strategic investments across our portfolio to drive sustained innovation and position ourselves for long-term growth. Considering all the puts and takes, we expect another strong year of growth in 2025 with EPS growth of at least 10%, which is consistent with our historical approach when we start the year with appropriate prudence. Now I'll briefly summarize our performance for the quarter. Building on our momentum, our focus in discipline third-quarter execution positions us to meet our full-year 2024 and long-term growth targets. The Cigna group has earned a reputation for delivering differentiated value for those we serve and driving new innovation in ways that lead the industry. Our ability to consistently do this year-after-year is directly attributable to the strength of our leadership team and the passion and commitment of our 70,000 colleagues worldwide. And the deliberate structure of our company, which is designed with growth platforms capable of navigating even the most dynamic environments. As a result, in the third quarter, we delivered on our financial commitments with adjusted EPS of $7.51, and we remain on track to deliver full-year adjusted earnings per share of at least $20.40 in 2024. Our company has attractive and sustainable growth opportunities over the long-term and we remain confident in delivering our continued average annual EPS growth rate of 10% to 14% on average, building on our track record of achieving 13% adjusted EPS on a compound growth rate over the past decade. With that, I'll turn it over to Brian to share additional perspective on our performance for the quarter and our outlook for the rest of the year."
},
{
"speaker": "Brian Evanko",
"content": "Thank you, David. Good morning, everyone. Today I'll review Cigna's third quarter 2024 results and discuss our outlook for the full-year. During the year where the environment has been highly disrupted and dynamic, we're pleased with another quarter of strong results, highlighting our consistent execution and delivering against our prior commitments. Key consolidated financial highlights for the third quarter include revenue of $63.7 billion and adjusted earnings per share of $7.51. These results, combined with our breadth of capabilities in diverse portfolio businesses, reinforce our confidence in our full-year 2024 adjusted earnings per share outlook of at least $28.40, representing more than 13% year-over-year growth. Now turning to our segment results, I'll first comment on Evernorth. Evernorth continues to deliver strong results driven by consistent execution across our businesses with particularly significant growth within our specialty and care services business in the third quarter. Total Evernorth revenues for third quarter 2024 grew to $52.5 billion and pre-tax adjusted earnings grew 9% to $1.9 billion, slightly ahead of expectations. This growth came despite a $33 million headwind to net investment income related to the absence of the VillageMD dividend. Our strong Evernorth results reflect our continued execution amidst the ongoing long-term trend of pharmacological innovation. With rising clinical needs, the introduction of new therapies to the market, and more availability of biosimilars, Evernorth is well positioned to assist patients and clients in navigating these trends. Moving to our businesses within Evernorth, specialty and care services revenue of $23.8 billion and adjusted earnings of $825 million both grew 23% in the quarter, a significant acceleration in year-over-year growth when compared to the first-half of 2024. While we had expected strong contributions in the quarter, this performance was above expectations, reflecting growth across our specialty businesses driven by more rapid uptake of specialty medications. Additionally, the quarter also benefited from increased adoption of Humira biosimilars. The increased adoption benefits both patients through lower out-of-pocket costs, as well as clients through lower net costs. And in the quarter, we saw approximately one-third of eligible Humira scripts transition to biosimilars. As we have highlighted, we are the leader in the specialty market. We are confident in delivering long-term profitable growth, given the pipeline of new drug innovation and our decades of experience in the space, as we've established a differentiated business model with proven, superior clinical outcomes for complex, high-cost conditions. Pharmacy benefit services also posted robust revenue growth driven by the addition of new business wins, expansion of existing relationships, and continued demand for new drugs through our innovative products and solutions. Pre-tax adjusted earnings increased to $1 billion as our differentiated capabilities continue to drive affordability and value to our patients, customers, and clients. Overall, Evernorth delivered results slightly above expectations, even while absorbing the aforementioned net investment income headwind. And we continue to expect accelerating growth in the fourth quarter. Regarding Cigna Healthcare, third quarter 2024 revenues were $13.3 billion. Pre-tax adjusted earnings were $1.2 billion and the medical care ratio was 82.8%. The medical care ratio was in line with expectations. As we have discussed, we planned and priced for elevated trend coming into the year. During the quarter, we did observe elevated trends in specialty medications in our Cigna Healthcare book. This is consistent with the higher volumes we saw in our specialty and care business within Evernorth and speaks to the balance of our well-diversified portfolio, which we intentionally created to position our company for some of the highest growth secular tailwinds in healthcare. Overall, Cigna Healthcare delivered solid results this quarter, demonstrating consistent, steady execution in a dynamic environment. Now turning to our outlook for full-year 2024. Given the strength and diversity of our portfolio, we have the confidence to reaffirm our full-year 2024 expectation for consolidated adjusted earnings per share of at least $28.40. Moving to our 2024 outlook for each of our growth platforms, in Evernorth we continue to expect full-year 2024 pre-tax adjusted earnings of at least $7 billion. This reflects a continued acceleration of earnings in the fourth quarter, driven by strength and specialty volumes and increasing adoption of Humira biosimilars, as well as the continued advancement of new client relationships. This is partially offset by lower expected net investment income. For Cigna Healthcare, we continue to expect full-year 2024 pre-tax adjusted earnings of at least $4.775 billion. And we are maintaining our full-year medical care ratio outlook of 81.7% to 82.5%, although we now expect to be toward the high-end of the range due to the aforementioned increase in specialty medication utilization, which we expect to continue through the fourth quarter. We expect the impact of the higher fourth quarter MCR to be offset by other levers within Cigna Healthcare, such as operating efficiency. Turning to our 2024 capital management position, we remain confident in our strong balance sheet and cash flow generation due to our efficient asset-like strategy that delivers attractive returns on capital. I would note that timing-related items impacted third quarter cash flow from operations. We are anticipating a meaningful step up in cash flow in the fourth quarter, and our capital deployment priorities remain consistent with our long-term framework. Regarding share repurchase, year-to-date through October 30, 2024, we have repurchased approximately 16.9 million shares of our common stock for approximately $5.7 billion, including our repurchase of $715 million in the month of October alone. We continue to expect additional share repurchase in the fourth quarter, demonstrating our confidence in the strength and sustainable growth of our business. Now to recap, strong results through the first three quarters of the year give us confidence to deliver on our full-year 2024 adjusted earnings per share outlook of at least $28.40, representing over 13% year-over-year growth toward the higher end of our long-term average adjusted EPS growth target range. As David mentioned, we look forward to providing our 2025 outlook on our fourth quarter earnings call. We are confident in delivering another year of competitively differentiated EPS growth of at least 10%, consistent with our historical approach where we start the year with appropriate prudence. The ability to consistently meet our financial commitments is a testament to our team executing to drive value for our clients and customers and our portfolio of complementary businesses that we've strategically positioned for strong, stable, and sustainable long-term growth. And with that, we'll turn it over to the operator for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of AJ Rice with UBS. Your line is open."
},
{
"speaker": "AJ Rice",
"content": "Thanks, hi everybody. Maybe I'll just ask about two things here. One, you obviously had a little bit of an elevated commercial trend this year, but you said all year long that you were able to price for it and anticipate it? I wonder at this early date as you look out to ‘25, are you assuming more of the same? Are you getting any pushback from employers on taking that approach if you are, again? And then on the VillageMD, I know you'd laid out a strategy for working with them as one of the ways that Evernorth could address the primary care market. Obviously, that situation's in flux. I wonder if there's any pivots the company's considering and how important putting something in place with respect to physician groups, particularly primary care, it is for the overall Evernorth strategy."
},
{
"speaker": "David Cordani",
"content": "Good morning, AJ, it's David. Let me ask Brian to take your first question relative to trend ‘24 and ‘25, and then I'll provide a little call around Village and specifically our value-based care strategy and where we go from here. Brian?"
},
{
"speaker": "Brian Evanko",
"content": "Good morning, AJ. So first off, we're very pleased with the strength of our U.S. employer business within Cigna Healthcare. That business continues to perform well for us. And as a reminder, our U.S. employer book is nearly 85% ASO or self-funded, which includes earning levers that go well beyond the peer risk-based MCR. That said, our U.S. employer book is currently operating from a position of strength as we've been performing within our target margin ranges here in 2024. As it relates to the external market to your point on employers, we characterize the environment as competitive but rational, and we've remained disciplined with our own pricing strategy in this environment. As it relates to 2025, we do expect cost trends to remain elevated above historical levels, and we're pricing for 2025 rate increases that are greater than what we achieved in 2024, given that continued elevated cost trend expectation, the firm competitive environment, as well as our desire to preserve our margin levels. So David, I'll turn it over to you to talk about the Village piece."
},
{
"speaker": "David Cordani",
"content": "Sure. AJ, so relative to Village, you brought up part of your question, talks about the strategy. So stepping back first and foremost, VBC, Value-Based Care, from our point of view is how do we align incentives, leverage information, and then leverage clinical resources and extenders to deliver improved overall quality and ultimately value. Within our Cigna Healthcare platform, that's done day in, day out for collaborative accountable care relationships, and those relationships continue to evolve. Those are partnered relationships, leverage relationships that we drive forward. Increasingly, some of Evernorth's capabilities are in support of that. Second, specific to the VillageMD relationship, we sought to accelerate that through our Evernorth Accountable Care relationship for lives and patients outside of those that were within our program and chassis on the benefit side of the equation. And in hindsight, the timing of that, given the disruptions at the marketplace, including the risk-adjusted disruption and some of the cash flow disruption from some of the underlying investors proved to be poorly timed. Moving forward from an Evernorth standpoint, the Evernorth Accountable Care relationships will continue to probe and identify where and how we can expand relationships. I would note that we do continue to make very good progress of deepening relationships with healthcare professionals out of Evernorth, specifically off of our CuraScript capabilities that could use to grow meaningfully. But we will continue to take a paced path with the Evernorth Accountable Care relationships currently given the disruption, again, meaningfully caused by the change in the risk adjuster environment. Thanks, AJ."
},
{
"speaker": "AJ Rice",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Justin Lake with Wolfe Research. Your line is open."
},
{
"speaker": "Justin Lake",
"content": "Thanks. Good morning. First, I want to follow-up on, David, your comments around capital deployment and some of the rumors out there in the market. Just to be clear, do you, you talked a lot about the share repurchase in 2024, which has been significant. The fourth quarter, the proceeds, are you -- the last time we had this discussion, you also talked about a forward year and where you kind of saw the predominance of capital going as well. Are you also saying -- or did I miss that you were going to talk about that you are going to deploy capital to share repurchase or the vast majority of the share repurchase in 2025 as well? And then just on the business, can you give us some more color on what's going on in Specialty? There have been a few companies talking about that. What do you think is driving that? And any other specifics you can give us, we'd appreciate."
},
{
"speaker": "David Cordani",
"content": "Justin, good morning, it's David. Let me take your first question, and then I'll ask Eric to give you, I think your broader second question is relative to what's transpired in the Specialty space. So first, to the specific part of your question, you didn't miss anything I communicated. We've not provided detailed guidance for 2025. We'll provide more comprehensive guidance as we always do on our fourth quarter call and we look forward to doing so. Second, stepping back, as I noted in my prepared remarks, given the disruption in the space, we wanted to ensure that we had as much information out there and the clarity of put forth. I'd ask maybe to step back and reflect for a moment. If you think about to the core of your question, what we've done, our actions that both Brian and I reinforced meaningful share repurchase in 2024, which has been on a repurchasing through the month of October and expect it to continue to repurchase in the fourth quarter. If you reflect back on the last four years, we've repurchased about $24 billion of our stock, right? That was strategically guided as we were harnessing the benefit of the combination. We did have some divestitures within the context of that and as we leverage the broad cash flow generation of our asset-light portfolio and capabilities. So I would ask you to stay tuned for more comprehensive 2025 guidance, but reflect on our disciplined track record of being a good steward of capital and demonstrating the ability to create real sustained shareholder value in the way we deploy capital. Eric, I'll ask you to talk about the Specialty space."
},
{
"speaker": "Eric Palmer",
"content": "Great. Thanks, David. And good morning, Justin, it's Eric. As we find at our Investor Day earlier this year, the Specialty market is a $400 billion market and growing. And we're leaders in this space, driven by our focused condition-specific model, our clinical expertise and our overall geographic reach. And this positions us well to be helpful to our clients across the board, whether it's health plans, employers, health systems and the like. Now specific to this quarter, this was the first full quarter where we dispensed our biosimilar Humira. And additionally, we had some expansion with existing clients choosing to move more business to Accredo. And we had broad-based volume strength as well. And I'd call out therapies for inflammatory conditions, for oncology and neurology as areas with particularly strong growth in the quarter. With respect to the 23% growth in the quarter, we've noted in the past that the results in any given quarter is going to depend on the timing of new volumes, new customers, new therapies being available and so on. But over time, we expect this market to be a meaningful part of the growth of our enterprise. We've talked about our Specialty and Care Solutions space growing at 8% to 12% on a sustained annual basis. And all of these factors are built into our assessment there. So we continue to be well positioned in this market and quite excited about the opportunities to serve the market to grow and to serve our patients. Operator Thank you. Our next question comes from Ryan Langston with TD Cowen. Your line is open."
},
{
"speaker": "Ryan Langston",
"content": "Hi, thank you. I think in the prepared remarks, you said you had 8 million lives now on the EnCircleRx program. My understanding is that was only -- I say only about 3 million to 5 million only just a couple of months ago. That seems like incredibly strong growth and demand. I guess, what's driving that? And I guess, where do we see that pick up moving over the next couple of years, just given it seems in the past couple of months, that's risen pretty dramatically?"
},
{
"speaker": "Eric Palmer",
"content": "Good morning, Ryan, it's Eric. Thanks the question. As you can imagine, there's real interest in need from our clients is they're looking for help with managing the affordability of GLP-1s and these conditions overall. We're really excited about the opportunity to bring this first of its kind solution to the market. And as David noted, I think you said we're almost at 8 million lives. So not quite there yet, but approaching it rapidly. We launched this program just a handful of months ago. And as we've talked about previously, it targets the right patient population, working to bring the relevant clinical markers and engage patients with the support they need to help make changes that make the impact last, provides a guaranteed clinical comes to our clients and provides a strong overall return for the investment in the program. Performance so far is that the solution is working well. The early results, our clients are enrolled. They're seeing significant savings and reductions in trends compared to those who are not enrolled as we mature the process or mature the data, we'll have more to report here. David, maybe any other perspective you want to share?"
},
{
"speaker": "David Cordani",
"content": "Sure. Thanks. I'll just amplify two points. As we all spend a significant amount of time in the market, we're a field-based organization. This is typically a top one, two or three topic with clients, with brokers, with consultants and with others in the market. So as we noted, GLP-1s remain front and center. The specific piece I would add, though, is as the market continues to absorb the challenges of affordability, the market also is observing and clients are observing and physicians are observing the start and stop dynamic that is transpiring for some patients, which also doesn't generate the desired or intended outcome if a patient starts on a regimen and stops in eight months and then maybe starts up and then maybe stops as well. So folks are really -- the value proposition really resonates relative to the clinical wrappers, the care wrappers, the coaching wrappers, the behavioral support wrappers that exist in the value-based care nature of the underlying program. So I appreciate you calling out the growth because it is significant and it underscores the need for innovation that we lead as these new treatments come to market."
},
{
"speaker": "Ryan Langston",
"content": "All right. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Lisa Gill with JPMorgan. Your line is open."
},
{
"speaker": "Lisa Gill",
"content": "Thanks very much. Good morning. Can you maybe talk about the 2025 selling season on the PBM side? I'm just really curious around a few things. One, as we have more biosimilars, are we seeing a change in the economics of how contracts are formulated going into 2025? And then just as a follow-up, David, you highlighted the FTC report and the report that the University of Chicago professors looked at. Is there any update on potential legislation or anything you're seeing from a state perspective that potentially is using some of this information when they're thinking about legislation?"
},
{
"speaker": "David Cordani",
"content": "Lisa, it's David. Let me ask Eric to start with the Evernorth selling season, including the PBM dynamic and what's transpiring and then I'll address your FTC question."
},
{
"speaker": "Eric Palmer",
"content": "Thanks, David. Lisa, fundamentally, we start with a portfolio that's equipped to offer choice and flexibility in how we work to support our clients. We work to make the pharmacy benefit accessible for the patient and more affordable, and we continue to innovate to bring new ways to the market to do that. And stepping back, Evernorth is well positioned to continue to grow. The strength of those innovations and our solutions continue to resonate. And just as we talked about the growth EnCircleRx, we continue to have growth in our various innovative programs. Now specifically with respect to the pharmacy benefit services business for 2025, we had a good 2025 selling season, and our retention rate continues to be consistent with recent years in the mid- to high-90s percent range. We're driving meaningful innovations, whether it's EnCircleRx, our oncology benefit services are just recent examples. And we're positioned for another good year in 2025. As far as change, again, I'd say there's good interest in discussing what services, what financing arrangements are going to best align with our clients' needs, but I wouldn't call out any wholesale or substantial change in terms of what our customers and clients are actually purchasing from us. David?"
},
{
"speaker": "David Cordani",
"content": "This is relative to the FTC, I think the end of your question really pointed toward legislation, but let me just pull back for a moment. First and foremost, and you know the space extremely well, right? PBM and pharmacy benefit service industry exists to create real, sustained differentiated value through improved affordability, through expanding access to services that are more affordable like generics, through patient coordination and clinical coordination programs, which are especially critical for the chronic and polychronic population. And as a validation of the value we deliver, our client retention levels reinforce that with historic client retention levels in the 95% plus range. And as we look to the year ahead in 2025, it being even at the higher end of that range. And secondly, as we've talked about, whether it's through EnCircleRx, through the biosimilars, our ability to continue to lead the market with innovations that deliver more value especially with new treatments coming to market is mission-critical. Specific to the FTC report, let me be really clear. We disagree on the unfounded assertions that were put forth. Second, the clear direction that was put forth by Dr. Carlton's report is in direct contrast to that. And going forward, we will engage in fact-based conversations. As it relates specifically to legislation, we do not see any specific fully mature proposed legislation right now that looks like it will be put forward. Obviously, there's a bit more time left in the year. There's no doubt relative to that. We remain actively engaged. I was in Washington on Monday of this week on a variety of topics. We remain actively engaged. But I think most importantly, at capping it off, we're confident in the durability of our model, our proven ability to partner, our proven ability to drive ongoing innovation to make sure we are able to continue to grow and deliver the value, both in the pharmacy benefit service space as well as in the specialty space."
},
{
"speaker": "Lisa Gill",
"content": "Great. Thanks for the comments, David."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Andrew Mok with Barclays. Your line is open."
},
{
"speaker": "Andrew Mok",
"content": "Hi. Good morning. You called out planned investments across both core PBM and specialty in the release, and it sounds like that will continue into 2025. Can you give us a little bit more detail on the nature and magnitude of those investments? Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Andrew, it's Brian. So as we intend to do in any year, we have a fair amount of our discretionary capital that goes back into internal reinvestments. So when we talk about the continued investment in the business, not just in the Evernorth platform, but also in Cigna Healthcare, that's a core part of our capital deployment framework before we start talking about capital being returned to shareholders. So this year, we're tracking to, call it, $1.5 billion or so of discretionary CapEx, and that's kind of over and above the core administrative expenses, which are round numbers about $20 billion that we spend in the year. So most of that will go toward technology going forward, so that some of that customer patient-facing technology. Some of that is provider-facing technology, and some of that is a broker or field-facing technology as well. So the majority of when you think about our discretionary CapEx is headed in that direction. And as we think about the long-term growth opportunity we have, for example, in the specialty space, which is already a $400 billion addressable market growing at the secular high-single-digit type rate. We see opportunities to continue strengthening our capabilities there to make ourselves even more relevant. So think of it as primarily technology, and we gear that up or down in any given year."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Erin Wright with Morgan Stanley. Your line is open."
},
{
"speaker": "Erin Wright",
"content": "Thanks so much. I wanted to dig into specialty a bit more. It just sounds like you're seeing the traction with the Humira biosimilar strategy. Just how would you compare that to the strategy around products like Stelara and the ramp you expect with Stelara relative to what you saw with Humira and other biosimilars that are coming down the pipe? I guess, how do you think about the cadence of that opportunity over the next several years but also just in terms of 2025 from an LOE perspective? Thanks."
},
{
"speaker": "Eric Palmer",
"content": "Hi, Erin, it's Eric. I appreciate the question. Stepping back, I think the model that we've built here and that we've deployed around our biosimilar Humira has provided another good choice in the market, and it's one that we think we're well positioned to replicate in the appropriate situations going forward. As David mentioned in his prepared remarks, we will be launching a no out-of-pocket cost alternative to Stelara in 2025. And I could envision us using this playbook and approach for additional biosimilars as we look ahead into the coming years. We've noted at our Investor Day earlier this year that we see nearly half of the specialty market having biosimilar alternatives choice available in terms of bringing new affordability to the market. And this is one example of a strategy that will help to improve the affordability and the accessibility of these medicines for the patients that need them and for the plan sponsors that are funding them. So every different therapy will have a different alternatives, they will have different kind of adoption of paths based off of the clinical needs of the patients being served based off of the break and pace of availability of products and such. But at a macro level, we're really well positioned to continue to lead in this market and bring new solutions to market just like we did with the biosimilar Humira, like we are in the process of doing with Stelara and like we'll do with other drugs coming after that. David?"
},
{
"speaker": "David Cordani",
"content": "Erin, just one point I want to add to Eric's comment relative to the specialty market specifically, and maybe it's a statement of the obvious, but when we operate in an environment of elevated medical cost pressure which the industry is seeing in a broader sense, you could also think about the high-performing nature in this case, of our specialty capabilities, both through Accredo as well as through CuraScript, in some ways, provides us a natural or structured hedge against the medical cost pressure that is natural to manifest itself on the benefit side of the equation. So when we talk about the conscious way, we've structured the corporation, we've structured it, obviously, with different addressable markets. We've structured it with an asset-light framework. But in this case, also highlighting the structure provides some natural hedge when inflationary pressure or utilization pressure manifests on one side, it also provides growth opportunity and value capture opportunities on the other side of our very diverse portfolio. So I just wanted to punctuate that."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Scott Fidel with Stephens. Your line is open."
},
{
"speaker": "Scott Fidel",
"content": "Hi, thanks. Good morning. Question if I could try to do a two-part or would be one, just on the cost trend side, maybe if you could just drill in a little bit, give us an update on the inpatient side as well in terms of what you've been seeing there relative to expectations recently. And then I did want to get your perspective just on the competitive environment for the exchanges in 2025. It looks like from our analysis of the CMS landscape data for the federal exchange is that we do see a number of the major carriers with actually negative rates in their same-store plans for 2025. So it does seem like the competitive framework has intensified quite a bit. And so I'm certainly interested in your perspective right now on that market category as well? Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Scott, it's Brian. I'll take both of your questions here. So first off, we're pleased to have delivered another solid quarter of MCR performance within Cigna Healthcare with the overall performance in line with expectations, as I noted earlier. And just as a reminder, we had planned and price for the overall elevated utilization levels that began in 2023 to continue throughout 2024. And within the quarter specifically, we had a range of affordability initiatives that proved to be beneficial to the MCR, and it had some offset to the uptick I mentioned in specialty drug utilization in the quarter. And where we saw that most notably was, we saw some deceleration in cost trends in surgical activity in particular. You asked about inpatient. Inpatient was broadly in line with our expectations in the quarter. So I wouldn't flag that as a particular hotspot or an area of favorability. And as David said, we're fortunate to have the natural hedge at the enterprise level where the elevated customer demand for specialty drugs resulted in the favorable performance, we saw in our Evernorth business, specifically within the specialty and care services platform. As it relates to the individual exchanges, so we continue to see this market as being an important subsegment of the U.S. health care system for those who don't have access to employer or government-sponsored coverages. We've been a consistent player in this market over the past decade since the ACA went into effect. And for us, 2024 has been a year focused on margin expansion in our individual exchange business. And that approach is playing out largely as we expected here with fewer customers in 2024, but carrying a higher profit margin profile compared to our 2023 experience. As it relates to 2025, specifically, as you noted, the weighted average rate increase for our customer base is in the low double digits, which based on the publicly available information is on the higher end of the competitive set. That said, there's a considerable variation by geography when you dig into that. And for us, the exact margin profile and customer volumes will be a function of geographic mix and competitor behavior in each of those different geographies. But taken all together, we continue to invest in this business, see it as a growth engine for the company and over time, look forward to 10% to 15% annualized growth here."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Adam Ron with Bank of America. Your line is open."
},
{
"speaker": "Adam Ron",
"content": "Hey, thanks for the question. I also wanted to dig into the specialty comments. But from the managed care side, you mentioned that it was the reason that you're increasing your MLR guidance. And I know that you still do currently own the Medicare Advantage company. That also has the Part D business. And so wondering if you could delineate like the pressure that you're seeing in specialty between the Medicare side and the commercial side. And on the Medicare side, if you think it's being driven by the IRA at all? Thanks."
},
{
"speaker": "Brian Evanko",
"content": "Good morning, Adam, it's Brian. I'll start. If you my colleagues want to pile on, you're welcome to. So as it relates to what we saw in Cigna Healthcare on the Specialty drug side, really, the uptick in the utilization was broad-based across most of our Accredo therapeutic resource centers in the third quarter. In particular, we saw it in inflammatory conditions, oncology and neurology. And really this transpired across all the Cigna Healthcare product lines, Commercial Employer, Medicare and the individual exchanges. The Medicare volumes were slightly more elevated than commercial, but not enough that we would flag it as having a different root cause, and we do not see the IRA is having driven a meaningful amount of the third quarter experience. And as I said earlier, I'm pleased to have the natural hedge with the Evernorth Specialty business benefiting from those increased volumes in the quarter."
},
{
"speaker": "David Cordani",
"content": "And Brian, the only thing I would add is, Adam, to your broader question, as noted in our opening comments, but by and large, the Medicare Advantage portfolio of our business is performing in line with our expectations as we build the plan out for the course of the year. So Brian's reference is on the margin in terms of the elevation there."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from George Hill with Deutsche Bank. Your line is open."
},
{
"speaker": "George Hill",
"content": "Yes, good morning, guys. And David, I kind of want to come back to the -- your comments on the Medicare Advantage market that you opened up the call with, which is in the past, you kind of said that MA is a strategically important market with a lot of long-term value. And on this call, you're saying it's a challenged market. So first, I guess, number one is kind of can you help me bridge the gap between those two lines of thoughts? And then as you look at the MA market from where you sit, given that you guys still participate, do you see its challenges as cyclical or structural?"
},
{
"speaker": "David Cordani",
"content": "George, my comments relative to the marketplace are our view, a statement of fact, given the current environment, drawing back to your broader point of view, we see from a societal standpoint, MA as currently and in the future, an important part of the offering to the marketplace. So it would be very clear. Secondly, as we've discussed before, within our Evernorth portfolio today, fully approaching one-third of all of our product programs and services face off against government-sponsored programs, very inclusive of MA and the supporting programs are on MA and we will continue to invest in and grow those programs, products and services. What I was seeking to draw back to was, again, given the disruption in the marketplace and the headline that we were drawn into great clarity that the marketplace is disrupted and our actions and our behaviors are consistent with what we said they were going to be specifically using our discretionary free cash flow for share repurchase. Looking forward, I would expect to see the MA marketplace find its footing again, albeit it's going to go through a choppy phase right now for the forces I talked about before, elevated medical costs. Significant reset the stars. So if you look back, there was a time when the marketplace had almost 90% of all lives in four-star plus plans that gets reset down to 60% plus of lives. That's a large resetting for the marketplace. The risk adjuster part of the program coming through is also quite meaningful. So I deem it to be transitional for the marketplace. The leaders in the marketplace will find a way to lead through this. And importantly, MA serves a very important value prop from a societal standpoint. On average, an MA life as lower income on average in MA life is supportive of better clinical coordination, clinical efficacy and an average in MA life is getting better overall value and affordability. The space is just going through a choppy time right now, and that's what we're trying to call attention to."
},
{
"speaker": "George Hill",
"content": "I appreciate the color, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Josh Raskin with Nephron Research. Your line is open."
},
{
"speaker": "Josh Raskin",
"content": "Thanks. So I'll harp on those. I'll sort of keep on the topic here. But just in terms of the cadence of buybacks, I want to understand you guys were relatively strong in the first quarter, particularly strong in the second quarter. A noticeable pause in 3Q, and I heard David, your response to Justin's question around this disruption in the space and wanting to get as much clarity as possible. Should we assume that you now have the clarity that you need to understand the Medicare Advantage business and that is what's leading to this reacceleration in the buybacks and into 2025? And then just a smaller one, just on favorable development, it was a little larger in 3Q. Could you talk were there any specific drivers of that or areas where development came in better?"
},
{
"speaker": "David Cordani",
"content": "Josh, good morning, it's David. Let me take your first question and then ask Brian to take the second part of your questions. No. If the specific answer to your question, the call -- the cadence of our buybacks is driven by cash flow timing. So you'll note that our cash flow, and we've highlighted this in the past, doesn't happen ratably throughout the course of the year. So early part of the year, we expected to have significant deployment of capital and toward the latter part of the year, we expect to have significant deployment of capital. So specific to your question, the timing and cadence of deployment of free cash flow is tied to the timing of the cash flow generation in the fourth quarter will be a high cash flow generation quarter for us. And we highlighted the fact that we are quite active in the marketplace, noting the share repurchase through the month of October thus far. Brian, can I ask you to take the second part of the question?"
},
{
"speaker": "Brian Evanko",
"content": "Sure, David. So as it relates to the prior year development that we saw in the third quarter, it was a little bit higher than we typically would see in the third quarter. But Important to keep in mind that, that's gross prior year development, which doesn't translate one for one to a net P&L impact, just given the variety of factors like client sharing, MLR rebate impacts and other items. And in any given period, we tend to see a fluctuation as you can appreciate, in reserve development from year-to-year, quarter-to-quarter. And overall, the net P&L effect of prior period reserve development was not a significant driver of the Cigna Healthcare MCO or the Cigna Healthcare income in the third quarter. So I appreciate the questions."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Lance Wilkes with Bernstein. Your line is open. Lance, your line is open. You may need to unmute yourself."
},
{
"speaker": "Lance Wilkes",
"content": "Thanks so much. Just a couple of cleanup questions and one broad strategic question. On the strategic level, as you're looking at deployment of capital as you're thinking about inorganic moves, how do you look at things from a management and board level with respect to management stability, stability and volatility of a business model, et cetera? And are there other important criteria’s we should be aware of? And the little items are just over in the employer market, given high premium inflation, are you seeing different behaviors from employers whether that's faster shift to ASO or certain types of cost containment features that they're looking for? Thanks."
},
{
"speaker": "David Cordani",
"content": "Lance, good morning, it's David. Let me take your strategic question specific to M&A criteria and then ask Brian to take your follow-up. You painted a mis-cleanup. I find that interesting. But specific to your strategic question, if you step back and think about our M&A criteria, which is the core of your question, our criteria has not changed. And to remind you, first is strategic alignment. Then second is financial attractiveness. I'll come back to that in a moment. And then third is our need to see a clear path to close. As it relates to financial attractiveness, we take into consideration EPS accretion. So the level of, the timing of, the visibility of, the durability of. We also look at capital efficiency, return on invested capital on a relative basis in terms of assessing it. So to the core of your question, if I heard you correctly, a more disruptive environment or a less stable asset would increase the beta. Increasing the beta requires a higher visibility to highly durable synergies, value capture and the durability of that. So to the core of your question is, of course, we have to consider that because you're looking for strategic value creation and strategic value capture. And adjacency versus further adjacency and the more stable and predictable versus the more volatile has to be taken into consideration. And I'll end with, I believe we have a very clear, good track record of applying these criteria and creating shareholder value over a long period of time. Brian, I'll transition you?"
},
{
"speaker": "Brian Evanko",
"content": "Yes. Lance, on the second question in terms of how employers are reacting to a higher cost trend environment, a few things highlight there from our U.S. employer portfolio. Affordability is generally the number one topic when we talk to employer clients. And historically, they look at benefit buy-downs, changes to deductibles and out-of-pocket maximums maybe premium contribution changes. But the strategies are becoming more precise and more granular now. So as an example, we're seeing more and more interest in our specialty pharmacy capabilities, programs like the EnCircleRx to help mitigate GLP-1 spending and ensure clinical appropriateness of all those programs. So we're seeing interest in more precise affordability programs. We're also seeing a lot of interest in our mental health and substance of these capabilities. Since the pandemic started, this has been a higher cost trend category. And even this year, it's contributing about 1% to employer cost trends just in the year. So there's interest in what programs and services we have available to address that as well as the link between mental and physical health, which has been shown, metal health utilization deflects physical health needs down the line. And then finally, there's interest in more precise provider network configurations that help to optimize cost, quality incentive alignment. So things like our Pathwell Specialty offerings, things like our Pathway Bone & Joint program, so all those things are of increased interest to employers in a high trend environment. And taken all together, our Cigna Healthcare offerings are well positioned to address those themes."
},
{
"speaker": "Lance Wilkes",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from Michael Ha with Baird. Your line is open."
},
{
"speaker": "Michael Ha",
"content": "Hi, thank you. So firstly, on '25 headwinds and tailwinds, thank you for providing that list in your prepared remarks. I was just wondering if you could maybe flesh that out a bit more specifically, which of those building blocks perhaps are you most confident about in terms of helping you on your path to 10% or at least 10% EPS growth next year? And then following up on Erin's question, maybe a different approach to it. I know biosimilar quickly rose to 20% share of your specialty book last quarter. Where has that trended in third quarter? Where do you see both HUMIRA biosimilar adoption, which I believe is now one-third of eligible and that biosimilars share, especially by trending into year-end and over the next year. And then as I think about Evernorth's earnings growth, I think you mentioned last quarter that biosimilars is going to help drive it to high single-digit growth in third quarter, which you did. So I wanted to get your thoughts on how are we now in a spot where it can sustainably grow high single digits going forward, are we officially now in that sort of new paradigm of earnings contribution Evernorth from biosimilars? Thank you."
},
{
"speaker": "David Cordani",
"content": "Michael, good morning, it's David. You packed a lot in there for us to begin to bring our call to a close in short order, but important topics. So first, let me just frame a little bit of the headwind tailwind framework and then ask Brian to peel it back, although it will give you a bit more specificity. And then we'll transition to Eric, who will talk about the trends in direction, et cetera. I don't think we're declaring a new normal as opposed to the growth trajectory we see relative to that business in the 8% to 12% compounded over time, which is above the secular trends. But let me shift back to the headwind tailwind. As I noted in my prepared remarks, we'll provide much more detail in our fourth quarter call as we provide the 2025 outlook and guidance as we always do. Importantly, and we want to stress, this will come off of 2024, which is going to be another strong year and competitively differentiated year. And our outlook for 2025 will be a strong year and competitively differentiated year. And we highlighted several of the headwinds and tailwinds as you put them all together, even at this point, we're confident to step forward and say that our growth algorithm will be intact for 2025, yet we would expect to guide at the lower end of our algorithm range with taking a posture prudence. So Brian, could I ask you to give a little bit more color on some of the drivers within the headwinds and tailwinds and some dimensioning?"
},
{
"speaker": "Brian Evanko",
"content": "Sure, David. Michael, I'll give you maybe a little bit more detail on the three tailwinds and three headwinds that David outlined earlier on the call. So in terms of the three tailwinds we see for 2025, continued biosimilar adoption is one. Obviously, that's been a theme throughout the morning here, and we do have a high degree of confidence in that being delivered in 2025. Secondly, we expect advancements in our large PBS client relationships. Obviously, we had a very sizable new client in '24. We also have others that we've onboard in recent years. And then the third tailwind is EPS accretion from the deployment of the Medicare sale proceeds. And given we know the magnitude of this, we would expect this to be a low single-digit percent impact on 2025 EPS when you think about the deployment of those proceeds. That's offset by three primary headwinds that we see at this juncture. The first is the absence of the 2025 VillageMD dividend recognition. So as I made reference to earlier, that was $33 million in the third quarter. You annualize that out. It's about $130 million of a headwind for 2025 to the Evernorth segment income as well as, obviously, the enterprise. Secondly, we'll have some stranded overhead from the Medicare divestiture, which is currently at about $150 million for the year. And you can think of that as split roughly half and half between Cigna Healthcare and Evernorth. And obviously, our teams will work to whittle that down over time, but we see that as about $150 million headwind for '25. And then finally, continued investments for long-term growth, as I made reference to an earlier question, that will gear up or gear down depending on the market opportunities that we see as we balance short-term and long-term needs for the company. So Eric, you can pile on here on the biosimilars part of the question?"
},
{
"speaker": "Eric Palmer",
"content": "Thanks, Brian, and thanks for the question, Michael. With respect to HUMIRA, a couple of notes I wanted just to be clear on, we began to spend in a biosimilar HUMIRA at the end of June. We noted in our second quarter call that throughout the month of July, had achieved about 20% -- or about 20% of our customers had elected to use the biosimilar HUMIRA. And that's grown throughout the quarter. The number we provided today was that across the third quarter in its entirety now about 33% of the eligible patients had adopted. So really nice growth throughout the quarter. We would expect that to continue to grow over the balance of the year. And to your more macro question, just I'll step back for a minute. We're well positioned to bring value to the benefit of our customers and clients overall. And as we've noted for several years now, we see and have worked to deliberately position ourselves to be lined up to capture the forces associated with pharmacological innovation and we've positioned our company to play a leading role in connecting patients with the medicines that they need there. At our Investor Day back in March, we again increased the top end of our long-term growth range for Evernorth up to 5% to 8% growth, and that reflects all of these dynamics. And so that's the I think the fourth time we increased the growth trajectory of Evernorth since Evernorth was launched just a few years ago, and we're excited about the opportunity to continue to grow in this space are the same, the positive forces that we've just talked about and the ability to have a meaningful positive influence on affordability of health care and the patients that we serve overall. So we're excited about the opportunity and well positioned to play a leading role here."
},
{
"speaker": "Operator",
"content": "Thank you. I'd like to turn the call back to David Cordani for closing remarks."
},
{
"speaker": "David Cordani",
"content": "Thank you. I just want to briefly wrap up. Most importantly, thanks for your questions, your time and your engagement on our call today. Just to highlight a few headlines. Cigna Group once again, given our business momentum and complementary growth platforms delivered a strong third quarter, and we remain on track to deliver our 2024 EPS outlook of at least $20.40, and we're on track for another competitively differentiated year in 2025. Before I close, I want to thank our 70,000 colleagues around the world and a fantastic senior leadership team. It's their focus, caring orientation and commitment that allows us to do what we do day in, day out for those we have the privilege to serve. We're proud of what we've accomplished in the third quarter and the trajectory that we have for the full-year, and we look forward to talking you in the future. Have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes the Cigna Group's third quarter 2024 results review. Cigna Investor Relations will be available to respond to additional questions shortly. A recording of this conference will be available for 10 business days following this call. You may access the recorded conference by dialing (888) 282-0035 or (203) 369-3602. There is no passcode required for this replay. Thank you for participating. We will now disconnect."
}
] |
ci | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for standing by for the Cigna Group Second Quarter 2024 Results Review. At this time all callers are in listen-only mode. We will conduct a question-and-answer session later during the conference. [Operator Instructions] As a reminder, ladies and gentlemen, this conference, including the Q&A session, is being recorded. We'll begin by turning the call over to Ralph Giacobbe. Please go ahead."
},
{
"speaker": "Ralph Giacobbe",
"content": "Thank you. Good morning, everyone. Thanks for joining today's call. I'm Ralph Giacobbe, Senior Vice President of Investor Relations. With me on the line this morning are David Cordani, the Cigna Group's Chairman and Chief Executive Officer; Brian Evanko, Chief Financial Officer of the Cigna Group and President and Chief Executive Officer of Cigna Healthcare; and Eric Palmer, President and Chief Executive Officer of Evernorth Health Services. In our remarks today, David and Brian will cover a number of topics, including our second quarter financial results and our financial outlook for 2024. Following their prepared remarks, David, Brian and Eric will be available for Q&A. As noted in our earnings release, when describing our financial results, we use certain financial measures, including adjusted income from operations and adjusted revenues, which are not determined in accordance with accounting principles generally, accepted in the United States, otherwise known as GAAP. A reconciliation of these measures to the most directly comparable GAAP measures, shareholders net income and total revenues, respectively, is contained in today's earnings release, which is posted in the Investor Relations section of the cignagroup.com. We use the term labeled adjusted income from operations and adjusted earnings per share on the same basis as our principal measures of financial performance. In our remarks today, we will be making some forward-looking statements, including statements regarding our outlook for 2024 and future performance. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. A description of these risks and uncertainties is contained in the cautionary note to today's earnings release and in our most recent reports filed with the SEC. Regarding our results in the second quarter, we recorded an after-tax net special item charge of $64 million or $0.23 per share. Details of the special items are included in our quarterly financial supplement. Additionally, please note that we will make prospective comments regarding financial performance, including our full year 2024 outlook, we will do so on a basis that includes the potential impact of future share repurchases and anticipated 2024 dividends. And with that, I'll turn the call over to David."
},
{
"speaker": "David Cordani",
"content": "Thanks, Ralph. Good morning, everyone, and thank you for joining our call today. For the second quarter, we again delivered strong performance as we continue to build on our momentum. Today, I'll discuss our performance for the quarter and key strategic drivers of our growth, demonstrate how the strength and durable nature of our model is fueling our success. Then Brian will review additional details on our results and our outlook for the rest of the year, and we'll move to your questions. So let's get started. For the second quarter, I'm pleased to report that the Cigna Group delivered total revenue of $60.5 billion and adjusted earnings per share of $6.72. We achieved these positive overall results in a dynamic environment, and I'm proud of our team for continuing to focus on those we serve, ensuring that they get care of the need, to get their medications at an affordable cost and they get the support they need in order to make the best decisions about their health and vitality. All of this requires a relentless focus on innovation, disciplined execution and a passionate commitment to our mission. During the quarter, our Evernorth Health Service businesses demonstrated continued strength with our market-leading specialty and pharmacy benefit services capabilities. Within Evernorth, I'll start with our accelerated growth specialty and care businesses, which provides specialty drugs for the treatment of complex and rare diseases, distribution of specialty pharmaceuticals as well as clinical programs to help clients improve health and vitality. We saw strong growth in the quarter with adjusted income growing 12% year-over-year, reflecting continued demand for our services while we also continue to invest in broadening our offerings and expanding our reach. In Accredo, our specialty business, our growth continues to be fueled by secular tailwinds as well as Accredo's differentiated strength which makes us the market leader in the space. Biosimilars, for example, represent a force of change and a substantial opportunity for continued growth and impact. At the end of June, we began dispensing our interchangeable biosimilar for Humira. Our program has zero dollar out-of-pocket cost for patients, saving them on average $3,500 per year. To deliver these savings, we have agreements in place with multiple manufacturers that will produce biosimilars for Evernorth pharmaceutical distributor, Quallent Pharmaceuticals. Now the biosimilar opportunity goes well beyond Humira. By 2030, we expect an additional $100 million of annual specialty drug spend in the U.S. will be subject to biosimilar and generic competition. And Accredo is well positioned to deliver differentiated value for our clients, customers and patients. In our care services businesses, we are continuing to grow and expand in key areas of increased demand, including behavioral health, virtual and home care. For example, in summer, we further expanded Evernorth behavioral care group to an additional seven states. We are seeing positive patient outcomes from our unique clinician matching capabilities based on individual needs and preferences with fully 84% of patients experiencing clinically significant reductions in the depression and anxiety symptoms. Now shifting to Express Scripts, our foundational pharmacy benefit services businesses, we are seeing continued strong client demand given our breadth of clinical and supply chain expertise as well as our proven partnership orientation. This quarter, Express Scripts built on a long track record of innovating for those we serve with continued enhancements and new solutions. For example, given the high cost of GLP-1 drugs, we're continuing to see meaningful interest from our clients in EnCircleRx, now with more than 2 million lives already enrolled. Our program starts with our longitudinal data to target patients who will most benefit from these medications and we provide patients with resources to make lasting changes to help maximize the effectiveness of these medications, both in the short and long-term. Another example of our innovation orientation is a recent announcement of Express Scripts oncology benefit services, which will be available in 2025. Our new solution helps patients navigate the challenges of cancer care by providing a single oncology benefit, integrating pharmacy, medical and behavioral health treatments. Our patient centered approach will help to ensure the earliest possible detection guide individuals to high-quality providers and coordinate care across clinical teams. Now moving to Cigna Healthcare, our health benefits platform, we continue to deliver solutions that create value and better outcomes for clients and customers, coupled with highly competitive total cost of care. Similar to others in the industry and as we've anticipated, we are seeing increased utilization in our book of business. I would note that our results are largely in line with the elevated levels in our planning and pricing assumptions. Our U.S. employer foundational growth business continues to perform in line with our expectations. Over this year, I've met with hundreds of clients across the U.S. and globally. And while the needs of every client are unique, there are a few consistent themes across every discussion. First, continued focus on affordability, particularly in light medications like GLP-1 and gene therapies coming to market. Next, an increased need of improved access and importantly, coordination of behavioral health services. Third is mounting point solution fatigue. And fourth, the opportunity and need for leverage of our longitudinal data and clinical programs to help keep people healthy and vital. Our solutions continue to resonate well given our highly consultative approach to help clients choose the right set of solutions, our proven capabilities to support their workforce and our innovative programs that help to keep costs down. As a result, we are further gaining share and continue to see outsized opportunities, for example, in our Select segment. Another capability of our U.S. employer business to deliver integrated and tailored benefits for our clients and customers, our modular solutions that incorporate innovative services from Evernorth, including Behavioral health, virtual care and pharmacy. Our Pathwell suite of solution, which continues to drive exceptional value is a prime example. Pathwell specialty is another way we are reducing costs associated with specialty drug therapies, while also providing improved care and clinical outcomes for patients. With our Accredo nurses, nearly 50% of our Pathwell specialty patients, who've transitioned their site of care, now receive treatment in the comfort and convenience of their home. We are pleased with how the market continues to recognize the value we are delivering through solutions like Pathwell. Turning to our Medicare Advantage business. We continue to make great progress regarding the sale of this business, and I'm pleased that we remain on track to close in the first quarter of 2025 as planned. Next, I want to take a few minutes to talk about the current environment surrounding pharmacy benefit managers and the relative landscape. At the heart of this debate is the cost of pharmaceuticals. As we previously discussed, a key force of change in health care is the surge of pharmacological innovation. For context, prescription drug coverage is the most frequently used care benefit. And on average, it used 15x per year per person resulting in billions of dollars -- billions of prescriptions per year annually in the United States. Today, and for the foreseeable future, and most meaningful advances extending and improving quality of life will come through gene therapies, breakthrough and treatments for cancers and other conditions as well as personalized medicines. In the U.S., for example, there are already more than 20 gene therapy and cell therapies available. However, there are nearly 1,000 more in the pipeline. Additionally, as we know, GLP-1s are growing rapidly, helping to treat diseases and complications that stem from obesity and diabetes. This class of drug is on tap to be the #1 pharmacy benefit trend driver for plans of all sizes this year. And the impact will grow with some forecasting nearly 10% of the U.S. population using GLP-1s in the next 10 years or sooner. The applications rippling from these fast-growing pharmaceutical trends across the entire health care system are undeniable. And one of the biggest unanswered questions is how could society afford this continued trajectory? Our role is to negotiate with pharmaceutical manufacturers as well as pharmacies to ensure that individuals are able to access pharmacological innovations at a fair and affordable price. In fact, pharmacy benefit companies are the only part of the drug supply chain who work to drive cost down. To underscore this, new drugs coming to market with unsustainable prices in 2023, were up $300,000 on a median basis, up over 35% over 2022. And last year, median brand drug price increases were greater than 5% more than the rate of inflation. Let me repeat this. Last year, the median annual price for new drugs coming to market was $300,000, up 35% over 2022. Meanwhile, in 2023, Express Scripts change in pace and cost sharing was relatively flat on average. Express Scripts patients with employer sponsored drug coverage pay, on average, $15 out of pocket for a 30 day supply. And for clients, Express Scripts delivered more than $38 billion in savings annually. Stepping back, our industry negotiations to drive these results can at times generate friction in the system. Friction that is spilled into and now has reached tightened levels in the political arena and media with industry winners and losers being declared at every report and every headline. We believe that the facts and results and outcomes delivered to our clients, customers and patients will rule the day. However, the environment calls on us to be more proactive. This means ensuring that what we do and the value we bring is more widely and better understood. And we continue to evolve our model to address legitimate pain points and opportunities. For example, in 2023, 1% of the patients in the United States experienced out-of-pocket costs above $2,000 a year. From our point of view, that's too many. We accept the responsibility to accelerate innovation to make medications more affordable, while continuing to improve health outcomes in finding solutions for every person we serve. Make no doubt our team will continue to lean into the challenge for the benefit of our patients, clients and the health care ecosystem and we are proud of the work that our team does every day and the role we play and the results we're able to achieve. Now let me pause and summarize before transitioning to Brian. When you combine our compelling growth potential and strong execution focus, we have confidence in our ability to meet our 2024 and long-term growth targets. We have a proven track record of delivering differentiated value for those we serve by innovating new solutions like in EnCircleRx and our Pathwell suite as well as expanding meaningful partnerships. As a result, in the second quarter, we delivered on our financial commitment with adjusted EPS of $6.72, and we remain on track to deliver our guidance for full year adjusted earnings per share of at least $28.40 for 2024. Further, our company has attractive sustainable growth opportunities over the long-term, and we remain on track to deliver average annual adjusted EPS growth of 10% to 14% and building on our track record of achieving 13% adjusted EPS growth over the last decade, all while we generate cumulative operating cash flow of $60 billion over the next five years, while continuing to meaningfully invest capital for the benefit of shareholders. We also continue to make strategic investments in strengthening our capabilities in our foundational and accelerated growth business and remain focusing on harnessing the breadth of our capabilities of our organization to meet the evolving needs of those we serve. Overall, our strong performance through the first half of the year reflects the balance in our company portfolio and the significant value creation that positions us for sustained and differentiated growth. With that, I'll turn it over to Brian."
},
{
"speaker": "Brian Evanko",
"content": "Thank you, David. Good morning, everyone. Today, I'll review Cigna's second quarter 2024 results and discuss our outlook for the full year. We're pleased with our strong second quarter results, reflecting growth across Evernorth and Cigna Healthcare. The results underpin the strength and the stability of our diversified portfolio of businesses in a dynamic environment and demonstrate continued execution against our operating and financial commitments. Key consolidated financial highlights for the second quarter include revenue of $60.5 billion, which represents 25% year-over-year growth and adjusted earnings per share of $6.72 or 10% year-over-year growth. With the strong first half performance, we continue to have confidence in our full year 2024 adjusted earnings per share outlook of at least $28.40, which represents more than 13% year-over-year growth in EPS. Now turning to our segment results. I'll first comment on Evernorth. Evernorth continues to deliver strong results driven by both of its operating segments. Second quarter 2024 revenues grew to $49.5 billion, while pretax adjusted earnings grew 7% to $1.6 billion, slightly ahead of expectations. Specialty and Care Services showed strong growth with revenue up 18% to $22.9 billion, and pretax adjusted earnings were up 12% to $756 million, at the high end of our long-term target growth range. This performance is a demonstration of our robust and diversified capabilities, as we delivered broad-based growth across our specialty businesses, Accredo and CuraScript as well as in our care services businesses. Pharmacy Benefit Services also posted strong revenue growth, driven by the addition of new business wins and expansion of existing relationships. Pretax adjusted earnings increased to $798 million as our innovative capabilities continue to drive value for our clients, customers and patients. Overall, we're pleased with Evernorth's second quarter results and continue to expect strong income growth in the second half of the year. Turning to Cigna Healthcare. Second quarter 2024 revenues were $13.2 billion and pretax adjusted earnings were $1.2 billion. Second quarter earnings were in line with expectations and included approximately $50 million of unfavorable prior year impact related to Medicare Advantage risk adjustment. The second quarter medical care ratio of 82.3% was within our expected range, inclusive of the aforementioned unfavorable prior year impact of approximately $50 million or 40 basis points on the medical care ratio. Absent this item, the underlying medical care ratio was broadly in line with expectations. As noted previously, we had planned and priced for 2024 medical cost trend to be above 2023 levels, which took into account both unit cost inflation as well as continued elevated utilization. Year-to-date, we have seen elevated cost trends, consistent with our planning and pricing assumptions. The net medical cost payable at the end of the second quarter was $5.04 billion, compared to $5.66 billion at the end of the first quarter. As noted previously, in the first quarter, we had booked approximately $650 million in incremental reserves relating to the Change Healthcare disruption. Those reserves have since developed in line with expectations and claims payments have returned to more normalized levels. driving the sequential decline in net medical cost payable. Moving to Cigna Healthcare Medical Customers. We ended the quarter with 19 million total medical customers. We expect growth in Cigna Healthcare medical customers for the remainder of the year, primarily driven by growth in our U.S. employer Select and Middle market segments. Overall, Cigna Healthcare delivered consistent results in a dynamic operating environment. Now turning to our outlook for full year 2024. With our continued strong underlying performance in Evernorth and Cigna Healthcare, we are reaffirming our full year 2024 expectation for consolidated adjusted income from operations of at least $8.065 billion or at least $28.40 per share. Regarding cadence of earnings, we expect the third quarter adjusted earnings per share to be approximately 25% of the full year outlook. Now turning to our 2024 outlook for each of our growth platforms. In Evernorth, we continue to expect full year 2024 pretax adjusted earnings of at least $7 billion. This reflects continued momentum into the second half, with third quarter Evernorth earnings expected to accelerate to high single-digit year-over-year growth, in part due to an increase in adoption of our interchangeable biosimilar offering. For Cigna Healthcare, we continue to expect full year 2024 pretax adjusted earnings of at least $4.775 billion, and we expect the third quarter adjusted earnings to be approximately 25% of the full year outlook. We continue to expect the full year medical care ratio within the range of 81.7% to 82.5%. With the first half medical care ratio coming in at 81.1%, the midpoint of our guidance implies an 83.1% medical care ratio for the second half of the year. We would expect the third quarter to be slightly below that level. Turning to our 2024 capital management position. As of July 31, we have repurchased 14.7 million shares of common stock or approximately $5 billion, consistent with our previous commentary. We continue to expect at least $11 billion of cash flow from operations. Our balance sheet and cash flow outlook remains strong, benefiting from our efficient asset-light framework that drives attractive returns on capital. Now to recap. Our first half 2024 consolidated results reflect strong contributions and execution from both Evernorth and Cigna Healthcare. Our 2024 outlook reflects the sustained momentum and strong fundamentals of our two growth platforms, which gives us confidence to deliver on our full year 2024 adjusted earnings per share outlook of at least $28.40. With that, we'll turn it over to the operator for the Q&A portion of the call."
},
{
"speaker": "Operator",
"content": "Our first question comes from Justin Lake with Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "Appreciate the commentary on cost trend. Maybe you can give us an update on what you're seeing by business line and also how things have trended 2Q versus 1Q? When you say it's in line with your pricing and your expectations, is that a year-to-date discussion? Or is that where trend is running today coming out of the second quarter? Is that in line? Or is that more or less elevated versus what you expected?"
},
{
"speaker": "Brian Evanko",
"content": "Justin, it's Brian. So I'll start by saying we're pleased to have delivered another solid quarter of MCR performance at Cigna Healthcare which ran toward the lower end of our MCR guidance range when you exclude the prior year Medicare risk adjustment revenue impacts in the quarter that I mentioned earlier. Now within the quarter, total cost of care was broadly in line with expectations. There are a few puts and takes that I call out if we get into specific cost drivers. So we continue to see elevated usage of facility-based services, including emergency room. Additionally, we saw a continuation of elevated utilization of mental health care services, which we do see as a positive over the longer term given the correlation to whole person health. You'll recall in the first quarter, I highlighted slowing growth in surgical costs. During the second quarter, we continued to see abatement in the rate of growth of surgical costs although costs still didn't grow. Now taken all together, we are seeing sustained high cost trends, yet these are broadly in line with our guidance as we planned and priced for the elevated utilization levels that began in 2023 to continue throughout 2024. Now specifically in the second quarter, we did not witness aggregate acceleration or deceleration of care patterns within the quarter. I also would not note any month-to-month variability relative to the year-to-date experience that we've seen. So overall, we remain confident in the full year MCR range outlined in our guidance."
},
{
"speaker": "Operator",
"content": "Next question comes from Lisa Gill with JPMorgan."
},
{
"speaker": "Lisa Gill",
"content": "I want to start with the 2025 selling season on the pharmacy side. You made comments around GLP-1. We continue to see new indications there. I'm just curious, one, when we think about the opportunities in '25, how would you characterize that to what kind of programs are people buying going into 2025? And then lastly, David, you made a comment that the facts need to be more widely understood when it comes to the pharmacy business. What are your plans around making those facts more wiping known? Because as you know, I agree with you that both Congress as well as the media reports don't fairly reflect what the benefits are of the business."
},
{
"speaker": "Eric Palmer",
"content": "Lisa, it's Eric. I'll start then maybe invite David to add some additional comments on the end here. But overall, our foundational pharmacy benefit services business, Express Scripts is off to a really good start for 2025. We've got strong new sales and our 2025 retention rate is going to be consistent with three years and the mid-90s or better. Stepping back a little bit, Evernorth overall is -- continues to be well positioned to grow. The specialty business is also positioned for strong growth with significant growth driven by our pharmacy benefits clients electing to use our specialty capabilities as well as strong growth in services sold directly to health systems and other health plans. So overall, we are quite excited about the strength of the solutions and how they continue to resonate with the market overall. The themes or specific programs that I would point to come back to areas that help to make the value of the dollar spent on medicine is more effective, right? So programs like our EnCircleRx program that helps to effectively manage weight loss medication GLP-1 or our most recent oncology benefit offering that David mentioned a bit ago in his prepared remarks. So targeted specific types of programs that work really well with the broader suite of benefit offerings continue to resonate really well in that scenario we continue to invest in. David, do you want to take a bit on the broader environment comment?"
},
{
"speaker": "David Cordani",
"content": "I appreciate the call out. First and foremost, let me reiterate we're proud of the work we do daily, and I'm greatly appreciative of our team that gets up everyday serving our patients and customers through employer relationships, health plane relationships, governmental entity relationships and increasingly through partnerships and collaborations to health care professionals. Second, we will and need to continue to innovate for the benefit of those we serve, whether that's through the likes of ClearCareRx, our patient insurance program, our EnCircle program, our independent pharmacy program, all of which are first in the space. Now specific to your question, we challenged ourselves to be much more aggressive and complete relative to communication and engagement in support of our clients, be they employers or health buying customers collaborate even more deeply and intensely with the independent pharmacies and subsegmenting the independent pharmacists who are truly independent and rural working on the hill, of course. And then lastly, more aggressively leveraging credible third-party independent analysis of what our industry does and specifically what we do on behalf of those we serve in a fact-based incredible way. So you should expect to see us a bit more complete and aggressive ensuring that we're amplifying that. But make no doubt, we also need to continue to innovate as we have, and we will continue to innovate for the benefit of those we serve."
},
{
"speaker": "Operator",
"content": "And this question comes from A.J. Rice , your line is open. You may ask your question from UBS."
},
{
"speaker": "A.J. Rice",
"content": "I might just flip over and ask you about the any distinctive you're seeing in the health benefit selling season across your book, and a large group and select, et cetera. And then also, you called out for quite a while now, fatigue on point solutions. I wonder, I understand how you're addressing affordability and understand how you addressing behavioral health integration. But on the point solution question, is there anything that is -- or do you think you'll consider buying some of these point solutions and then offering them as part of your integrated offering? Do you sort of see yourself getting in the middle of helping employers choose between the myriad of point solutions? How are you addressing that?"
},
{
"speaker": "Brian Evanko",
"content": "A.J., it's Brian. I'll start on the Cigna Healthcare selling season and buying pattern dynamic. And then I think David will pick up on the second part of your question relative to point solutions and some of our inorganic activities. So as it relates to the Cigna Healthcare selling season, I'll concentrate my comments on the larger end of the U.S. employer market just given the time of the year. We're seeing a relatively consistent number of RFPs this year in comparison to last year at this time. And similarly, in terms of our existing clients, we have a similar amount out to bid as we did last year at this time. So, just for some context on the numbers. Now each of these larger employer clients tend to have unique needs. There's a few areas that thematically I'd call out in terms of what our teams are seeing out in the market. One, as David made reference to earlier, affordability continues to be a key area of focus particularly with the wave of drug innovation, including GLP-1s and gene therapy hitting the market. Secondly, to your point, some of the larger employers are seeking to consolidate vendors or point solutions with those who can supply more integrated offerings. Third, we're seeing mental health and substance of these benefits and programs becoming more and more important each year, particularly given some of the downstream effects of the pandemic. And finally, many of these larger clients are interested in digitally enabled care navigation capabilities to drive either further study care optimization or consumer empowerment. So taken all together, our Cigna Healthcare offerings are well positioned to address these themes and demands from large employers. And importantly, we also continue to see strong traction in net growth in our under 500 Select segment as you'll see in the statistical supplement, 7% year-over-year growth in customers within our Cigna Healthcare Select segment specifically. David, maybe you want to pick up on the point solution question?"
},
{
"speaker": "David Cordani",
"content": "Sure. So first, if you think about some of the solutions we identified both in today's call and in prior conversations, you can think about our digital health formulary, as a way that we connect capabilities and work to connect them seamlessly. You can think about the way the Encircle program is designed. It's designed to have actually coordination and continuity that is patient-centric the oncology program that we will roll out in 2025 is another example of taking specific care need or episode of care and redesigning the pathway to care in a much more coordinated basis, staying focused on the patient and the health care professional. The Cigna Behavioral Group offering that I referenced has much more continuity and coordination of the care experience, starting from the access to the medical professional, the matching and the coordination and there'll be new offerings. You can think about all those as largely having been built organically as we continue to invest back in the organization. To the core question through acquisition, you could think about that as well, you never roll it out largely not fueled through acquisition, although there could be episodic coordination of point solutions. And then I would graph in the middle, I'd remind you that we operate the Cigna Ventures organization where we have a now meaningful track record of partnering with organizations where they are, by definition, almost point solutions and helping collaboratively to co-innovate with them as we go forward. So stepping back, largely organically driven proven track record and the acceleration of new innovations that are coming to market for the benefit of those we serve to meet that demand."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrew Mok with Barclays."
},
{
"speaker": "Andrew Mok",
"content": "With all the changes coming to Part D, there could be significant changes, not only to membership, but also formulary managing for next year. How does the shifting risk to Part D sponsors impact Evernorth more broadly? And how are you helping clients navigate these changes?"
},
{
"speaker": "David Cordani",
"content": "Andrew, it's David. Let me comment briefly on the PDP macro environment and then ask Eric to walk through our capabilities and our proven track record of supporting our clients relative to their PDP offerings. As you step back, it was clear that the Inflation Reduction Act as it was designed and the ultimate implementation of it was going to cause PDP premiums to rise meaningfully. And most likely, that was going to create some meaningful disruption for seniors. Now as the bids have gone in, CMS has assessed those bids and has drawn apparently some of the similar conclusions relative to the acceleration of the bids and the acceleration of the premiums required given the design features. And after reviewing those has created a short-term window for some bid adjustments that we and like others are going through that on an accelerated basis. So that disruption was designed from the Inflation Reduction Act in the marketplace is reacting to that. Mok Eric to talk more specifically to our capabilities and how we work and supportive in many cases, our health plan clients in their PDP book of business to ensure we deliver great quality and overall affordability. Eric?"
},
{
"speaker": "Eric Palmer",
"content": "Evernorth and Express Scripts specifically has a long history of supporting health plans to offer Medicare Part D plans. We've got a great track record of a treatment and strong stars outcomes for them and supporting our plans and their offerings and helping them with the tools to manage formularies and model the impacts of changes for example. We're continuing to make investments to help ensure our plans are well positioned with the continued evolution of Part D coverage. We even with the most recent round of changes from the IRA like the administrative requirements associated with the copay smoothing just as one example. This continues to be an important part of the Evernorth and Express Scripts business that we're positioned to continue to help our plans succeed and thrive as they work through these changes."
},
{
"speaker": "Operator",
"content": "The next question comes from Scott Fidel with Stephens."
},
{
"speaker": "Scott Fidel",
"content": "I was hoping to maybe just touch on the marketplace and a couple of things there. One, just with the [Hips] 2023 risk adjustment true-up, if you can tell us what the net impact was to earnings if there was any relative to how you had accrued for that? And then also, just when thinking about the commentary on cost trends. Maybe if you could overlay that into the marketplace in terms of if you're seeing a similar trend there and how that's influencing your view on exchange margins for the full year. I think that prior view had been probably still a bit below long-term target there for marketplace margins this year, just interested in an updated view on margins for the year."
},
{
"speaker": "Brian Evanko",
"content": "Scott, it's Brian. Maybe I'll try to just take a big picture view of the individual exchange business in aggregate and hit your risk adjustment question as part of that. So the headline I'd ask you to take away broadly speaking, our individual exchange book is performing as we expected in 2024. As it relates to the final 2023 individual exchange risk-adjusted true-up, we had already been accrued for a sizable risk adjustment payable. And in the second quarter results, we did have a small unfavorable true-up that was recorded in the Cigna Healthcare P&L. But overall, this was not a meaningful performance driver in the second quarter for us. And then as it relates to the 2024 performance year, we did receive our first look at the industry-wide risk adjustment data for the specific states we participate, as we closed up the second quarter books and the preliminary industry data confirmed that our previous 2024 risk adjustment assumptions were reasonable. My earlier commentary on cost trends was broadly applicable to the individual exchange business as well. So when you put all the pieces together, we are tracking toward the improved 2024 margin profile we outlined during our first quarter call. And therefore, we'd expect to land the year slightly below our long-term target margin range of 4% to 6% for the individual exchange business."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ryan Langston with TD Cowen."
},
{
"speaker": "Ryan Langston",
"content": "Just looks like the exchange business was down maybe 99,000 to 100,000 members sequentially. I certainly understand why it was down versus '23 year-end, but wasn't exactly expecting that sequential move anything to call out there? And maybe a little early, but I'll ask just any expectations on 2025 in terms of growth trajectory and perhaps even margin profile?"
},
{
"speaker": "Brian Evanko",
"content": "Ryan, it's Brian. Congratulations on your new role. As it relates to the individual exchange lives intra year, maybe I'll just step back and give you kind of a year-to-date perspective, and then I'll get into the sequential component of your question. So as we discussed during our first quarter results call, the primary driver of the year-to-date change in Cigna Healthcare customer volumes is our individual exchange book. You'll recall that we repositioned this business in 2024, including taking some needed pricing actions in certain geographies in order to improve profitability and we expected to see a reduction in customer volumes as we have witnessed. And sequentially, the individual exchange business drove the majority of the modest decline in the second quarter customer volumes. Now you should think of the primary driver of that being non-payment of premiums as a result of some of the pricing actions we took in a couple of the larger geographies. So it's essentially the delayed effect of those grace periods kicking in. It was an immaterial impact to our financial results in the quarter. Over the course of the balance of this year, we would expect to see continued strong growth within our U.S. employer under 500 Select segment, which should result in sequential growth in U.S. employer and Cigna Healthcare lives for the balance of the year. So taken all together, we're pleased with the overall balance in the Cigna Healthcare portfolio. As it relates to 2025 in the picture there, we've just recently completed all the pricing and rate filings network design. And until we really see all the competitive dynamics, it's hard to know how that will shake through we would expect our margins to be similar or potentially a little bit better next year in the individual exchange book as we look forward. But too early to know exactly how we'll shake out from a membership standpoint."
},
{
"speaker": "Operator",
"content": "The next question comes from Josh Raskin with Nephron Research."
},
{
"speaker": "Josh Raskin",
"content": "I'd be curious to get your views on the potential for ICRA and specifically how that could impact the small group or select market? And maybe how does stop-loss fit into that equation?"
},
{
"speaker": "Brian Evanko",
"content": "Josh, it's Brian. I'll take that one as well. So we see the ICRA market in its current form is likely being a niche market, but one that we're monitoring closely. So more specifically, we see the ICRA market as something that could be in a feeling option for smaller employers who tend to be more commoditized buyers. And we expect this is most likely to be an attractive option for employers with less than 50 employees, which is a market segment that is financially immaterial for us today. And within the under 50 market, the average employer there has fewer than 10 employees, so very small employers typically. Now all that said, our individual exchange business represents an opportunity for us to participate in the ICRA space, should it gain more momentum? Again, I didn't know where I started and that we see this most likely being a niche market our stop-loss offerings, to your question, are fully integrated with our Select segment business. So you should not think of that as something that is a net threat to us in the select market provided that the under 50 concentration transpires the way that I described earlier."
},
{
"speaker": "Operator",
"content": "Our next question comes from George Hill with Deutsche Bank."
},
{
"speaker": "George Hill",
"content": "I thought I'd just ask a question on what I consider to be your cost of goods sold line, which is there continues to be a lot of discussion from the retail pharmacy side of the business around trying to negotiate new payment models or changes in terms. I don't know if there's any update that you can provide on how those conversations are progressing?"
},
{
"speaker": "Eric Palmer",
"content": "George, it's Eric. First, I'm going to comment on any specific negotiations with any pharmacies or things along those lines. But as you know, we've got a wide array of choices and options for our clients. That extends to how we've constructed our network as we look to balance access and affordability that best meets the needs of our clients and their patients. So we work to assemble a range of different network options under a range of different reimbursement types that match up with the needs for cost access and the associated trade-offs and touch there for our clients. So overall, that approach has served us well. We work to continue to innovate to bring new solutions to market. An example of a new solution there would be like late last year, we announced our ClearNetwork Solution. ClearNetwork provides a comprehensive simple solution in that, the pricing is based off of independent, externally created index and then it's got a simple margin that's shared between us and the pharmacy. So it's a new offering we put in the market last year that's generating interest. But again, overall, the portfolio of offerings that we continue to pull together resonates with our buyers and is part of the reason we've continued to grow the pharmacy benefits services, chassis nicely over the last few years."
},
{
"speaker": "Operator",
"content": "Our next question comes from Kevin Fischbeck with Bank of America."
},
{
"speaker": "Unidentified Analyst",
"content": "This is Adam on for Kevin. So you raised guidance in Q1 on what seems like a smaller beat at least for street expectations, but you didn't raise guidance this quarter. Can you give a little more color on why maybe you wouldn't raise and how things came in versus your expectations? And if there's anything to read into on the PYD or on the -- maybe on DCPs being down. Any color would be helpful."
},
{
"speaker": "Brian Evanko",
"content": "Adam, it's Brian. So first off, we're pleased to have delivered another strong quarter of results on both the top and bottom lines with overall results slightly ahead of our expectations in the second quarter. Now within the quarter, we did have some timing-related benefits, including tax items that contributed to the strength in the EPS line, and we're pleased to reaffirm our full year guidance as well as all key supporting metrics considering this dynamic environment. And importantly, both Evernorth and Cigna Healthcare are delivering against their respective commitments. Taking into account the environment, we're being prudent with this attractive full year EPS outlook of at least $2.40, representing over 13% growth near the high end of our long-term average annual EPS growth rate range of 10% to 14%."
},
{
"speaker": "Operator",
"content": "Our next question comes from Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wright",
"content": "So you called out the strength across specialty and services at Evernorth. I guess, how do we think about the Humira strategy contributing to the results now? And then how does that influence sort of the quarterly progression across Evernorth in the back half of the year? And just the strategy around Humira, and how that's playing out relative to your expectations? Have you, for instance, in-sourced? Humira similar across your CuraScript business. Does it make sense to in-source more than the 50%, for instance, that you're targeting on that front?"
},
{
"speaker": "David Cordani",
"content": "It's David. Let me start. You have a lot in your question and appreciate it, given the importance of the space. First, just to reiterate, the Specialty and Care part of the portfolio represents really 30% of our enterprise today. And we're quite excited about the growth potential for that business. We see the product business portfolio as a provision of care business that leverages in many cases, and we're talking about the specialty services. As noted, we had strong growth in the second quarter of 12% and as we discussed for quite some time, the breadth of our capabilities position us well relative to changes in the marketplace, more specifically the biosimilar opportunity. Now you have multiple questions here that I'll ask Eric to peel back a little bit relative to the more specific opportunities we see both in terms of our core business through Accredo as well as through CuraScript as we're expanding our capabilities in our portfolio. Eric?"
},
{
"speaker": "Eric Palmer",
"content": "Thanks, David. So, just stepping back a little bit again as well. Biosimilars are really important opportunity to improve the affordability of these high-cost specialty medicines. And we're really well positioned to help to connect our clients and their customers with these therapies. Our approach here has been consistent in that we offer choice and value to best align with our clients' needs. And we're focused on getting to low net cost fuel and competition and aligning incentives for everyone involved. The patients, our clients, our plan sponsors and the pharma supply chain. As you've made reference to in your question through Quallent Pharmaceuticals, our private label distributor we contracted with multiple manufacturers for interchangeable biosimilar Humira, and this is available at no cost to patients and attractive cost to plan sponsors began shipping this product at the very end of June. So just a few weeks ago, we've already seen meaningful uptake in the last few weeks, consistent with our expectations. We expect the customer adoption to continue to grow over the balance of the year. And it's early, five weeks in, really or so, but we see biosimilars having about a 20% share of our book at this point after just shipping this product for the last five weeks. I've said to overall continue to see that this is a real opportunity for us to improve the affordability of health care for the benefit of our clients and our plan sponsors."
},
{
"speaker": "Operator",
"content": "Our next question comes from Stephen Baxter with Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "One of the questions has been asked, but I wanted to ask about in-group membership trends. It does seem we're starting to see more mixed data on the job front. Could you spike out a little bit what you're seeing in the in group trends? And do you think your sequential membership changes are generally a good reflection of that?"
},
{
"speaker": "David Cordani",
"content": "It's David. As we discussed back in 2023, as the year was unfolding, just by way of context, we were very mindful of the potential for some softening of the employer marketplace. And then to your point, in group trends softening a little bit. And when we state of quite close to monitoring it, it didn't really manifests itself in any material way, given employers we're still working to get to a full level of employment. For 2024, we've taken a similar cautious curious monitoring approach and built a little bit of consideration relative to softening. And by and large, we have not seen that to date. So the membership headlines that we've delivered represent good fundamental strength as Brian noted previously, the change in our membership is largely driven by our as expected, dampening of the marketplace, as you would call it, our individual exchange business. But we remain closely monitoring any dampening tied to the economy and thus far haven't seen anything material to call out there."
},
{
"speaker": "Operator",
"content": "Our next question comes from Dave Windley with Jefferies."
},
{
"speaker": "David Windley",
"content": "Brian, in your comments, I think I heard you say that the excess reserves from 1Q have basically developed in line with your expectations. I think I also heard you say that you didn't see any, say, intra quarter trends or a particular month in the quarter that stood out as an anomaly. And I think in looking at our -- your progression looks like MLR implied for the second half is maybe in the neighborhood of 200 basis points above the first half historical normal, maybe about half of that. So just wanted to understand if the higher MLR expectation for the second half is kind of cautious posture or if you're expecting certain things to accelerate in the second half that would drive that. And maybe a last question would be relative to pricing, would you view yourselves as pricing to forward view of trend as you head into next year? Or would you be pricing to expand margin? Another long question."
},
{
"speaker": "Brian Evanko",
"content": "No problem, Dave. So as it relates to the second half MCR guidance, I think your question was in a year-over-year context. Really, three factors that I'd highlight, if you're looking at it relative to the back half of '23, you may recall from our first quarter earnings release, we discussed that the 2024 seasonality would be more similar to pre-pandemic norms with the MCR increasing as the year unfolded, in part driven by our individual exchange business metal tier mix, which is skewed more bronze this year. Additionally, we had some favorable stop loss utilization in the fourth quarter of 2023 that we are anticipating will normalize in 2024 and our year-to-date experience is consistent with that expectation. And then finally, there is one additional business day in the third quarter of this year, which has some elevation in the MCR in the third quarter specifically for that. So all those factors combined to generate a higher second half MCR year-over-year. But again, we remain comfortable and confident with the full year MCR guidance range that we provided here. As it relates to the pricing environment, and I'll comment specifically on our U.S. employer business, as a reminder, this is a book that's nearly 85% ASO or self-funded. So therefore, we have earnings levers that go well beyond a pure risk-based MCR, but that said, our U.S. employer book is currently operating from a position of strength as we've been performing within target margin ranges. And we remain disciplined with our own pricing strategy in the current environment. We continue to price to our best estimate of forward-looking cost trends. To your point, I don't need additional margin recapture at the book level. We are seeing the impact of inflation work its way through our provider contracts. As these contracts renew, we continue to expect elevated levels of utilization through 2024. So when you put all those pieces together, our all-in pricing trend for 2024, slightly higher than what we had assumed a year ago for the corresponding 2023 pricing cycle. And we're confident in our ability to secure appropriate pricing for 2025 and beyond. So a long answer to your long question."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jessica Tassan with Piper Sandler."
},
{
"speaker": "Jessica Tassan",
"content": "I'm curious how you're thinking about the possibility that Skyrizi and Rinvoq substitutions could maybe foreclose the Humira biosimilar opportunity? And I guess just what recourse do you have to ensure that the biosimilar products that you've got in the market succeed, I think you've given us plenty of evidence that they're the best for the patients. So just yes, how are you thinking about the possibility of foreclosure and what can you do to kind of prevent or mitigate that?"
},
{
"speaker": "Eric Palmer",
"content": "Jessica, it's Eric. So I guess stepping back, our approach is focused on getting -- offering choice and value and getting to the lowest cost and best available solution from a patient perspective. So a couple of things I would note. First of all, our biosimilar offering is interchangeable. And so that facilitates an easier election if a patient chooses to choose a biosimilar, it's an easier process by being interchangeable, so that would be one thing I would note as a differentiator for us. More broadly, we're here to facilitate and ensure patients have access to the medicines that they need. So if the Skyrizi or Rinvoq will be in a position to fulfill that as well. But overall, we're working to make sure that we've got the right access to all of the medication. As we look ahead, ensuring we've got on a fully developed portfolio of all of the available biosimilar offerings will be important, and we'll continue to be in a position to lead here."
},
{
"speaker": "Operator",
"content": "Our last question comes from Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Could you just give me a little more color on some of the faster growth areas in Evernorth, in particular, if you could talk a little bit about GLP-1 coverage outlook for -- during the selling season for next year, so fee growth has been really strong. How much of that is coming from traditional PBM versus care services growth? And are you seeing any of that in Accredo?"
},
{
"speaker": "Eric Palmer",
"content": "It's Eric. So let me start and just talk a little bit about the Encircle and then I'll ask Brian to talk a little bit more about the numerical dimensions of things. So within the Encircle program, we've got over 2 million covered lives at this point. So that's growing nicely. Stepping back a little bit in terms of just looking at the coverage for GLP-1s for weight loss indications overall in the Express Scripts business, we've now got essentially 50% or so of plan sponsors covering for weight loss indications. So we've seen continued incremental growth there. The underlying utilization levels also continue to grow nicely. We've seen growth there, consistent with what you might have seen from an industry growth perspective or things along those lines."
},
{
"speaker": "David Cordani",
"content": "Looking ahead, we expect the use of these medications to continue to grow. And that is part of the growth algorithm for Evernorth overall. Stepping away from GLP-1 specifically, we see broader growth opportunity in specialty with continued growth, both through new therapies through biosimilars coming to market as well as us continuing to expand our relationships whether that's through our CuraScript, specialty distributor or through other direct opportunities. So overall, growth across a number of different fronts within Evernorth that we're pleased to be in a position to deliver. Brian, do you want to pick up the second part of Lance's question?"
},
{
"speaker": "Brian Evanko",
"content": "Sure. So as it relates to the fees and other revenue line in Evernorth, which is up 14% quarter-over-quarter, I think about a number of different areas contributing to the strong performance. contributions from our Evernorth Care businesses are reflected here. So think of EviCore, MDLIVE, our behavioral health business. And then additionally, to the core of your question, we are seeing continued growth in service-based solutions within the pharmacy benefit services business where clients are electing more fee-based orientations with us. So finally, the other contributor to this is the cross enterprise leverage that we're driving with Cigna Healthcare results in revenue from Cigna Healthcare showing up in fees and other revenue in Evernorth and then being eliminated at the corporate level. So all of those contribute to that strong growth in the fees and other revenue line."
},
{
"speaker": "Operator",
"content": "Thank you. I will turn the call back over to David Cordani for closing remarks."
},
{
"speaker": "David Cordani",
"content": "First, let me thank you all for your engagement today, your time and your questions. I just want to highlight a few headline points. With our momentum, we are confident that we will deliver on our EPS outlook of at least $28.40 for 2024, which represents over a 13% growth rate from 2023. Additionally, before we close, I want to recognize and express appreciation to our 70,000 co-workers across the globe. It's their continued focus, dedication and commitment to support our clients, our customers, our patients and our partners that enable us to deliver on our commitments, including those to you, our shareholders. We're proud of what we've achieved, and we're excited about the opportunities that stand as we look ahead. And as always, we look forward to our future discussions. Have a great day. Thanks."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes the Cigna Group's second quarter 2024 results review. Cigna Investor Relations will be available to respond to additional questions shortly. A recording of this conference will be available for 10 business days following this call. You may access the recorded conference by dialing (800) 839-1190 or (203) 369-3031. There is no passcode required for this replay. Thank you for participating. We will now disconnect."
}
] |
ci | 2,024 | 1 | [
{
"speaker": "Kevin Fischbeck",
"content": "All right. I want to thank everyone for joining us today. It's my pleasure to be hosting The Cigna Group. Presenting today, we have Brian Evanko, who is the CFO of the company as well as President and CEO of Cigna Healthcare. We also have Hasan Riaz and Ralph Giacobbe for the company as well in the audience. So I think we should jump right into Q&A. I guess maybe take us -- one of the things that we're trying to figure out here at the conference is just kind of the backdrop for utilization. There's a lot of moving pieces and seems like some degree, different points of view about where we are in the utilization perspective. Can you just talk a little bit about what you're seeing utilization, I guess, first in the core commercial book but then also any color on the Medicare Advantage side as well?"
},
{
"speaker": "Brian Evanko",
"content": "Sure, Kevin. And thanks to you and Bank of America for hosting us here this week. As it relates to utilization, in 2023 across the board, we saw strong levels of utilization in our Cigna Healthcare health plan book, which is something we had priced for, guided for and included in our projections. And so as a result of that, you would have seen we had a strong year in Cigna Healthcare in 2023. The MCR performance was strong. The revenue growth was strong, in spite of what were elevated levels of utilization compared to 2020, 2021, 2022. So '23 was a stronger year of utilization. As we stepped into '24, we assumed those strong levels of utilization would continue through the entire year. So our pricing anticipated that, our guidance anticipated that and our projections did as well. So we are pleased with our first quarter results coming in better than expectations in Cigna Healthcare, where the MCR was better than we had projected and also the income was ahead of expectations, which again we come back to the firm pricing that we've had in the market, 2024 reflecting that utilization, is consistent with what we experienced in the first quarter. So far, the second quarter is largely in line with what we had expected coming out of the first quarter, which again is persistently high utilization levels relative to what we had in '23. In the first quarter, we had strong levels of inpatient utilization, a little bit of decelerating outpatient and surgery utilization, but still at high levels in absolute terms. So that's broadly how I would think about the picture we're seeing at The Cigna group."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. And any different color on the Medicare Advantage side versus the commercial side?"
},
{
"speaker": "Brian Evanko",
"content": "The Medicare Advantage book for us and granted we only have about 600,000 lives, so it may not be representative of the nation, has been broadly in line with our projections. Strong levels of utilization, '23 persisted through the first quarter of '24. So I wouldn't call it out as a significant outlier relative to our commercial employer experience."
},
{
"speaker": "Kevin Fischbeck",
"content": "And I guess let's talk about the commercial side for a minute. I mean, you're one of the few companies that really talks about commercial as a growth business. And to your credit, you have been growing commercial well. I mean, but what is the opportunity that you guys see in the marketplace overall? What type of growth can you think you can deliver in commercial?"
},
{
"speaker": "Brian Evanko",
"content": "Yes, if you step back and think about the company in total, we've got three scaled growth platforms. We've got Cigna Healthcare, which is our health plan business. That's about 40% of our income. And our commercial employer business is the cornerstone in Cigna Healthcare. We've got our Evernorth Specialty and Care Services platform, which is about 30% of the company, which we expect to grow 8% to 12% per year on average. And then we have our Pharmacy Benefits Services business in Evernorth, that's about 30% of the company that we expect low- to mid-single-digit type growth on an ongoing basis. So three large scaled platforms. You asked specifically about the commercial employer business that's in Cigna Healthcare, which again is our health plan business. We've had a long track record of success here and part of it's the focus and the expertise that we've built up over time. But the opportunity we have going forward for disproportionately high growth is in the under 500 employer size segment, what we call the Select segment. So you can think of this employers who have between 50 and 500 employees. Today, we have about 7% market share. That's up from it was 5% just five years ago. So our share has been gradually building and we see the opportunity for that to eventually get into the double-digits from share standpoint, which is where our over 500 market share is today in the commercial employer space. We see that as a significant opportunity going forward. The reason we've been successful in that space is both improved affordability at a local market level, but also a very consultative model, that we've employed with employers from the standpoint of understanding how health benefits can be a weapon for them relative to talent attraction and retention and the fact that we're agnostic to funding arrangements. So we've for a long time had ASO or self-funded arrangements in the down market segment, which some of our competitors have been reluctant to do because it's lower revenue, even though it's very attractive from a profitability standpoint. So that's the subsegment within commercial employer that we're most excited about growth going forward."
},
{
"speaker": "Kevin Fischbeck",
"content": "Yes, I guess in Q1 when I looked at your commercial membership, the membership was down pretty much in every segment except for I guess the Select business. So what happened there? Why weren't we seeing better membership trends when the economy is doing relatively well? And then how should we think about the rest of the year?"
},
{
"speaker": "Brian Evanko",
"content": "Yes, the Select segment, I'll come back to the core of the question, the Select segment, you can think of as having more rolling renewal dates. So because these are smaller employers, they're -- it's not as concentrated on January 1st. So we tend to see intra-year growth, in that sub-segment specifically, so the under-500 Select segment. So we'll see throughout the year growth, in terms of sequential lives into 2024. As it relates to your point on the larger segments, if you look at our middle markets and national accounts, we did have some self-funded fee based clients that were lost for 1124. We knew about that because from the standpoint of the pricing environment, we didn't chase the pricing. So not material to our income, but they did create a dent to the lives on 1124. Now that's on the heels of a couple of years of really strong growth. If you go back and look at where we were at the end of '21, our commercial employer book now is much bigger, 2 million, 3 million lives bigger. So it's we've had a lot of growth. But in this specific time period, we had a couple of known employer losses, Kevin."
},
{
"speaker": "Kevin Fischbeck",
"content": "And so then does that mean that the market's getting more competitive in that marketplace or is this just digesting recent growth?"
},
{
"speaker": "Brian Evanko",
"content": "Yes, I wouldn't characterize it as more competitive in general because these are only -- there were two significant fee based clients. So out of the 100s that we serve in that space, I wouldn't necessarily conclude it's more competitive. We're broadly seeing rational pricing from our competitors. But here and there, you'll see a situation, where the pricing is a bit aggressive."
},
{
"speaker": "Kevin Fischbeck",
"content": "And so as far as the rest of the year goes, do you expect membership to kind of trend up from here as the year goes on, is that?"
},
{
"speaker": "Brian Evanko",
"content": "We do. In the employer business, we expect there to be intra-year growth in the lives such that the full-year commercial employer book, year-end '24 versus year-end '23 should be flat to potentially up a bit."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. And then you guys are getting out of the Medicare Advantage business and you don't have a Medicaid business. Can you just talk about your views on the government business? Like why isn't that part of your portfolio strategy today? And it seems like almost every company has a diversified portfolio. Aren't there benefits of having that?"
},
{
"speaker": "Brian Evanko",
"content": "There's a few different questions in there, so maybe I'll try to go deliberately through this to make sure the audience understands all the pieces in our thought process. So to your point, we're in the process of divesting our Medicare businesses as we speak to HCSC on track for early 2025 closing date of that. We've completed the DOJ review process. We got through the federal antitrust review already, so a couple of key milestones have already been met. Again, on track to deliver that divestiture in the first quarter or early part of 2025. Stepping back, though, why would we divest the business, I think is more where you were going with the question. We continue to see the Medicare subsector of the U.S. healthcare space as an attractive part of the U.S. healthcare market. So this was not a verdict about Medicare not being an attractive subsector. But for us, relative to where The Cigna Group is positioned, our strengths, our existing assets and where we can create the most value, we concluded that given its relatively small size in our portfolio, the amount of human capital and financial investment that would be required to scale it to a level that's significant for our company was too tall of a task and that it was best in someone else's hands. So that's what led to the decision to divest the business. So this was not a verdict about the Medicare market. It was relative to the size of our company and the things that we're prioritizing and focusing in. So I talked about specialty pharmacy earlier, our commercial employer business and the strength in our Pharmacy Benefits Services platforms. Those are getting disproportionate investment resources and we have a sustained right to win in each of them. Now, stepping back from that, our Evernorth Health Services business serves a lot of Medicare lives today. We serve a lot of Medicaid lives today, particularly with the win of Centene that has now gone effective, January 1st into our book. So we now serve 20 million or so so customers of Centene across Medicaid, Medicare and across the entire Evernorth portfolio. About 30% of all the customers we serve there are government sponsored: Medicaid, Medicare, DoD. So between our Pharmacy Benefits Services, specialty pharmacy, we serve a lot of Medicare, Medicaid, government lives, but through the services chassis as opposed to the health plan chassis. So in the long run, not having a health plan presence presents an opportunity for us strategically, something we could consider. It's not necessarily in the near-term where we're going to be focused, but it's an opportunity in the long-term for us to consider."
},
{
"speaker": "Kevin Fischbeck",
"content": "Is that true for Medicaid as well as Medicare or do you have a different view about those programs?"
},
{
"speaker": "Brian Evanko",
"content": "Similarly to Medicare, after the divestiture, we won't have any health plan presence in Cigna Healthcare. And as we go through our strategic reviews of any decision that we make, we'll assess Medicare, Medicaid and other lines where we're not active. So I wouldn't say we have a stronger view of one versus the other in terms of the relative attractiveness. Ultimately, it'll come back to, as we think about the criteria for where we invest or the criteria for M&A, each of the specific situations would need to be -- need to be carefully reviewed. We have concluded that we don't intend to organically enter Medicaid or Medicare. So if we are in those lines in the health plan business, it would be through some sort of acquisition down the line."
},
{
"speaker": "Kevin Fischbeck",
"content": "All right. Can we talk a little bit about Evernorth then for a minute? You guys have kind of broken out that PBM business separately from the special two business. Can you talk a little bit about the decision to do that and why you think that's important for investors to understand?"
},
{
"speaker": "Brian Evanko",
"content": "Sure. Yes, so starting in the first quarter, we divided the Evernorth business into two operating segments or subsegments. And again, stepping back, Evernorth is a health services platform for Cigna. It's about 60% of our income. And then Cigna Healthcare is the health plan, about 40%. So the 60% we divided into the two components. And part of this was we had a lot of questions coming in from investors to help us understand the pieces better. But also part of it is we wanted to make sure, we really put a spotlight on the Specialty and Care Services platform, which can you think of each of them as approximately equal today in terms of their contribution, 30% of the total company's income from both of those two operating segments. We found many people were taking our specialty pharmacy business and grouping it with the rest of our Pharmacy Benefits Services business and just thinking of that as a prescription drug oriented business. Yes, the two have very different growth profiles going forward. So the Specialty and Care Services business, $400 billion addressable market, it'll grow high-single-digits for the foreseeable future and we're the leader in that space. And we've expected 8% to 12% annual income growth out of that operating segment on a go forward basis and we've delivered that historically. However, we don't feel like everyone understands or appreciates the power of that business today, because historically, when it was lumped together with the rest of Evernorth, it was easy to say that's a big PBM. Yet, the reality is the specialty pharmacy business is really a heavy duty clinical care delivery model in a really attractive, highly growing addressable market. And so we wanted to put a spotlight on that for investors and allow you all to see the fact that that's going to be a very high growth business for the company and ideally think of it from a valuation standpoint differently than what the rest of Evernorth is, which is our Pharmacy Benefits Services platform, which we expect to grow 2% to 4% going forward. So it'll still grow and still has secular tailwinds, but not to the 8% to 12% growth rate of the Specialty and Care Services platform. So that's why we decided to go down that route, Kevin. We have a lot of questions and we wanted to put a spotlight on the high growth subsegment that we have within Evernorth."
},
{
"speaker": "Kevin Fischbeck",
"content": "And I guess maybe to that point, I think since this was the first quarter where we could look at it, it's optically looked a little bit strange when the PBM business grew so much off the Centene contract, but the specialty business didn't seem to get the same lift. Can you talk about why specialty didn't get the same bump that PBM did?"
},
{
"speaker": "Brian Evanko",
"content": "Sure, yes. And you're right. We had the benefit of the Centene contract onboarding in the Pharmacy Benefits Services operating segment. So if you look at the quarter-over-quarter growth, it's very high in excess of 40% in the Pharmacy Benefits Services platform. Now, the Specialty and Care Services still grew 12% year-over-year, so nothing to sneeze at in that regard. But to your point, the Centene recognition, if you will in terms of where the financial show up is largely in the Pharmacy Benefits Services platform. So we have our Accredo Specialty Pharmacy as one of the specialty pharmacy options for Centene customers, but it's not exclusive. It's one of the options. So to the extent that a Centene customer fills a script at our Accredo Specialty Pharmacy, we recognize it in that subsegment. But the Lion's share of the relationship is in the Pharmacy Benefits Services platform today."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. And when you think about that 8% to 12% growth algorithm, like how should we think about it? What are the key drivers to that?"
},
{
"speaker": "Brian Evanko",
"content": "The most significant driver of that is the core secular growth in the specialty pharmacy market. And what I mean by that is looking back over the past decade or so, much of the innovation in health care has been in medical devices. Now we're starting to see pharmaceutical innovation not even in the early innings we're starting to get in the middle innings of pharmaceutical innovation over the next decade really being the next wave of health care. And the specialty pharmacy market in particular will see a lot of that. So whether it's gene therapies, Alzheimer's drugs, we're seeing right now the effect of GLP-1s starting to ramp, as you all know. Those are all examples of drug innovation that will drive high secular growth in that $400 billion specialty pharmacy market. And our Accredo Specialty Pharmacy today, we have depending on which measure you use in the 20% market share range, something along those lines. We have a scaled business in a high growing subsector with a lot of clinical experts, because these are high cost drugs. Often, they require temperature control or they require specific administration in a person's house or in a physician's office. So these are high cost drugs. This is not going down to your local drugstore and picking up a generic. They're complicated specialty drugs and we're really well positioned. So that's the primary driver of the 8% to 12% growth within there. The two others that I would highlight are we have a Distribution business for specialty pharmacy as well called CuraScript. It's been growing double-digits for many years. And we have an opportunity to see that grow, at an even faster rate on a go forward basis as more biosimilars are brought to market and more competition for high cost branded drugs enters the markets, we got an opportunity there. And then our Behavioral Health business, we have an opportunity for outsized growth there as well. Today, that's a relatively small part of the company, but there's a tremendous amount of demand for mental health right now both from our Cigna Healthcare customers, but also our external and affiliated clients that Evernorth serves. So all those things taken together lead to the 8% to 12% expectation."
},
{
"speaker": "Kevin Fischbeck",
"content": "That at last one, so the first two were actually kind of specialty drug driven the last one, that's a medical management overlay, not a pharmaceutical?"
},
{
"speaker": "Brian Evanko",
"content": "Correct. Yes. So from the standpoint of trying to keep things simple, only having two operating segments in Evernorth, the specialty and care services includes primarily specialty pharmaceutical, but we have some health care services in there as well things like behavioral health, things like our MDLive Virtual Care, things like our EviCore medical benefits management."
},
{
"speaker": "Kevin Fischbeck",
"content": "And so it seems like everyone is talking about adding more of these services and these carve out benefits. I mean, what you -- how would you characterize the competitive environment today for these types of things like behavioral? It seems like, again, Elevance is doing it, United has been doing it, you're doing it like how do you win in that market?"
},
{
"speaker": "Brian Evanko",
"content": "I think to this point, it's important to sub segment the employer space a bit more. I think your question is probably geared to the employer market, if I heard you right there. So the under 500 market that I was referencing earlier, we have outsized growth opportunity, what we call the select segment within Cigna Healthcare. Generally speaking, those employers are buying the full suite of solutions from us. They're not going through procurement for mental health separately from their medical benefits, separately from their prescription drug. They're generally buying the full suite of solutions from us. That's a function of generally, small HR departments. They want simplicity as opposed to having to go through complicated procurements and having to manage multiple partners. As you go upmarket, into the over 500 space and then eventually up into the largest employers, there tends to be more of the a la carte or multi-partner procurements. And so, that tends to be the case -- that's been the case for a long time. That's still the case. We're seeing a little bit of -- we use the term point solution fatigue where some of our largest clients I'd spend a lot of time with them in my Cigna Healthcare role have said, I've over time invested in some of these smaller point solutions, and they're not really paying back the way that I thought they would. So I'm looking for a more integrated solution, which presents an opportunity for us and some of our large scale competitors to see some consolidation from the point solution vendors. But broadly speaking, down market, we have everything in if we sell to the client. Up market, it's a bit more fragmented today with some opportunity for consolidation."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. Can you talk a little bit about, the PBM environment? You guys just won a large contract. Anything to highlight there as far as over the next year or two that anything you have up for re-procurement or any larger contracts that might be coming to market?"
},
{
"speaker": "Brian Evanko",
"content": "The Centene contract that was just effective 1,124, far and away bigger than anything else that's in the kind of short to intermediate horizon for us. And for '25, we'd expect based on where we sit here in the middle of May, mid-90s or better retention on our PBM book of business, based on where things stand and a few opportunities for new business coming in as well. That's all factored into the forward-looking 2% to 4% average annual growth algorithm for the Pharmacy Benefits Services business, but not anything anywhere near as sizable in the '25 cycle that's we had with Centene."
},
{
"speaker": "Kevin Fischbeck",
"content": "And as far as the Centene contract, I guess last year was a drag, you should prepare for it. This year it's talking more break even and next year you should be at target margins. Is that are you still on track for that dynamic?"
},
{
"speaker": "Brian Evanko",
"content": "We are on track for that dynamic. So we don't intend to every quarter talk about the financial performance of Centene. But that broad picture you just painted is consistent with our latest expectations. '25, we should be at run rate profitability on the contract. And the installation went great. So, we still have regular dialogue with Centene. They've been pleased from everything we've heard in terms of the operational performance, which was not an easy thing to do to bring 20 million new customers over into our environment. We're really pleased with the performance from the team."
},
{
"speaker": "Kevin Fischbeck",
"content": "All right. Great. Can you talk a little bit about, just going back to the Health Plan business, the exchanges? You guys pulled back noticeably on the exchanges in a couple of states. Where are the margins today and how do you view the exchanges going forward?"
},
{
"speaker": "Brian Evanko",
"content": "Sure. So the exchanges are within Cigna Healthcare for us, and you can think of it as this year about a $4 billion book of business from a premium standpoint. So within Cigna Healthcare, that represents under 10% of the total, but it's an area we see growth opportunity on a go forward basis. Now, we had to do some repositioning in '24, because '23 in two of our largest states with the benefit of hindsight, we underpriced the business in two of those states. And so we went through, a new product positioning as well as a repricing exercise in two of those states, which led to a reduction in membership year-to-date, as we expected. So the good news for us is we've delivered '24 where we needed to from the standpoint of fewer customers, but more profitable. As we went through the repricing that I made reference to, our '24 expectations are that the book itself will run slightly below our target margins, and our target margins are 4% to 6% on that business, so we expect to be slightly below that. That's what's incorporated in our guidance. The first quarter and the April experience is consistent with that expectation."
},
{
"speaker": "Kevin Fischbeck",
"content": "Is that would you expect to be at target next year [indiscernible] repricing?"
},
{
"speaker": "Brian Evanko",
"content": "Barring any unforeseen events, that will be our expectation."
},
{
"speaker": "Kevin Fischbeck",
"content": "I think you guys have a longer term view that that business will grow, is it 10% to 15%?"
},
{
"speaker": "Brian Evanko",
"content": "Yes. So inherent in our -- in Cigna Healthcare, we expect average annual income growth of 7% to 10%. Within that, we expect the individual exchanges to grow 10% to 15%. So the weighted effect of 10% to 15% versus the other components gets to 7% to 10% at the total Cigna Healthcare level. Part of that for us is addressable market expansion, since we're only in about a dozen states. So we have new states we can get into. Some of the existing geographies, our market share is lower, so there's opportunity there. And ultimately, that $4 billion of premium we see growing in time. Not that the entire company, of course, isn't predicated on that business performing, but we see it as an important part of the health care system."
},
{
"speaker": "Kevin Fischbeck",
"content": "Is that the only part of your commercial business that was kind of under target? Are you generally speaking back to target margin and commercial outside of exchanges?"
},
{
"speaker": "Brian Evanko",
"content": "Yes. So Cigna Healthcare, if you think of the components, the U.S. Employer business essentially at target margins, the International Health business essentially at target margins, the individual exchange a little bit below as we just talked about. And then our Medicare business, which we're in the process of divesting currently weighed down by SG&A, so it's below targets. Although the medical care ratios are not out of line with where we would expect."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. It's interesting. It feels to me like Cigna is in a pretty good spot right now. When I think about next year, there's not really any obvious headwinds that I can see to your business. So next year you're going to have trends going to remain high, unit costs seem to be driving commercial trend and that's probably going to be high again next year. So that's good for revenue growth. You've got the Centene contract ramping up. It sounds like the RFP pipeline is going well on the PBM side. So it seems like everything's kind of going well in your favor. Is there anything we should be thinking about from a headwind perspective that, is an offset or anything that keeps you up at night as far as next year's growth goes?"
},
{
"speaker": "Brian Evanko",
"content": "I hate to say there are no headwinds, but there are no known headwinds that are sizable that I would highlight, and I broadly agree with the framing that you provided there. And actually, two months ago on our Investor Day, you all may have noticed we increased the ceiling of our EPS growth algorithm on a go forward basis. It was 10% to 13% for a long time. We increased it to 10% to 14%, because we see the next several years being opportunities for strong rates of growth, despite it being a pretty disrupted environment that we're operating within. So whether that's -- the forces you described or the drug innovation that I made reference to, all those things contribute to our businesses being really well positioned for the next few years and not a specific one, two, three headwinds that I would call out as we step into '25. Of course, we always have to respect the fact that medical cost utilization could be higher than expectations. And of course, we're always going to be investing in operating expense or making investments in strategic capabilities that could weigh on operating expenses in any given time period. But broadly speaking, don't see any notable one time headwinds."
},
{
"speaker": "Kevin Fischbeck",
"content": "Yes. And then, you talked a bit about the share repo that you're doing this year. You guys are in the process of doing the first $5 billion. What's the appetite or ability to do it to continue share repo on the back half of the year? And your good debt to cap is in Q1 was 44%. You guys usually talk about 40% as the target. How does that play into how you think about share repo and the timing?"
},
{
"speaker": "Brian Evanko",
"content": "Yes. So we've continued to see our shares as a great use of our deployable capital, which is one of the reasons we've done so much share repurchase the last few years. And in '24, we've committed to the majority of our discretionary cash flow going for share repurchase. We're on track to deliver against the commitment we made, which is at least $5 million by the end of the first half of '24, so at least $5 billion to share repurchase. So we've we initiated a $3.2 billion ASR in February that will complete by the end of this month. And then we'll do some open market repurchase to achieve that goal by the end of June. So we're fortunate to have the cash generation that allows us the flexibility to do this sort of repurchase. And as you think about the back half of the year, even after you remove CapEx and you remove shareholder dividends, there's still call it, $3 billion or so of fungible cash that will be available for deployment between either some debt repayment to the extent we de-lever a bit or to the extent we see a strategic M&A opportunity. So we see those buckets as a bit fungible in the back half of the year, but we continue to see share repurchase as a very attractive lever for the company. To your point on debt, we were a little bit elevated in the first quarter from the timing of our debt issuance, which was part -- in part to fund the ASR. We also had, a write off of one of our assets that temporarily elevated the debt to cap. Over time, we're committed to a 40% debt to cap ratio. That's what we've aligned with our rating agencies on. And so the times we'll be above that. We were at 40% at the end of the year. So we'll de-lever down to that level at some point."
},
{
"speaker": "Kevin Fischbeck",
"content": "And I guess when you think about -- you guys talk about 65% of your cash flow either going to M&A or share repo. And I appreciate, viewing your own stock as attractive. We do too. But if you think about M&A, one of the pushbacks that I have on Cigna's strategic capital deployment, it just seems like that there should be something out there that could kind of push the company forward. But since you bought Express Scripts, you've raised more money in asset sales than you've deployed on acquisitions. And so it feels like everyone around you is kind of more aggressive on deploying capital. So what are your thoughts about, I don't want to say it's an arms race, but like -- are you missing out on anything? Is there anything that you look at today and say, yes, it would be better to have this or that?"
},
{
"speaker": "Brian Evanko",
"content": "Yes, we see M&A as an important part of our capital deployment strategy, so full stop. And even though, to your point, there haven't been as many high dollar, high profile acquisitions since we acquired Express Scripts, it's a constant area of review and focus for us strategically. So to your point, 60% to 65% of our capital available for deployment we see as fungible between M&A and repurchase, but we're not going to sit on cash either. So if there's not an attractive M&A prospect, we're going to use the repurchase lever because we view our stock as a very good investment, with where we sit today. Now strategic M&A for us falls into a few different categories. There's where can we improve our competitive position and our competitive advantage in our existing businesses. So I went through the different components of the company earlier. And then there's where can we expand our addressable market, our reach, which could be in Cigna Healthcare. We talked about a few of the lines where we don't have a presence or we won't have a presence in the future or it could be in Evernorth where we have more opportunities for services, particularly health services. So those are examples of areas that we're constantly looking at. But importantly, every asset needs to be viewed individually and we put it through the lens of does it strategically push the company forward, is it financially attractive, meaning accretive over time and meeting return on capital expectations, And can we get it done, both from the standpoint of having the right counterparty and getting through antitrust."
},
{
"speaker": "Kevin Fischbeck",
"content": "I guess I understand getting into new markets or getting to new geographies. What does it mean, say, to improve your competitive positioning? Like what does that mean?"
},
{
"speaker": "Brian Evanko",
"content": "So in the three large scaled assets I made reference to Cigna Healthcare, Specialty and Care Services and Pharmacy Benefits Services, there are examples of ways where we can further extend our advantage into subsectors. So, in Cigna Healthcare, we have certain geographies where we're less competitive. In the Specialty and Care Services business, we're a little more nascent as it relates to serving health systems and hospitals. Those are examples of within already large scale businesses where there could be an advantage to build."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay, I think that is all we have time for. Thank you very much."
},
{
"speaker": "Brian Evanko",
"content": "Thanks Kevin. I appreciate the time."
},
{
"speaker": "End of Q&A",
"content": ""
}
] |
cinf | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the Cincinnati Financial Corporation Fourth Quarter and Full Year 2024 Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. Please note this event is being recorded. I would now like to turn the conference over to Dennis McDaniel, Investor Relations Officer. Please go ahead. Hello. This is Dennis McDaniel of Cincinnati Financial Corporation."
},
{
"speaker": "Dennis McDaniel",
"content": "Thank you for joining us for our fourth quarter and full year 2024 earnings conference call. Late yesterday, we issued a news release on our results along with our supplemental financial package including our year-end investment portfolio. To find copies of any of these documents, please visit our investor website investors.cinfin.com. The shortest route to the information is the quarterly results section near the middle of the investor overview page. On this call, you will first hear from President and Chief Executive Officer, Steve Spray, and then from Executive Vice President and Chief Financial Officer, Mike Sewell. After their prepared remarks, investors participating on the call may ask questions. At that time, some responses may be made by others in the room with us, including Executive Chairman Steve Johnston, Chief Investment Officer Steve Soloria, and Cincinnati Insurance's Chief Claims Officer, Mark Shambo, Senior Vice President of Corporate Finance, Teresa Hopper. Please note that some of the matters to be discussed today are forward-looking. These forward-looking statements involve certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules and therefore is not reconciled to GAAP. Now I will turn over the call to Steve."
},
{
"speaker": "Steve Spray",
"content": "Good morning, and thank you for joining us today to hear more about our results. Our hearts go out to those impacted by the LA wildfires. You have lost homes, treasured belongings, a sense of community, and in the most devastating cases, loved ones. I also want to thank the first responders who put their lives on the line, our agents for their support and partnership, and, of course, our claims associates who are working tirelessly to help our policyholders with immediate needs and longer-term plans. Before I share more details about our current estimate for this catastrophe, let's dive into how we performed last year. Operating performance for the fourth quarter was very strong and many key areas showed improvements. We are also pleased with performance for full year 2024, thanks to the superb work of our associates providing service to agents who we consider to be the best in the insurance business. Our fourth quarter results compared to the same period last year included a better combined ratio and excellent growth in premiums and investment income. The result boosted net income, and we had double-digit growth in operating income. Net income was $405 million for the fourth quarter of 2024. It included recognition of $107 million on an after-tax basis for the decrease in fair value of equity securities still held. An unfavorable swing of $931 million from the same period a year ago. Net income for the year rose 24%. Non-GAAP operating income for the quarter increased 38% to $497 million and rose 26% for full year 2024. Our 84.7% fourth quarter 2024 property casualty combined ratio was 2.8 percentage points better than a year ago. It brought the full year combined ratio to an outstanding 93.4%, 1.5 points better than 2023. The full year improvement included a catastrophe loss ratio effect only 0.2 points lower. Our 86.5% year 2024 combined ratio before catastrophe losses improved by 1.9 percentage points compared with accident year 2023, including 5 points of improvement for the fourth quarter. We reported another quarter of strong premium growth. We believe it's profitable growth as our underwriters diligently use pricing precision tools to support their risk segmentation efforts on a policy-by-policy basis. Estimated average renewal price increases for the fourth quarter were similar to the third quarter of 2024. Commercial lines moved slightly lower in the high single-digit percentage range and excess and surplus lines remained in the high single-digit range. Our personal line segment was also similar to the third quarter with personal auto in the low double-digit range and homeowner in the high single-digit range. New business growth produced by agencies representing Cincinnati Insurance continued at a nice pace. Nearly one-third of the growth for the year was from agencies appointed since the beginning of 2023, reflecting our strategy of appointing additional agencies where we identify appropriate expansion opportunities. Policy retention rates in 2024 were similar to last year, with our commercial line segment up slightly, but still in the upper 80% range. Our personal line segment remained in a similar position of the low to mid-90% range. The overall result was consolidated property casualty net written premiums growing 17% for the quarter, including 15% growth in agency renewal premiums, and 23% in new business premiums. Next is a brief review of performance by insurance segment for full year 2024 compared with 2023. Most metrics also improved on a fourth-quarter basis. Commercial lines grew net written premiums 8% with an excellent combined ratio that improved by 3 percentage points to 93.2%. Personal lines grew net written premiums 30% and improved the combined ratio by 2.9 percentage points, to 97.5%. Excess and surplus lines grew net written premiums 15% with a 94.0% combined ratio. Although that was 3.4 percentage points higher than last year, it's still quite profitable. Both Cincinnati Re and Cincinnati Global also very profitable. Cincinnati Re grew net written premium 7% with an 85.0% combined ratio, while Cincinnati Global's growth was 8% with a 73.6% combined ratio. Our life insurance subsidiary also improved its result with a 21% increase in 2024 net income and term life insurance earned premium growth of 3%. These strong results combined to bring our value creation ratio in above our target of 10 to 13% on a five-year average basis. Our fourth quarter VCR was 1.8%, and we reached 19.8% on a full-year basis. Net income before investment gains or losses for the year contributed to a higher overall valuation of our investment portfolio. The other half. Before I turn the call over to Mike, I'll provide our current estimates of financial effects related to the recent California wildfires and an update on our 2025 reinsurance program. We estimate first quarter 2025 pretax catastrophe losses of approximately $450 to $525 million net of reinsurance recoveries. That includes approximately 73% for our personal lines insurance segment, 24% for Cincinnati Re, and 3% for Cincinnati Global. We reinstated the applicable layers of our primary property catastrophe reinsurance treaty coverage and will cede additional premiums to our reinsurers. Cincinnati Re will receive additional premiums from treaties reinstated. The estimated net effect of first quarter premium revenue is a decrease of $50 to $60 million. To keep this event in perspective, had the wildfire effect occurred in 2024, we believe we would still have earned a modest underwriting profit. On January 1st of this year, we again renewed our primary property casualty treaties that transfer part of our risk to reinsurers. For our per risk treaties, we retained while retention for the casualty treaty remained at $10 million. Other terms and conditions for 2025 are fairly similar to 2024. A primary objective for our property catastrophe treaty is to protect our balance sheet. The treaty's main change this year is adding another $300 million coverage, increasing the top of the program from $1.2 billion to $1.5 billion. We again retain all of the first $200 million, then retained 56% of the next $100 million, 25% of the next $100 million, and approximately 14% of the next $1.1 billion. Now let me turn the call over to Chief Financial Officer, Mike Sewell, for additional highlights of our financial performance."
},
{
"speaker": "Mike Sewell",
"content": "Thank you, Steve, and thanks to all of you for joining us today. Investment income reached $1 billion for the year and significantly contributed to our improved operating performance. It grew 17% for the fourth quarter and 15% for the full year 2024 compared with the same periods of last year. Dividend income was down 4% in the fourth quarter driven by third-quarter sales of equity securities from previously disclosed rebalancing of our investment portfolio. Interest income grew 28% for the fourth quarter this year. Net purchases of fixed maturities securities totaled $1.1 billion for the quarter and $2.5 billion for the year. The fourth quarter pre-tax average yield of 4.93% for the fixed maturity portfolio was up 45 basis points compared with last year. The average pre-tax yield for the total of purchased taxable and tax-exempt bonds during 2024 was 5.66%. Valuation changes in aggregate for the fourth quarter were unfavorable for both our equity portfolio and our bond portfolio. Before tax effects, the net loss was $136 million for the equity portfolio, and $350 million for the bond portfolio. At the end of the fourth quarter, the total investment portfolio net appreciated value was approximately $6.7 billion. The equity portfolio was in a net gain position of $7.2 billion while the fixed maturity portfolio was in a net loss position of $553 million. Cash flow, in addition to higher bond yields, continue to benefit investment income growth. Cash flow from operating activities for full year 2024 was $2.6 billion, up 29% from last year. Regarding expense management, our objective is to balance spending control efforts with investing strategically in our business. Our 29.9% full year 2024 property casualty underwriting expense ratio was in line with 2023 in total and for each major expense category. The fourth quarter ratio was 1.4 percentage points lower than last year primarily due to lower accruals for agency profit sharing commissions in addition to premium growth outpacing the increase in employee-related expenses. My next topic is loss reserves where our approach remains consistent and aims for net amounts in the upper half of the actuarially estimated range of net loss and loss expense reserves. As we do each quarter, we consider new information, such as paid losses and case reserves. Then we updated estimated ultimate losses and loss expenses by accident year and line of business. During 2024, our net addition to property casualty loss and loss expense reserves was $1.1 billion including $998 million for the IBNR portion. We experienced $236 million of property casualty net favorable reserve development on prior accident years that benefited the combined ratio by 2.7 percentage points during 2024. For our commercial casualty line of business, there was no material reserve development for any prior accident year during the fourth quarter. On an all-lines basis by accident year, net reserve development during 2024 included a favorable $369 million for 2023, favorable $63 million for 2022, favorable $5 million for 2021, and an unfavorable $201 million in aggregate for accident years prior to 2021. My final comments highlight our capital management activities. For full year 2024, we returned capital to shareholders through $490 million of dividends paid. In addition to share repurchases. Shares repurchased totaled 1.1 million shares at an average price of approximately $113 per share, including an immaterial amount during the fourth quarter. We believe our financial flexibility and our financial strength are both in excellent shape. Parent company cash and marketable securities at year-end totaled $5.2 billion. Debt to total capital remained under 10%. And our quarter-end book value was at a record high $89.11 per share. With nearly $14 billion of GAAP consolidated shareholders' equity, providing plenty of capacity for profitable growth for our insurance operations. Now I will turn the call back over to Steve."
},
{
"speaker": "Steve Spray",
"content": "Thanks, Mike. 2025 marks the 75th anniversary of the Cincinnati Insurance Company. Over that time, we have come to understand the importance of stability, consistency, and financial strength. We understand that we are in the business of accepting risk. We plan for it, we price for it. We spend considerable time and effort focused on appropriately balancing growth and profitability through geographic and product diversification, pricing sophistication, and enterprise risk management. No one expects to experience a catastrophic loss such as those felt by the people who found themselves in the paths of hurricanes Helene or the California wildfires. However, it's in the aftermath of these events that Cincinnati Insurance can shine. Confident in our financial strength, our claims associates can focus on delivering fast, fair, and empathetic service. At the same time, we are ready to build value for shareholders. The Board recently reinforced their confidence in our strategy by declaring a 7% dividend increase payable in April and paving the way to extend our streak of increasing dividends to 65 years. As a reminder, with Mike and me today are Steve Johnston, Steve Soloria, Mark Shambo, and Teresa Hoffer. Gary, please open the call for questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Our first question today comes from Michael Phillips with Oppenheimer. Please go ahead."
},
{
"speaker": "Michael Phillips",
"content": "Thank you. Good morning, everybody. Just want to start off, I guess, Steve, love to hear your perspective on a higher-level question on the outlook for the reinsurance sector in the aftermath of California. I guess, how do you see capacity as the year progresses? How do you expect Cincinnati Re to respond and maybe, how should that translate into kind of premium for 2025 for that segment? Thanks."
},
{
"speaker": "Steve Spray",
"content": "Yeah. Mike, are you talking specifically on Cincinnati Re or ceded Re?"
},
{
"speaker": "Michael Phillips",
"content": "Well, I guess, first of all, just your thought yeah. Just your thoughts on the market in general, more broadly from the industry, how it responds. And then kind of drill down to how you guys it looks there's gonna be some opportunities how you guys would respond and what that means for Cincinnati."
},
{
"speaker": "Steve Spray",
"content": "Right. Let me maybe I'll start with just the reinsurance market to your question, Mike, first. You know, I think the reinsurers, appropriately, the last couple of years, I think, have shown, you know, just the industry itself has shown an underwriting profit. I think that's good. That's healthy. We all need that. I'll speak specifically for Cincinnati Insurance. We've just got such long-term relationships and partnerships with our you know, our ceded partners, our reinsurers, and talk to them on a regular basis, obviously. You know, we expect to pay all of our losses ground up. Plus the reinsurers margin over time. We need them healthy. They know that. We've traded with them that way. Over time, and that won't change. That would probably be my remarks there. Cincinnati Re, they're gonna stay the course. You heard, we had an extremely profitable 2024, inception to date with Cincinnati Re. Has is very profitable. As well. They plan for catastrophe. That's what they do. Know, their losses on specifically, on the California wildfires were within expectation, and you know, they'll they'll proceed throughout the year with their with their 2025 plan. No change."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Alright. Thanks, Steve. Next question is I ask I I wouldn't classify your umbrella exposure in general for your company as is is tiny, but it's only not outsized. But question related to sort of umbrella. In in personal lines, I think this quarter, it didn't see a lot it's a personal line I didn't see a lot of change in claim count activity in that two to five layer. But dollar amount did move up. So, you know, some something's there. Thirty ten plus twenty five, thirty-five on that as well. So the two to five layer. Any call you can add on anything in a quarter specifically that would help justify that that extra amount of dollars in that layer and and and more broadly after the quarter, anything you're seeing in umbrella excess layers that would cause any concerns. Thank you."
},
{
"speaker": "Steve Spray",
"content": "Yep. Thanks, Mike. Appreciate the question. Now, you know, looking at a quarter for umbrella, whether it be commercial or personal, I think it's gonna it's gonna kinda mislead you a little bit. Like, you gotta pull back to more of an annual number. There's just you know, the frequency with umbrella is is obviously very low. It's a severity line. Inherent volatility in it. So we look at every single large loss we have, in every single line of business we have, and look for trends whether it be by state, by agency, by class of business, you know, that's obviously I'm speaking to commercial. We do the same thing for personal lines as well. So we don't see anything in that commercial book or excuse me, in that personal lines umbrella book that causes us any concern."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Steve, thank you, and congrats on the call. Appreciate it."
},
{
"speaker": "Steve Spray",
"content": "Yeah. Thanks so much, Mike. Appreciate it."
},
{
"speaker": "Operator",
"content": "Next question is from Gregory Peters with Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Good morning. I I wanna go back to the the comments on the fire loss. Could you provide some perspective on, you know, you I think you said fifty to million dollars of reinstatement cost. But the gross loss might be or what you're pegging for using for your gross loss number and just trying to figure out how far up the tower you want."
},
{
"speaker": "Steve Spray",
"content": "Yeah. Thanks, Greg. And as you can imagine, this is an active still an active catastrophe. And for right now, our range our net range that we're providing you is our best estimate of ultimate loss, and we're gonna just stick with that net range of the four hundred and fifty to five twenty-five."
},
{
"speaker": "Gregory Peters",
"content": "Just not Okay. Not there's not any move no."
},
{
"speaker": "Steve Spray",
"content": "So many moving parts right now, Greg. Just providing a gross number. You know, we're not we're not ready to go."
},
{
"speaker": "Gregory Peters",
"content": "Can can maybe pivot away from that then and just you know, I know the there there was a call recently with the insurance regulator and the governor and a bunch of insurance companies. And it feels like there's some movement to making allowing more rate activity in homeowners to compensate for the the fire risk. Can you can you talk about what your perspective is of that market looking forward? You know, once we get through paying all the losses, etcetera."
},
{
"speaker": "Steve Spray",
"content": "Yeah. Sure. One thing I'd point out from the Cincinnati book is seventy-seven percent of our homeowner premiums in California today, are on a non-admitted basis. On the admitted side, you know, I don't I think it's pretty well documented. I don't think it's any secret that California is a is a challenging market. We've got great agents and policyholders, and we wanna support them. As you can imagine also, after you know, I just mentioned any individual single large loss, and also after any catastrophe event, we do a deep dive as a company and objectively look at everything regardless of the of the event and determine if there's you know, lessons learned. There's always lessons learned. There's anything we need to do in changing our strategy moving forward, you know, if anything, obviously, do that here with California. And with the wildfires, there's just a lot of as you can imagine, Greg, there's a lot of moving parts with this as well. And, yeah, the regular the regulation rate environment and things of that nature. There's there's a long list of things that we will look at you know. But I think right now, we are really focused on paying claims you know, fairly empathetically, face to face, and the lessons learned, although we are we're looking at them actively, you know, that'll take a little longer to to really formulate if we're gonna make any changes going forward."
},
{
"speaker": "Gregory Peters",
"content": "Okay. I'll I'll pivot away from that line of questioning. Just my my question broader broadly speaking is know, there's there's in in in the commercial lines market, maybe in the personal lines market ex California, you know, just to growing sense that the pricing cycle's kind of peaked. Maybe it's, you know, moderating price increases aren't as robust, and some instances are going down. Can you can you remind us and just give us a snapshot of where you were at the end of the year? And I know I know part of your book has multiyear policies. Can you give us a snapshot of where those those policies reside and what the percentage of the total was?"
},
{
"speaker": "Steve Spray",
"content": "Yeah. Sure. So you know, as we as we just talked about, you know, on the for the major lines of business, commercial property, general liability, and auto were in the high single-digit range. Work comp is down the mid single-digit range, that's been, you know, that's pretty been been pretty well documented. So we're still seeing rate into that commercial lines book. But I think the point estimate or the average Greg, just doesn't it doesn't tell the story for us. Our underwriters at the desk level working with agents using the precision you know, the pricing tools that they have, are segmenting our book. So there's a large percentage of our book, business, and as you know, we're package underwriter. That may just as an example, may get a flat increase. And there's a percentage of our book it's albeit smaller. You know, may get twenty or thirty percent. Point being, is that we are segmenting. We're underwriting and pricing policy by policy risk by risk. So we're still seeing rate come into the book. The rate from last year, eighteen months ago, was still earning into the book. So you know, I, you know, I I I suspect here throughout twenty twenty-five, you'll still see rate coming into that commercial lines book."
},
{
"speaker": "Gregory Peters",
"content": "Thank you for your answers."
},
{
"speaker": "Steve Spray",
"content": "Sure. Thank you, Greg."
},
{
"speaker": "Operator",
"content": "The next question is from Dean Crecydielo with KBW. Please go ahead."
},
{
"speaker": "Dean Crecydielo",
"content": "Hi. I wanted to start and sort of dive deeper into the reserve strengthening both in commercial auto and the excess and surplus lines segment. I was just sort of curious, like, there's anything else you could provide on sort of the accident years that the strengthening came from and what sort of trends you're seeing in those lines."
},
{
"speaker": "Mike Sewell",
"content": "Yeah. Thanks for the question, Dean. This is Mike Sewell. Yeah, you're you're you're keying in on a couple of points there. So on the personal auto, know, it's it's really I think our case incurred for some of the liability coverages that are in there, we're showing an upward trend. And I would say that those were mostly for the twenty twenty-three and the twenty twenty-two accident years mostly. So that's where you saw a little bit of reserve strengthening there. And then as it relates to the surplus lines, our case incurred are there, they were just they were they were just materializing greater than what we had had expected. E and S is about ninety percent casualty at least of our book. So it's really kinda similar to the industry averages you know, that we're seeing with inflation, etcetera. So more prudent reserving was there. And as I indicated, we added nine hundred and ninety-eight million of IBNR. So for for the overall book, about a third of that went to commercial casualty. So you know, just prudent reserving, watching what we're doing, and being being consistent with our process. So thanks for the question."
},
{
"speaker": "Dean Crecydielo",
"content": "Yeah. Got it. That makes sense. And then just quickly on, you know, the commercial property, like, current accident, your ex-cat loss ratio. It it seemed abnormally low this quarter. Is there an any other color you can provide on why the profitability was so strong this quarter?"
},
{
"speaker": "Steve Spray",
"content": "Sure. Dean, this is Steve Spray. Yeah. We'll take it. But what's driving that is was just a a a drop in large losses has drove them. Absolute lion's share of those commercial property results. But I would be you know, you can get you can get volatility with those large losses quarter to quarter. We've had it where we you know, where it's gone the other way. So, again, prefer to look at the kind of the full year. Our teams I I'd be remiss if I didn't talk about commercial lines underwriting teams working with the agents. And underwriting that commercial property book. It was, you know, it was running a bit of a temperature, and so just as we always do, all hands on deck with risk selection and pricing segmentation got us in a good spot there."
},
{
"speaker": "Dean Crecydielo",
"content": "Got it. Thank you."
},
{
"speaker": "Steve Spray",
"content": "Thank you, Dean."
},
{
"speaker": "Operator",
"content": "Again, if you have a question, please press star then one. The next question is from Michael Zaremski with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Michael Zaremski",
"content": "Hi. Morning. It's Dan on for Mike. You know, if I could just go back to know, adding to commercial casualty, IBNR. You know, you're still adding to those levels year over year, maybe a little less so in magnitude than twenty twenty-three. You just talk about the lost cost inflation trend that you're seeing now and how that's changed throughout the year? Thanks."
},
{
"speaker": "Steve Spray",
"content": "Sure. Mike, Steve Spray again. Yeah. We you know, as you know, we don't disclose a a specific loss cost increased. But I would say, maybe I'll answer this a little broader too, is we feel we feel that that our rates, our premiums again, this is on a prospective basis. Everything we do with rate making is prospective that that our our pricing is exceeding or or matching loss cost? The only one caveat on that would be with the workers' compensation line of business."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. Thanks. Then maybe just on know, the casualty trend. You know, what how much of that would you say is a reaction to since he's contractors industry exposure, I think some peers have talked about this industry as being, you know, overly exposed to social inflation."
},
{
"speaker": "Steve Spray",
"content": "Yeah. I mean, I can't say that we have seen the construction business, at least the business that we write Mike being overly exposed to social inflation. You know, a lot of the social inflation we see is into the umbrella off of auto commercial auto losses. You know, we do back to the construction piece, we do watch closely and it really depends on the jurisdiction you're in or the venue in. Construction defects, claims can be a challenge from time to time. And maybe that's what they're referring to. But for our construction book, which would be small to mid-market particularly. Trade contractors and such. With that mix of business, we haven't seen I can't say we've seen the social inflation into our construction book."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. Thanks. Then also just on workers' comp, you mentioned know, that's the only line of business where you're seeing trend above pricing. Just, you know, there was an acceleration reserve releases and comp. This year. Are there any thoughts to maybe adjusting that pick going forward? Or, you know, taking some more of the good news upfront?"
},
{
"speaker": "Steve Spray",
"content": "Yeah. That's something that know, we talked regularly here with with the actuarial team, and they're taking a look at it all the time. So I don't have anything to report on that, Mike. Obviously, you know, I've been talking about the deterioration of work comp pricing for I don't know how long now, and know, calendar year wise, the the results continue to be favorable. So we'll take it. But your points are also well taken as far as just understanding, and maybe taking a different view of it. We'll leave that in the hands or in discussions with the actuaries."
},
{
"speaker": "Michael Zaremski",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question and answer session. I would like to turn the conference back over to Steve Spray for any closing remarks."
},
{
"speaker": "Steve Spray",
"content": "Thank you, Gary, and thank you all for joining us today. We look forward to speaking with you again on our first quarter 2025 call."
},
{
"speaker": "Operator",
"content": "The conference is now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cinf | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day and welcome to the Cincinnati Financial Corporation’s Third Quarter 2024 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Dennis McDaniel, Investor Relations Officer. Please go ahead."
},
{
"speaker": "Dennis McDaniel",
"content": "Hello. This is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our third quarter 2024 earnings conference call. Late yesterday, we issued a news release on our results along with our supplemental financial package, including our quarter-end investment portfolio. To find copies of any of these documents, please visit our Investor website, investors.cinfin.com. The shortest route to the information is the quarterly results link in the navigation menu on the far left. On this call, you'll first hear from President and Chief Executive Officer Steve Spray, and then from Executive Vice President and Chief Financial Officer Mike Sewell. After their prepared remarks, investors participating on the call may ask questions. At that time, some responses may be made by others in the room with us, including Executive Chairman, Steve Johnston, Chief Investment Officer, Steve Soloria, and Cincinnati Insurance's Chief Claims Officer, Mark Schambow, and Senior Vice President of Corporate Finance, Teresa Hopper. Please note that some of the matters to be discussed today are forward-looking. These forward-looking statements involve certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules, and therefore is not reconciled to GAAP. Now I'll turn over the call to Steve."
},
{
"speaker": "Steve Spray",
"content": "Good morning, and thank you for joining us today to hear more about our results. We are pleased with our operating performance for the third quarter and first nine months of the year. Several metrics show the progress we are making as we work to provide value to shareholders over time and to deliver outstanding service to agencies and their clients through our dedicated associates. Our combined ratio continues to improve, absent the volatility caused by severe weather. While the devastation Hurricane Helene, in particular, inflicted on communities is heartbreaking, our claims associates are working tirelessly to deliver superior service with empathy and care. We had another quarter of strong premium growth, bolstered by improved pricing precision and risk segmentation by our underwriters on a policy-by-policy basis. In addition to another quarter with nice investment income growth, we executed investment portfolio rebalancing to a larger degree than a typical quarter. We believe that effort will produce both near-term and long-term financial benefits. Net income of $820 million for the third quarter of 2024 included recognition of $645 million on an after-tax basis for the increase in fair value of equity securities still held. Non-GAAP operating income of $224 million for the third quarter was down $37 million from a year ago, driven by an $86 million increase in after-tax catastrophe losses. Our 97.4% third quarter 2024 property casualty combined ratio was 3.0 percentage points higher than the third quarter of last year and included an increase of 3.9 points for catastrophe losses. Our 86.8% accident year 2024 combined ratio before catastrophe losses improved by 0.9 percentage points compared with accident year 2023 for the third quarter and was 0.8 points better on a nine-month basis. We had another quarter of what we believe is profitable premium growth. Agencies representing Cincinnati Insurance again produced a robust amount of new business for us and we continue to appoint agencies where we identify appropriate expansion opportunities. Our underwriters use pricing segmentation by risk plus average price increases along with careful risk selection to help improve our underwriting profitability. Estimated average renewal price increases for the third quarter improved incrementally compared with the second quarter of this year. Commercial lines moved a little higher in this high single-digit percentage range and excess and surplus lines remained in the high single-digit range. Our personal line segment also moved a little higher with personal auto in the low double-digit range and homeowner in the high single-digit range. Our consolidated property casualty net written premiums grew 17% for the quarter, including 16% growth in agency renewal premiums and 30% in new business premiums. As I next comment on performance by insurance segment, I'll focus on third quarter premium growth and underwriting profitability compared with a year ago. Commercial lines grew net written premiums 11%, with an excellent 93.0% combined ratio that improved by 2.2 percentage points, including 1.3 points from lower catastrophe losses. Personal lines grew net written premiums 29%, including growth in middle market accounts and Cincinnati private client business for our agency's high network clients. Its combined ratio was 110.3%, 10.4 percentage points higher than last year, driven by an increase of 12.7 points from higher catastrophe losses. Excess and surplus lines grew net written premiums 23%, with a combined ratio of 95.3%. While that's still quite profitable, it's less so than a year ago due to higher catastrophe losses and a modest amount of unfavorable reserve development on prior accident years. Both Cincinnati REIT and Cincinnati Global were again profitable and continue to reflect our efforts to diversify risk and further improve income stability. Cincinnati REIT grew third quarter 2024 net written premiums 5% and had a 95.6% combined ratio, bringing its nine-month combined ratio to a very profitable 81.5%. The $38 million of catastrophe losses Cincinnati REIT reported for the quarter included approximately $19 million for Hurricane Helene. Cincinnati Global's combined ratio was an outstanding 66.6% for the third quarter, with 12% growth in net written premiums. Our life insurance subsidiary had another profitable quarter, including net income of $20 million and term life insurance earned premium growth of 4%. Before I close my prepared remarks, I'd like to briefly comment on the estimated effects of Hurricane Milton on fourth quarter results. While it is still early, we estimate our pre-tax incurred losses will total between $75 million and $125 million, net of any applicable reinsurance recoveries. Catastrophe losses for direct business written by the Cincinnati Insurance Company represents less than $15 million of that estimate while Cincinnati REIT represents more than half. Now, I'll conclude as usual with our primary measure of long-term financial performance, the value creation ratio. Our third quarter 2024 VCR was 9.0%, bringing the nine-month total to an excellent 17.8%. Net income before investment gains or losses for the quarter contributed 1.7%, higher overall valuation of our investment portfolio and other items contributed 7.3%. Next, Chief Financial Officer Mike Sewell will highlight some additional aspects of our financial performance."
},
{
"speaker": "Mike Sewell",
"content": "Thank you, Steve, and thanks to all of you for joining us today. Investment income had another round of strong growth, up 15% for the third quarter of ‘24, compared with the same quarter in ‘23. Dividend income was down 1%, reflecting $959 million of net sales of equity securities during the third quarter, primarily from some portfolio rebalancing through trimming or exiting positions of seven common stocks among our 63 holdings at the beginning of the quarter. As Steve mentioned in our news release, this does not represent a change in our investment approach of holding a significant amount of equities as we work to balance near-term income generation with long-term book value growth. The large cash balance generated during the third quarter has been reduced and should continue to decline with additional bond purchases during the remainder of the year. Bond interest income grew 21% for the third quarter of this year. Net purchases of fixed maturity securities totaled $672 million for the quarter and $1.4 billion for the first nine months of the year. The third quarter pre-tax average yield of 4.8% for the fixed maturity portfolio was up 36 basis points compared with last year. The average pre-tax yield for the total of purchased taxable and tax-exempt bonds during the third quarter of this year was 5.53%. Valuation changes in aggregate for the third quarter were favorable for both our equity portfolio and our bond portfolio. Before tax effects, the net gain was $841 million for the equity portfolio and $411 million for the bond portfolio. At the end of the third quarter, the total investment portfolio net appreciated value was approximately $7.3 billion. The equity portfolio was in a net gain position of $7.5 billion, while the fixed maturity portfolio was in a net loss position of $203 million. Cash flow, in addition to higher bond yields, again, boosted investment income growth. Cash flow from operating activities for the first nine months of 2024 reached $2 billion, up 36% from a year ago. I'll briefly comment on expense management and our efforts to balance expense control with strategic business investments. The third quarter 2024 property casualty underlying expense ratio decrease of 0.2 percentage points was largely due to lower levels of profit sharing commissions for agencies. Moving on to loss reserves, our approach remains consistent and aims for net amounts in the upper half of the actuarially estimated range of net loss and loss expense reserves. As we do each quarter, we consider new information, such as paid losses and case reserves. Then we updated estimated ultimate losses and loss expenses by accident year and line of business. For the first nine months of 2024, our net addition to property casualty loss and loss expense reserves was $963 million, including $917 million for the IB&R portion. During the third quarter, we experienced $71 million of property casualty net favorable reserve development on prior accident years that benefited the combined ratio by 3.2 percentage points. For commercial casualty line of business, there was no material reserve development for any prior accident year during the quarter. On an all lines basis by accident year, net reserve development for the first nine months of ‘24 included favorable $326 million for ‘23, favorable $55 million for ‘22, favorable $10 million for ‘21, and an unfavorable $180 million in aggregate for accident years prior to ‘21. My final comments pertain to capital management. During the first nine months of 2024, we returned capital to shareholders through $365 million of dividends paid and nearly 1.1 million shares repurchased at an average price of approximately $112 per share. Earlier this month, another dividend was paid, returning another $120 million or so to shareholders. That payment completed the company's 64th consecutive year of increasing shareholder dividends, a streak we believe is matched by only seven other publicly traded companies based in the United States. We believe our financial flexibility and our financial strength are both in stellar condition. Parent company cash and marketable securities at quarter end exceeded $5 billion. Debt to total capital remained under 10%. And our quarter end book value was at a record high, $88.32 per share with nearly $14 billion of GAAP consolidated shareholders equity providing plenty of capacity for profitable growth of our insurance operations. Now I'll turn the call back over to Steve."
},
{
"speaker": "Steve Spray",
"content": "Thanks, Mike. The momentum we have right now is powerful. As we put the finishing touches on department plans for next year, you can feel the excitement and see the opportunities that lie ahead in all corners of the company. Agents Echo that feeling as they comment on their appreciation for our ability to deliver stability, consistency, and financial strength, giving them a first-class carrier to support their most well-managed accounts. Last week, Fitch Ratings Agency agreed, affirming our current financial strength ratings and revising our outlook to positive from stable based on our sustained track record of profitability and proven financial strength. As a reminder, with Mike and me today are Steve Johnston, Steve Soloria, Mark Schambow, and Teresa Hopper. Betsy, please open the call for questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Michael Phillips with Oppenheimer. Please go ahead."
},
{
"speaker": "Michael Phillips",
"content": "Thanks. Michael Phillips from Oppenheimer. I appreciate it. Thanks for the time, and good morning, everybody. I want to start with the commercial casualty. Steve, you mentioned no material favorable PYB there. Last quarter, you had a little bit, and the recent action years are favorable. I say as a backdrop, because if you look at the current action year there, it's up a bit. In commercial casualty, it's up almost 6 points and I kind of want to drill into what's driving that? You say in the Q that for commercial lines total, there's more IBNR. It looks like that might be the case for some other lines, but if we can kind of do back of the envelope, the higher loss pick for commercial casualty, it seems like it might be more paid activity. I want to see if you can confirm that and maybe what else might be going on in commercial casualty? Thank you."
},
{
"speaker": "Steve Spray",
"content": "Yes, thanks, Mike. Mike Sewell is going to go ahead and tackle this, and then I may add some commentary at the end."
},
{
"speaker": "Mike Sewell",
"content": "No, I appreciate it, and thanks for the question. So, yes, as you already noted, there was no prior accident year that had a material development during this quarter. So, recent quarters, we've added to or we've slowed the release of IBNR reserves as we've reacted to lost payments and case reserve increases that were higher than expected for some accident years related to the commercial casualty line. There has been some higher case incurred losses that were spread across several accident years that was more severity than frequency. But, as you're probably looking at page 9 of the supplement and you're seeing the loss pick being elevated a little bit, it's really, Mike, it's just related to prudent case reserves or prudent reserves that we're adding. There's a lot of uncertainty there. You're seeing a lot of things in the industry that's out there. If I were to take a look at the nine-month compared to nine-month for that loss pick, you're really only about two full points higher. We are adding to the IBNR you've seen that on page 11 of the supplement, and you'll see that the commercial casualty is the largest area that we're adding IBNR. So, that's probably a lot of information, but, yes, that's the background. Thank you."
},
{
"speaker": "Michael Phillips",
"content": "Okay, thanks. I guess if we stick with that line for a second, Steve, your opening comments didn't seem like there was much of a change in commentary on renewed price changes, and yet this line saw a pretty good jump in premium growth. I'm so curious what's driving that and how we should think about the commercial casualty going forward with top-line growth?"
},
{
"speaker": "Steve Spray",
"content": "Yes, I think, yes, Mike, the pricing there just remains strong. Everything that Mike said, I'd probably focus from the pricing standpoint, just the uncertainty around social inflation, legal system abuse, however you want to title that, but just uncertainty in general. I think the key with us, and I always go back to this, one, we're a package writer. We don't write monoline business. And two, our underwriters, whether they're in the field or here in headquarters, are just tackling these accounts risk by risk. One by one, they're using the art of underwriting that we've all grown up with, and then the science. I think we're kind of at a nice spot intersection there. Just the way we can segment our book with sophisticated pricing tools, I think there's runway and rate in all lines of business and commercial, may be minus workers' compensation, but general liability and umbrella, certainly I think there's runway for more rate there. And currently, as we disclosed, we're getting high single digits in the casualty, but again, that's that point estimate. You really have to look at the -- just kind of the -- that average doesn't tell the whole story. You got to look at the whole book, and there's a fair amount of our book that we would consider price adequate, and then in various levels and tranches where we need more rate."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Thank you. I'll follow up in a bit. Thanks so much."
},
{
"speaker": "Operator",
"content": "The next question comes from Mike Zaremski with BMO. Please go ahead."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. Thanks. I guess this is a quick follow-up to the last question and answer on playing offense in commercial casualty, and I could see commercial auto, too. Is it my understanding correctly that you're clearly playing more offense and feel better even despite the loss ratio in those two lines being booked at not ideal levels because you're just being more conservative in your picks like you have historically, and so as the years unfold, hopefully that conservatism comes back in a good guy through reserve releases over time? Am I thinking about it correctly?"
},
{
"speaker": "Steve Spray",
"content": "Yes. Mike, let me -- this is Steve again. Let me try that and then give me a follow-up. First of all, overarching, we feel good about our pricing. Obviously, where we're focused is on prospective pricing or rating periods. So we feel good about our pricing. We feel good about team that's executing on that as well. And we look at that state by state and like I said, risk by risk, by line of business. I would say we're definitely playing offense. We've got $13.8 billion of GAAP equity now supporting a little more than $9 billion of premium. I think that puts us in an enviable position. We -- as you know, our deep relationships with our agents we are regularly communicating with them. And I can tell you that the feedback we get from them is one of the appreciation for our consistency, our stability, our financial strength. We're playing offense, I think, in all segments and all lines of business. We've -- I talk about it a lot when we have these one-on-one investor meetings as well, but we've got that proven track record that proven business model, our field focused, the way we handle claims, our agency focus. But over the last 12, 13 years, the biggest improvement that has really driven our confidence and playing offense is that pricing sophistication and segmentation that we are -- we've been executing on for a decade plus. But that, along with the team that puts those predictive models in play, that just gives me a tremendous amount of confidence in everything we're doing and being able to grow through all market cycles. In Personal Lines, we're -- I've talked about this in the past, too. I think we're in a once in a lifetime, once in a generation, however you'd like to put it, you could call it hard market, I look at it as a market opportunity. And we -- our ex cat there continues to improve. We're not just -- that doesn't make us happy. We got to pay cat dollars with real money. Commercial lines -- or excuse me, personal lines last year had 100.4 combined. The four years prior to that, in a rising cat environment had an all-in underwriting profit. So just feel good about, again, all lines of business and all segments. I hope that answers it."
},
{
"speaker": "Michael Zaremski",
"content": "Yes. Honestly, if you're booking a much better loss ratio in some of those lines, may be the stock would be up today, but I don't know how much people -- would some people would believe in it. So it seems like you are being conservative, makes sense. I guess just switching gears. So on the large sell-down on the investment portfolio, I think what you're saying is just no real change there due to Steve's new leadership? Or you're just kind of saying, if we just do the math on equities as a percentage of shareholders' equity XOCI, we're running well above historic levels. So you're trimming. And is that the right way to think about it? And will you continue to trim to get to a lower ratio?"
},
{
"speaker": "Steve Spray",
"content": "Mike, I'll tackle the first part of that. I can tell you that there is absolutely no change in our philosophy because of a new CEO. But I'll let Steve Soloria kind of dive into the details there for you."
},
{
"speaker": "Steve Soloria",
"content": "Mike, this is Steve Soloria. Again, I would agree with what you said. We view it as just standard prudent portfolio management. We were trying to be opportunistic. We will periodically trim or prune names in the portfolio for a variety of reasons, managing within our investment policy statement, evaluating stocks on a fundamental basis. And we felt that with that in mind, selling into a strong equity market on a couple of names that had run a bit was, again, opportunistic. And as we looked at that, we started to look at where to invest those funds. Where was the best opportunity? Was it rolling back into a hot market or maybe taking advantage of interest rates that this -- the window may be closing on higher rates. So we started to roll into those, again, opportunistically. And as we looked at that, we were looking at tax implications and what booking gains was going to do for us and trying to offset some of those losses. So it was kind of a perfect storm of several different factors that kind of drove us to the scale of where we were. But the typical activity is stuff that we do on a quarterly basis anyway. So we feel we'll revert back to a more normalized activity level."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. That's helpful, Steve. And may be lastly, switching to the access and surplus lines segment. Just focusing specifically on the top line growth acceleration trend in recent quarters. I know there's historically been plenty of top line volatility in this segment, too, and it's a smaller segment, but is there a trend line we should be thinking of or something changing? Or I'm not saying we're going to run rate 23% top line growth. But I'm just curious if there's something underlying that we should be appreciating? Thanks."
},
{
"speaker": "Steve Spray",
"content": "Yes. Thanks, Mike. Yes, nothing changing there. We're about 90% casualty in our E&S space. You can get some inherent variability or volatility in E&S, just in general, as you mentioned, as you know, both with premium and with losses. If you lose a larger account or so that will put pressure quarter-to-quarter on that net written premium. But I would sum it up to you this way is that we're working on 12 years, again, of underwriting profit in our E&S company customary to the way we look at reserving throughout the entire company, we take prudent approach. We equipped to act when we see things. And as far as the growth goes, I would be consistent there as well. I think we're in a -- definitely in a favorable environment, but I think we can grow our E&S company through all environments. I think we're still just scratching the surface with what we can do from an excess and surplus line standpoint."
},
{
"speaker": "Michael Zaremski",
"content": "Is it worth elaborating on why do you think you discretion the surface? Is it just you, over time, get more data and can expand your underwriting appetite or hiring more folks or trying to understand that thing."
},
{
"speaker": "Steve Spray",
"content": "Yes. I think -- yes, yes, that's a good follow-up. I think it's all of the above. We continue to expand our expertise. We continue to expand the team. We continue to expand the products that we look at, we're adding more agencies across the entire company that favorably impacts our E&S company as well. So -- and when we look at the business that our agents write the amount of business that they placed in the E&S space, we can just see tremendous opportunity. And I think our business model the fact that we deal directly with the retail agents. We've got our own in-house brokerage. We can return more of the compensation directly to our agents. We have direct bill we handle claims with our own people. You get the point that I just think is an attractive model that we can continue to just expand."
},
{
"speaker": "Operator",
"content": "The next question comes from Gregory Peters with Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. So kind of, I guess, building a little bit on Mike's question, but more importantly, some comments that you made talking about the generational opportunities for growth, I think, in personal lines. Can you give us some perspective on your view on what used to be when you're throwing all the new business on the \"new business penalty\" and attended both personal lines and commercial lines? Can you give us a sense of how the profile business has changed over the last couple of years? Or is it a geographic change or just some color on how the company is changing as it grows."
},
{
"speaker": "Steve Spray",
"content": "Yes. I think it's -- I think, yes, that book of business has evolved for sure. 10 years ago, we were 90%, what we would call middle-market personal lines. that now, that book has grown considerably, as you can see, and we're just under 60%, which would be considered private client or high net worth I think the reason I say once in the lifetime is just there's just so many macro things going on there, Greg, both in the middle market space, primarily around severe convective storm, I'd say, in the Midwest. Inflation hit that pretty hard as well. The traditional competitors that we had in that marketplace just seem to be disrupted. Our balance sheet strength allowed us to take advantage of that opportunity. I think one of the big strengths we have in personal lines today, and I'll talk about it a lot, is that we -- and this is our agents telling this. I think we are considered a premier market, both in the high net worth or private client and in middle market. One of the advantages to us is, obviously, with deep agency relationships, we can be a solution or being more important to each of them with being able to handle middle market and the high net worth I think, in a first-class way. Financially, it's giving us some diversification both by a line of business and geographically. High net worth or private client is typically it's property driven, less so auto, middle market, the exact opposite, auto driven more or less so on the home high net worth tends to be on the coast. We write it everywhere, but it tends to be coastal, middle market, more in the middle of the country. So we just think we're getting a nice mix and diversification across that entire segment. Now on the pricing, yes, I think it's the same confidence that I talked about with Mike on commercial lines. It's just we've got an experienced team with a ton of expertise in building these models across the entire business. New business penalty, I don't believe in a new business penalty, I think you've got to write every risk at the right rate on a risk-adjusted basis. And I'm just confident in where our pricing is going on a prospective basis. I hope that answers."
},
{
"speaker": "Gregory Peters",
"content": "Yes, it does. It does. I mean one of the -- you were mentioning the opportunities with severe convective storms. You're talking about E&S. I just have this, I guess, this natural pivot that I think you're growing your exposures like in California, Texas and Florida, may be a little bit in the Northeast versus other areas of the country. But I guess that's what I was kind of thinking about because you talked about your losses to Milton, and it doesn't seem to be as large as, I guess, it could have potentially been but maybe your exposures are running in different areas of the state in Florida?"
},
{
"speaker": "Steve Spray",
"content": "Yes. Our Florida new business in Personal Lines is down a little over $4 million year-over-year. But let me make sure I'm clear on that as well. It's not just the rate that we're driving, particularly in the middle market severe convective storm exposed property. Terms and conditions are probably equally as important there, whether it be wind inhale deductibles, ACV or roof schedules. And then when you speak specifically to E&S on the personal line side, Greg that is predominantly right now for us. That's California home. We've got our E&S capability up and running in 10-plus states, most of those coastal. But as an example, even in Florida, we're writing new business on an E&S basis. But we just haven't seen that -- we feel that the pricing the terms and conditions that we can get are as attractive as we would need. So we'll continue to be conservative there."
},
{
"speaker": "Gregory Peters",
"content": "Fair enough. I just pivot to another company question on the agents. I view them as a critical strength of your company, the agent relationships. Can you talk to us as you look out to next year, what you think the growth of the agency force might look like or the appointments that you make in '25? Or do you have a target? Or how do you sort of approach that, please?"
},
{
"speaker": "Steve Spray",
"content": "Yes. We're not making public. Greg, our goal for agencies for next year. What I can tell you is that we are committed to expanding that distribution. We think there's plenty of opportunity without “diluting the franchise”. We will not -- this is kind of my thought, and this is the direction we're heading is we will not dilute the franchise by the number of agencies we appoint. What we have to focus on is making sure that we continue to do business with the most professional, and candidly, those who are most aligned just with the way we do business, locally fast, fair, handling business at the local level. You're right. The agency relationships are key to everything we do. I think it's our differentiator. It's something that we're going to continue to stay focused on doing business locally is a big piece of that. But you can expect us to continue to expand the distribution I would say, roughly at a clip that you've seen us this year and over the last couple of years."
},
{
"speaker": "Gregory Peters",
"content": "Fair enough. Thank you for answering my questions."
},
{
"speaker": "Steve Spray",
"content": "Yes, absolutely. Thank you for the questions."
},
{
"speaker": "Operator",
"content": "The next question comes from Jing Li with KBW. Please go ahead."
},
{
"speaker": "Jing Li",
"content": "Hi. Thank you for taking my questions. I just have a question on E&S unfavorable development. I know it's pretty small, but I appreciate if you can add some colors on that."
},
{
"speaker": "Steve Spray",
"content": "Jing, yes, the -- I think you were referring to the unfavorable development on the E&S casualty. And I would just say for you there. It's just that we saw case incurred losses that are emerging at amounts higher than we expected. Like I mentioned earlier, that business -- that book of business is 90% casualty, it's E&S. So it's got inherent volatility in it, inherent variability, but we've got a great track record of profitability in our E&S company. And we'll just continue to stay prudent like we always have company-wide with the reserves. So that's about all I'd have to add on unfavorable in the quarter for E&S."
},
{
"speaker": "Jing Li",
"content": "Got it. Thank you. I have a follow-up on the personal auto and personal line. So the rate accelerated from high single digit to low double digit. Just curious about your view to reach rate adequacy. Do you think that you still need double digit for 2025 and beyond?"
},
{
"speaker": "Steve Spray",
"content": "Yes. I wouldn't necessarily be able to give you, Jing the kind of run rate. All I can tell you is that we've still got a lot of rate earning into the book. And I think just with the -- all the things that we've talked about here, just with the changing weather patterns, I think there's still runway for rate across the entire personal lines book. We -- and I would say this, again, the key for us is looking at it prospectively, and we do feel on a prospective basis that our rates in personal lines are ahead of loss cost trends."
},
{
"speaker": "Jing Li",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. The next question comes from Grace Carter with Bank of America. Please go ahead."
},
{
"speaker": "Grace Carter",
"content": "Hi, everyone. I realize these are smaller segments, but the core loss ratio ticked up quite a bit versus recent history in both other commercial and other personal. So I was hoping that you could kind of give us an update on what you're seeing there? And if there's any sort of intra-year movement in there? And if it's just kind of related to some of the comments you've heard across the industry on pressure on long tail lines? Thank you."
},
{
"speaker": "Steve Spray",
"content": "Yes, Grace, thank you. You alluded to it. They're smaller premiums there. You're going to have -- I think it's just a lot of inherent variability or volatility in those lines. As an example, in personal lines, it could be a little watercraft that you're seeing there in our book. But we do a deep dive on every line of business on a regular basis. And there's nothing there that points us in the direction of anything to be concerned about as far as geographic or agency or line of business. So I think that's about all I'd have to add on that for you, Grace."
},
{
"speaker": "Grace Carter",
"content": "Okay. Thank you. And I guess I had another question on commercial casualty. I mean I think usually, you all have said that historically, you see the core loss ratio higher in core 1 or in quarter -- in the first quarter relative to the last three quarters of the year, just given higher uncertainty from the newness of the accident year I guess I'm just kind of trying to understand better like what exactly you all saw this quarter that resulted in Q3 kind of moving above Q1 and just kind of trying to think about if maybe a year-to-date number is the best way to think about sort of where we should see that trending going forward? Or just kind of any sort of color you can give on whether or not the Q3 level might be kind of the new run rate? Thank you."
},
{
"speaker": "Steve Spray",
"content": "Yes, Grace, you're absolutely right. We -- typically, every quarter that we get more data, more information, you just refine those picks even more. I think what you've got going on and commercial casualty is just the macro things that Mike alluded to earlier litigation costs up. The number of claims that are turning into litigation, social inflation, the legal system abuse, third-party litigation funding. It's all just really kind of in that line of business, industry-wide, I think, a little upside down. So I think that's why you're seeing that in the third quarter, it's just -- we're really trying to be prudent on that line of business just because the amount of uncertainty there has stayed pretty consistent. So as you know, we've got 30-plus years of favorable development. And we do that through a consistent process, consistent people and acting quickly when we see things that just cause us concern. But there's nothing specific in that third quarter other than, I would say, macro uncertainty."
},
{
"speaker": "Grace Carter",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Steve Spray for any closing remarks."
},
{
"speaker": "Steve Spray",
"content": "Well, thank you all for joining us today. We look forward to speaking with you again on the fourth quarter call. I hope everybody has a nice weekend."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cinf | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the Cincinnati Financial Second Quarter 2024 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I'd now like to turn the conference over to Dennis McDaniel, Investor Relations Officer. Please go ahead."
},
{
"speaker": "Dennis McDaniel",
"content": "Hello. This is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our second quarter 2024 earnings conference call. Late yesterday, we issued a news release on our results, along with our supplemental financial package, including our quarter-end investment portfolio. To find copies of any of these documents, please visit our investor website cinfin.com/investors. The shortest route to the information is the quarterly results link in the navigation menu on the far left. On this call, you'll first hear from President and Chief Executive Officer, Steve Spray, and then from Executive Vice President and Chief Financial Officer, Mike Sewell. After their prepared remarks, investors participating in the call may ask questions. At that time, some responses may be made by others in the room with us, including Executive Chairman, Steve Johnson, Chief Investment Officer Steve Soloria, and Cincinnati Insurance's Chief Claims Officer Mark Schambow, and Senior Vice President of Corporate Finance, Teresa Hopper. Please note that some of these matters to be discussed today are forward-looking. These forward-looking statements include certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules and, therefore, does not reconcile the GAAP. Now, I'll turn over the call to Steve."
},
{
"speaker": "Steve Spray",
"content": "Good morning, and thank you for joining us today to hear more about our results. We had a good quarter and first half of the year. In addition to our strong financial performance, recent travel to meet with agents reinforced my excitement about the future. Agents are quite enthusiastic about doing business with us, citing our responsiveness as we answer the call, both literally and figuratively, to help them navigate this challenging insurance market. While picking up the phone is part of our culture, the confidence we have in our expertise and Cincinnati's financial strength lets us continue growing profitably, delivering insurance solutions for our agents and their best clients. Net income of $312 million for the second quarter of 2024 included recognition of $112 million on an after-tax basis for the increase in fair value of equity securities still held. Non-GAAP operating income of $204 million for the second quarter was up $13 million from a year ago. Investment income continued to grow nicely and contributed $17 million of the increase. The 98.5% second quarter 2024 property casualty combined ratio was 0.9 percentage points higher than the second quarter of last year and included a decrease of 0.8 points for catastrophe losses. That brought the first half combined ratio to 96.1%. A nice place to be as we head into the second half of the year. Typically, the end of the year tends to be better than the beginning, in part due to the catastrophe loss ratio averaging about two points better in the second half based on the past 10 years. Our 88.2% accident year 2024 combined ratio before catastrophe losses improved by 2.2 percentage points compared with accident year 2023 for the second quarter. It was 0.7 points better on a six-month basis. Once again, overall reserve development of prior accident years was favorable. Although it was 3.6 points lower than a year ago, as we continue to consider uncertainty regarding ultimate losses and remain prudent in our reserve estimates until longer-term loss cost trends become more clear. We are entering the second half of the year with confidence and optimism. In addition to improved accident year results and an overall combined ratio for the first half of 2024 that was better than last year's first half, we are pleased with other measures regarding our operating performance. We had strong second quarter premium growth and believe it is profitable growth. We continue to use pricing segmentation by risk plus average price increases along with careful risk selection to help improve our underwriting profitability. Those efforts, plus others, are bolstering our progress in managing elevated inflation effects on insured losses. Agencies representing Cincinnati Insurance produced another quarter of profitable business for us and we continue to appoint additional agencies where we see appropriate expansion opportunities. Our underwriters continue to do excellent work as they emphasize retaining profitable accounts and managing ones that we determine have inadequate pricing based on our risk selection and pricing expertise. Estimated average renewal price increases for the second quarter were again at healthy levels with commercial lines near the low end of the high single-digit percentage range, excess and surplus lines in the high single-digit range, personal auto in the low double-digit range, and homeowner in the high single-digit range. Our consolidated property casualty net written premiums grew 14% for the quarter, including 12% growth in agency renewal premiums and 34% in new business premiums. Next, I'll briefly highlight operating performance by insured segment, focusing on second quarter premium growth and underwriting profitability compared with a year ago. Commercial lines grew net written premiums 7% for the second quarter with a 99.1% combined ratio that increased by 2.2 percentage points and included prior accident year reserve development that was less favorable by 2.9 points. Personal lines grew net written premiums 30%, including growth in middle market accounts in addition to Cincinnati private client business for our agency's high net worth clients. Its combined ratio was 106.9%, 0.7% percentage points better than last year, despite an increase of 1.2 points from higher catastrophe losses. Excess and surplus lines grew net written premiums 15% and was also profitable with a combined ratio of 95.4%, up 3.2 percentage points from second quarter a year ago due to unfavorable reserve development. Both Cincinnati REIT and Cincinnati Global were again very profitable and continue to reflect our efforts to diversify risk and further improve income stability. Cincinnati REIT's combined ratio for the second quarter of 2024 was an excellent 70.1%. It grew net written premiums by 17%, bringing the overall six-month written premium for 2024 in line with 2023. Cincinnati Global's combined ratio was also excellent at 63.2%. While it grew net written premiums 2% for the first half of the year, second quarter premiums were down 18%, reflecting pricing discipline in a very competitive market. Our life insurance subsidiary had an outstanding quarter, including net income of $24 million and operating income growth of 26%. Term life insurance earned premiums grew 2%. I'll conclude with our primary measure of long-term financial performance, the value creation ratio. Our second quarter, 2024 VCR, was 2.2%. Net income before investment gains or losses for the quarter contributed 1.6%. Our overall valuation of our investment portfolio and other items contributed 0.6%. Now Chief Financial Officer Mike Sewell will add his comments to highlight other parts of our financial performance."
},
{
"speaker": "Mike Sewell",
"content": "Thank you, Steve, and thanks to all of you for joining us today. Investment income continued to grow up 10% for the second quarter of 2024 compared with the same quarter in 2023. Dividend income was down 1% or $1 million for the quarter, primarily due to two unusual items that totaled approximately $2 million. One was a holding with a June x dividend date in 2023 that moved to July 1st in 2024. The other was a holding that reduced its dividend rate by 53% after a spinoff transaction. Bond interest income grew 18% for the second quarter of this year. We again added fixed maturity securities to our investment portfolio with net purchases totaling $771 million for the first six months of the year. The second quarter pre-tax average yield of 4.64% for the fixed maturity portfolio was up 30 basis points compared with last year. The average pre-tax yield for the total of purchased taxable and tax-exempt bonds during the second quarter of 2024 was 6.06%. Valuation changes in aggregate for the second quarter of 2024 were favorable for our equity portfolio and unfavorable for our bond portfolio. Before tax effects, the net gain was $149 million for the equity portfolio, partially offset by a net loss of $93 million for the bond portfolio. At the end of the quarter, total investment portfolio net appreciated value was approximately $6.7 billion. The equity portfolio was in a net gain position of $7.4 billion, while the fixed maturity portfolio was in a net loss position of $700 million. Cash flow continued to benefit investment income in addition to higher bond yields. Cash flow from operating activities for the first six months of 2024 was $1.1 billion, up 33% from a year ago. I'll move on to expense management, where we always work to balance controlling expenses with making strategic investments in our business. The second quarter of 2024 property casualty underlying expense ratio was 0.5% points higher than last year, reflecting higher levels of profit sharing commissions for agencies in employee-related expenses. Next, let me comment on lost reserves, where our approach remains consistent and aims for net amounts in the upper half of the actually estimated range of net loss and lost expense reserves. As we do each quarter, we consider new information, such as paid losses and case reserves. Then, we updated estimated ultimate losses and loss expenses by accident year and line of business. For the first six months of 2024, our net addition to property casualty loss expense reserves was $578 million, including $506 million for the IB&R portion. During the second quarter, we experienced $40 million of property casualty net favorable reserve development on prior accident years that benefited the combined ratio by 1.9 percentage points. The commercial line segment saw overall favorable reserve development of $29 million, driven by workers' compensation and commercial property, which more than offset the unfavorable development in commercial casualty. Commercial casualty was again the line of business having the largest amount of unfavorable reserve development, with a total of $28 million for the quarter, or less than 1% of that line's year-end 2023 reserve balance. We released reserves in some recent accident years and added reserves totaling $51 million in aggregate for accident years prior to 2021, including $30 million for 2018 through 2020, due to case incurred losses emerging at amounts higher than we expected. The unfavorable amounts reflects our slowing the release of IB&R reserves for some of those older accident years while adding to others. On an all-lines basis by accident year, net reserve development for the first six months of 2024 included favorable $269 million for 2023, favorable $36 million for 2022, favorable $17 million for 2021, and an unfavorable $182 million in aggregate for accident years prior to 2021, with commercial casualty representing $167 million of the unfavorable $182 million. I'll conclude my comments with the capital management highlights, another area where we have a consistent long-term approach. We paid $125 million in dividends to shareholders during the second quarter of 2024. We also repurchased 395,000 shares, an average price per share of $116.33. We think our financial flexibility and our financial strength are both in excellent shape. Parent company cash and marketable securities at quarter end was nearly $5 billion. Debt to total capital contributed continued to be under 10%. And our quarter end book value was at a record high, $81.79 per share, with $12.8 billion of GAAP consolidated shareholders equity providing plenty of capacity for profitable growth of our insurance operations. Now, I'll turn the call back over to Steve."
},
{
"speaker": "Steve Spray",
"content": "Thanks, Mike. Before we move on to questions, I'd like to share some additional observations based on my first few months as CEO. I've spoken with many of our agents and associates, and they share my high level of confidence in the future of this company. In the first six months of this year, we've achieved a combined ratio of 96.1%. That makes 12.5 consecutive years of underwriting profit. A core loss ratio that continues to improve. Growth in net written premiums of 14%, with investment income up 13%. We've set the stage for 64 years of increasing dividends to shareholders. In the most challenging market of my career, our balance sheet allows us to lean in and grow with our agents. And I'm really excited about where we're headed. As a reminder, with Mike and me today are Steve Johnston, Steve Soloria, Mark Schambow, and Teresa Hopper. Jason, please open the call for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Michael Phillips from Oppenheimer. Please go ahead."
},
{
"speaker": "Michael Phillips",
"content": "I want to make sure, Mike, on your comments, I guess it flowed pretty quickly. I want to make sure I got the [indiscernible] right. I wasn't clear. The commercial casualty, when you were talking about releasing the recent action years and added 51 for 2021 and prior, was that commercial casualty or was that all lines?"
},
{
"speaker": "Steve Spray",
"content": "That was for -- thank you for the question. That was for commercial casualty only."
},
{
"speaker": "Michael Phillips",
"content": "Okay. So, your ad sounds like it's more for those 2020, 2021, and prior, correct, for that line?"
},
{
"speaker": "Steve Spray",
"content": "That is exactly correct."
},
{
"speaker": "Michael Phillips",
"content": "Okay. And that's similar, I think, in 4Q. You took a bigger charge for the same -- I don't know the exact same action years, but again, for the prior years, not so much for the recent ones."
},
{
"speaker": "Steve Spray",
"content": "That's correct. Okay."
},
{
"speaker": "Michael Phillips",
"content": "Okay. So I guess you're not seeing so far, or maybe you don't think you ever will, kind of what we're seeing from some others so far this quarter of 2020 subsequent is starting to become a problem. You're not seeing that, and maybe tell us why you think you won't control it?"
},
{
"speaker": "Steve Spray",
"content": "Well, this is Steve, Mike. First of all, I would just say, from my perspective, overall, there always seems to be movement in prior accident year losses. Some develop better than expected, sometimes higher than expected, as you know. It can be different by segment, line of business, and certainly accident years. It's, as you know, reserving is not a perfect science. That being said, couldn't be more confident in our process and the experience team that we have that are setting those reserves and taking the approach that we do. Comfortable with management's best estimate of ultimate losses here at the end of the second quarter. We've always had a track record, a long history of overall favorable development on a line basis. And in these most recent accident years, in any most recent accident year, I feel like we've always been very prudent in realizing there's not as much data there and just recognizing the uncertainty. And I think that uncertainty is still there. It's always going to be there in those most recent accident years. But I think our actuaries, they look at that and they take it into account. And I think one of the other benefits is that we're all here in one building. I think that's something that sometimes gets underestimated is that we're all here and we are talking literally multiple times a day with pricing actuaries, with the reserving actuaries, and then with the business years. And I think we're quick to act to things that we see on reserving, and we're just as quick to act when we see things in underwriting. Commercial umbrella, I'm really peeling it back here now, Mike, but, commercial umbrella, we noticed in the second quarter of '22, if you recall, just some unfavorable results there. Our actuaries were quick to act and take the appropriate action on the reserves, and then our underwriting was just as quick to act as well. And we reduced limits. We took terms and conditions action based on the fleet size, let's say, on the auto, certain classes of business, certain jurisdictions, and I think we jumped all over that. And now through six months of this year, commercial umbrella is running in the mid-90s, and things are looking very favorable there as well."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Steve, thank you for all that. That's helpful. I guess the second question then is staying with commercial casualty. It looks like your comments on kind of the renewal pricing for that line from 1Q to 2Q are about the same, like you said, around high single digits. I just want to confirm that, and maybe anything you want to share on kind of directionally for commercial casualty in the recent quarters, how things might be moving around."
},
{
"speaker": "Steve Spray",
"content": "Yes, Mike. The high single digit on commercial casualty is correct, and that was consistent from the first quarter. I would say the commercial market -- we're a package writer, and the commercial marketplace, I would say, is rational and orderly. But my view is we still see runway for increased rate in the commercial marketplace. Now, the other thing I always have a caveat there is what we're really executing on and focusing here at the company at Cincinnati is segmentation and pricing these risks, risk by risk. And just the tools that we have, the predictive analytics we use to price the product is -- the average just doesn't tell the full story, as you can understand. And just the underwriting teams are just executing excellent on our segmentation strategy."
},
{
"speaker": "Michael Phillips",
"content": "Okay, Steve. Thank you. Congrats, and congrats on your first quarter at the helm. I appreciate it."
},
{
"speaker": "Steve Spray",
"content": "Yes, thank you, Mike. Much appreciated."
},
{
"speaker": "Operator",
"content": "The next question comes from Gregory Peters from Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Well, good morning, everyone. I guess sort of building on the commentary on pricing and casualty. I'm just curious about how you view your competitive positioning from a price perspective in the broader commercial book of business. It seems like the growth rates are beginning or have moderated except for perhaps property. So any added perspective on that would be insightful."
},
{
"speaker": "Steve Spray",
"content": "Yes. I think, again, Greg, I think I've got this right on your question, but, insurance from our perspective is a local business, and it varies by state. It varies by size of account. Like I said, we're a package underwriter. We compete with national carriers. We compete with the small regional mutuals. And where our real focus is, is just focusing on what we do and building those deep relationships with those local agents. And when we're showing up, and like I said in my opening remarks, when we answer the call, we're confident in our risk selection, confident in our ability to price that product, and we're confident in the relationships we have with our agents because we've built those deep relationships that I don't worry about growth. We're continuing to appoint new agencies across the country. Like I said, when we see opportunity, we'll continue to do that going forward. But, it's all about the discipline and the risk selection and the pricing, and then we let it come to us. If you look at new business and commercial lines through the first half, up over 30%. The first half of last year, we were down considerably. Our risk selection and our pricing has not changed. What's changed is the environment that we're operating in, and those risks came to us. We didn't change our pricing discipline one bit, and the beauty is, is we can see that risk by risk, line by line."
},
{
"speaker": "Gregory Peters",
"content": "Yes, fair enough. Pivot to and I know you provided some detail in your opening remarks. I'm focused on the expense ratio. That was up, I think there are some commission pressures, or maybe you can just go back and talk to us about the moving parts inside the expense ratio, and is the current level maybe on a six-month basis sort of the run rate we should think about going forward, or are there some unusual non-recurring items inside there that we should exclude?"
},
{
"speaker": "Mike Sewell",
"content": "Greg, this is Mike. Thanks for the question. On a year-to-date basis, as I mentioned, it did go up a little bit. Our combined ratio for the year was down a little bit, so the profit-sharing commission for the agencies, does go up, as we do invest for the future with hiring folks and so forth and other items, employee-related expenses is up a little bit. But when I look down the line, I do see where total dollars are going up, but, the rate of our earned premiums are outpacing the expenses as they increase, which is what I'm trying to do, what we're trying to do. So I think we're making good progress. I look at some of the expense categories, and actually they're down a little bit on a percentage, even though total dollars are up. So, seeing it right now at the 30.1 on a year-to-date basis, as we've been saying over the years, we've been trying to get below a 30, and so we're going to keep doing that. But, right now it's a little bit elevated probably from where I'd like it to be for all the right reasons of really paying the commissions to the agencies."
},
{
"speaker": "Gregory Peters",
"content": "Okay. Makes sense. Thanks for the answers. Congratulations on your first quarter. Out of the gate, Steve."
},
{
"speaker": "Steve Spray",
"content": "Thank you very much, Greg. I really appreciate it."
},
{
"speaker": "Operator",
"content": "The next question comes from Charles Lederer from Citigroup. Please go ahead."
},
{
"speaker": "Charles Lederer",
"content": "I guess, can you talk about how mature those pre-2021 accident years for general liability are at this point?"
},
{
"speaker": "MikeSewell",
"content": "Can you repeat that question again, please?"
},
{
"speaker": "Charles Lederer",
"content": "Yes. I guess, how mature are those accident years, like the 2018 to '20 accident years, in your guys' view? If you could give color around that."
},
{
"speaker": "MikeSewell",
"content": "Yes. I think we feel really good about the reserves. And first of all, the overall reserves with where we're at, but it was the 2020 to 2018 years that I mentioned the $30 million that was unfavorable versus the more recent accident years. If I think about the commercial casualty reserves and some of the things that actually makes me feel pretty good about it, when you look at the first six months of this year, we have been increasing our IBNR ratio, which I think we've kind of indicated. And so, for commercial casualty, we're about 10 percentage points higher of what we're adding for IBNR currently than when we were at the pre-pandemic full years of 2017 through 2019. So, just having the extra 10 percentage points, I think that's paying off for us. If I do look at through the end of the second quarter, our incurred loss, loss adjustment expense ratio, on average, if I take the '22, '23 year for commercial casualty, those picks are a little bit higher than those pre-pandemic years of 2017 through 2019. So, I think our ultimate picks are higher. And then, I think Steve mentioned it, with the confidence I think that we all have, with our process and so forth. If I look back over the last 15 years, I probably could have kept going. I think my spreadsheet was running out, but there was only two commercial casualty accident years that have not developed favorably during that time period from the original estimated ultimate picks at 12 months. So, I'm very confident as Steve is, with our process, the people doing it, et cetera, et cetera. So, I hope that's the color that you're looking for."
},
{
"speaker": "Charles Lederer",
"content": "That's helpful. When you talked about the 10 points higher of IBNR, that's for all lines? Just want to make sure I understand. Not all lines, all accident years?"
},
{
"speaker": "Mike Sewell",
"content": "That is actually, that is for the commercial casualty when I'm looking at that by accident year or calendar year."
},
{
"speaker": "Charles Lederer",
"content": "Okay. Yes. So, for all accident years. Okay. I guess on the personal line side, can you talk about, I guess, the divergence in, I guess, new business or can you bifurcate the new business trend and personal lines between middle market and high net worth? I know both were strong, but there's a lot of weight there. So, just curious."
},
{
"speaker": "Steve Spray",
"content": "Yes. It moves around a little bit, Charlie, but right now, both are growing, as you can see, both are growing in a very healthy manner. Right now, middle market is outpacing high net worth a little bit or private client a little bit. That bounces around from quarter-to-quarter. We're also growing our E&S personal lines opportunity. I think the real key, from my perspective and from all of our perspectives, is that we have become, for our agents, a premier rider of personal lines, both in middle market and in private client or high net worth. And that just gives our agents a tremendous amount of confidence. We can be a solution for a bigger percentage of their business. We've got the sophisticated pricing that we need in the middle market for the comparative radar world. And then we've got the expertise in the private client. Now you add an E&S option where we can provide capacity for our agents and the insureds in their communities. And I've never seen a personal lines market like this. I think it's generational. And I think we are really taking advantage of the opportunity to, again, help our agents and help the policy holders in their community. We are open for business. We're confident in our pricing on a prospective basis, which is the way we always look at it. We've got a great leadership team. We've got tremendous expertise throughout the organization. So I really believe that the personal lines right now is transformational for Cincinnati Insurance."
},
{
"speaker": "Operator",
"content": "The next question comes from Mike Zaremski from BMO. Please go ahead."
},
{
"speaker": "Mike Zaremski",
"content": "Hey, thanks. Taking those personal lines, and hopefully you appreciate it. I'm an analyst, so I focus on more of the negative than positive sometimes. But personal auto, the margins, there was some PYB there. Anything notable that's in personal auto we should think about?"
},
{
"speaker": "Steve Spray",
"content": "Mike, thanks for the question. I've always found you to be extremely positive. Obviously, personal auto, short tail line, the adverse development that you're seeing there is all in bodily injury. Our physical damage in personal auto is performing very well. I will say again, short tail line, the vast majority of that adverse development is in accident year 2023, and there's a little bit in the 2022. And if you think about this as well, we are a market for middle market and high net worth, like I was saying. But as our high net worth book continues to grow and be a bigger portion of our overall personal lines business, we're getting all kinds of diversification, positive effects from that. And one of those is in personal auto. When you have high net worth, it's driven by property and less so by auto. Middle market, more driven by auto and less in the property piece. So that mix is shifting as well. And I think you're seeing that in a favorable way in our overall results. We continue to get, we've had rate early into that book, that personal auto book for quite some time now, and that continues into 2024. And I don't see an end in sight of rate coming into that book either."
},
{
"speaker": "Mike Zaremski",
"content": "That's helpful. Switching gears to workers' comp, we know, we can see that [indiscernible] underweight comp and probably for a couple of reasons, I don't think we have to elaborate on it, but the results are fairly tremendous. I don't know if you want to comment on what's going on there this quarter or this year-to-date, actually. I know the market is soft from a pricing perspective, but what would you be waiting for, maybe patiently, to say we want to maybe start leaning into workers' comp in a growth way?"
},
{
"speaker": "Mike Sewell",
"content": "Yes. Thanks, Mike. We have a strong appetite for workers' comp. 10 or 12 years ago, we really got serious about all levels of comp, claims, loss control, risk selection, especially pricing. We are looking to grow comp when we think that we can get the right rate on a risk-adjusted basis, and you're right. I thought that this deterioration in rate would show up more so in the results, quite frankly, several years ago, and it hasn't. But I think it's such a long tail line, and it historically has such volatility to it. We just think being prudent in our risk selection and our pricing there and not to chase that is a prudent thing to do for the long-term. And when we can write work comp at the right rate today on business that we like, we're writing it, and we're looking for it, and we're talking to our agents about it. It's just we just don't see the rate environment right now as attractive. Again, I understand it's performing well on a calendar year basis, but we just think over the long pull, being extra vigilant on workers' compensation is prudent."
},
{
"speaker": "Mike Zaremski",
"content": "Got it. Sticking quickly on comp, one of your peers who also has a disproportionate amount of trade construction exposure in different regions, but you all have very strong practice there too, has said that they're seeing a bit of a change in comp frequency. I don't know if it's curious to throw it out there if you all are seeing any of that as well in your portfolio."
},
{
"speaker": "Steve Spray",
"content": "No, Mike, I can't say that we've seen that. We've been pretty stable on that front."
},
{
"speaker": "Mike Zaremski",
"content": "Okay. And I guess just lastly, you might have covered some of this, but on the overall commercial lines, marketplace competitiveness, I know pricing has been kind of flattish in a quarter or for a number of quarters now. Do you all sense that the marketplace is kind of stable at current rates, or do you sense that there's kind of a bit of an upwards trajectory to kind of the pricing environment, or downwards?"
},
{
"speaker": "Steve Spray",
"content": "Yes. No. Mike, as far as the rate environment, we've been stacking quarter-on-quarter-on-quarter of additional rate throughout every major line in commercial lines, except for workers' compensation. But I would say that the commercial market, and again, it all depends on size of the account. It depends on the state that you're in. But just generally speaking, I would characterize the commercial marketplace as responsible and orderly. There are moving parts. You see it in other carriers' reports. There's uncertainty out there. And I think that uncertainty has certainly promoted the continued rate that you're seeing across all lines in commercial lines. And I don't see a softening market in commercial lines. You'll hear little pockets of different things, different lines of business, maybe a different class here and there. But just generally speaking, all lines, all classes, countrywide, I think from Cincinnati's perspective, it's orderly and rational."
},
{
"speaker": "Operator",
"content": "The next question comes from Grace Carter from Bank of America. Please go ahead."
},
{
"speaker": "Grace Carter",
"content": "Looking at the commercial auto line for the past few quarters in a row, there's been a favorable year-over-year change in the underlying loss ratio as well as modest reserve releases. I was just wondering where you all think that line stands since it's been such a difficult line for the industry over the past several years, and if you feel like the worst of the challenges are in the past now. And just trying to consider any sort of maybe differences in experience in the primary auto liability versus maybe what you've seen in the umbrella lines. Thank you."
},
{
"speaker": "Steve Spray",
"content": "Thank you, Grace, and good morning. Yes, commercial auto is, we feel, again, feel really good about where we are there. You look back into 2016 and 2017, and we were having some real challenges in commercial auto. It's kind of the same story I was talking about with umbrella earlier. We recognized it, our actuaries acted upon it quickly, and we reacted very quickly. Personally, I think maybe a little ahead of the market on commercial auto. We got it in a good spot, but then we hit the pandemic, and inflation did what it did. And so we had to get some more rate in that book to keep up with inflation. But that commercial auto book was in good shape, quite frankly, from the actions we took in 2016 and 2017. And I think it also -- to really answer your question too, kind of peel that back, is if you look at the mix that we write at Cincinnati, one of the analysts just a minute ago mentioned, there's a construction book. We've got a manufacturing, retail, wholesale. We're not big into trucking or transportation risks. I think you see a lot more volatility there. We've just managed that book, I think, really well and feel really good about where we are with it today. So I think it's risk selection. I think it's just the makeup of our book. We're a package writer. We don't write motor auto. We don't write trucking or transportation. And I think that's what you're seeing."
},
{
"speaker": "Grace Carter",
"content": "Thank you. And, in the 10-Q, I think the walk year-over-year for the E&S underlying loss ratio mentioned a decrease in the contribution from IBNR and an increase in the case incurred. I think that that's a bit different than what we've seen in the other segments. Could you go over maybe what's going on there and why it would look different than the other segments? Thank you."
},
{
"speaker": "Steve Spray",
"content": "Grace, I'm sorry. You were coming in and out there. I apologize. Could you restate that?"
},
{
"speaker": "Grace Carter",
"content": "Yes, sure. In the 10-Q, when it talks about the walk and the underlying loss ratio in E&S, year-over-year it mentions a decrease in IBNR and increase in case incurred. I think that that was different than what it mentioned for the other segments. Could you just go over kind of the elements as to why that looks different relative to the other segments? Thank you."
},
{
"speaker": "Steve Spray",
"content": "I think, Grace, what I think, if I'm answering you correctly here, is we're looking at all the data. We're looking at paid. We're looking at case. We're looking at things that are happening inside the book for management views of the actuaries. And there's going to be noise quarter-to-quarter. I think looking at it over a longer period, 12 months or maybe even a little longer, will probably be more obstructive. And I hope I answered that for you."
},
{
"speaker": "Operator",
"content": "The next question comes from Meyer Shields from KBW. Please go ahead."
},
{
"speaker": "Meyer Shields",
"content": "I'm going to apologize for being an analyst also, but by that I mean just like an overexposure to publicly traded companies. Can you update us on how the non-public regionals that you compete with are responding to elevated social inflation and elevated property losses and what opportunity that implies for growth?"
},
{
"speaker": "Steve Spray",
"content": "Yes. Thanks, Meyer. I would say from my perspective, I just don't, and this might sound kind of crazy, I just don't pay a lot of attention to what others are doing around us. I'm more focused on what we're doing risk-by-risk, town-by-town, agent-by-agent, and how we compete. And sometimes we run into situations where we lose this account, or we write this account. So I think it would be too broad to generalize. I would say to you this, on personal lines, we're seeing more tumultuous time from all those markets, particularly here in the Midwest. And we're seeing more and more opportunities in the middle market personal line space just on an exponential basis. Just the number of quotes and the opportunities that we're seeing is just up considerably and there's something to that. And I think a big piece of that is that we've got the balance sheet. Like I mentioned in my comments earlier, we're showing up to the agencies with 12.7 billion of GAAP equity looking to grow. Our doors are open. We're confident in the way we price that business. The terms and conditions that we're putting on homeowner business are as strong today as I've ever seen them in my career. And I think that they'll stay, particularly, wind and hail deductibles, roof schedules to combat the continued severe convective storms. And I think those things, along with re-insurance, are putting pressure on some of those markets that you mentioned and it's creating opportunity for Cincinnati."
},
{
"speaker": "Meyer Shields",
"content": "Okay. Fantastic. That's very helpful. Related question. How do we think about the opportunity to appoint agents eventually impacting the value that agents see in the brand? Is there a point where that becomes diluted?"
},
{
"speaker": "Steve Spray",
"content": "Thank you. I would say no. I would say the key and the key message that I'm sending and that we're executing on, and we're doing an excellent job of this, is with Cincinnati, it's more about the quality of the agent and the professionalism of the local agent that we're doing business with than it is about the numbers. Now, we want to do business with as few agents as possible, but as many as necessary. We've got roughly 2,100 agency relationships across the country. By any measure, that is extremely exclusive as far as distribution goes. I'm not saying this is a goal at all, but if we doubled our distribution on a relative basis, we would still have an exclusive contract compared to any of our peers that I can see in the industry. And again, I'm not saying we're doubling our agency plan, but I am telling you that we have plenty of opportunity to continue to appoint professional agents across the country, and you'll see us continue to do that. I can show you areas here in Ohio. If you looked at the number of agencies we have in the community, you would say it's diluted to franchise value. But in essence, it's not, and we're continuing to grow with those agencies. Agencies run in different circles. Policyholders, when we show up, our local field rep just creates excitement. When there's an ease of doing business, there's a value to our contract. And yes, so we will not dilute franchise value by the number of agencies we appoint. We would dilute it as if we started working with agencies that don't meet our, I'd say, professional standards."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from Charles Lederer, excuse me, the follow-up from Charles Lederer from Citigroup. Please go ahead."
},
{
"speaker": "Charles Lederer",
"content": "I was just going to ask on the Cincinnati Re and Cincinnati Global commentary. I think you mentioned more competitiveness in Cincinnati Global. I'm just wondering what you're referencing, and I guess if you could give some color on the growth in Cincinnati Re and I guess how that book has maybe changed this year versus last year."
},
{
"speaker": "Steve Spray",
"content": "Yes, Charlie, Steve Spray again. Every line of business in CGU is growing except for direct in fact, or what many would refer to as shared lay. And I think you're hearing that out in the marketplace as well, is there's just more capital that's come into that large property space, and it's putting pressure on CGU. They're remaining, they're executing on the same underwriting and pricing discipline that we are here at Cincinnati Insurance. And they're just noticing the difficulty in finding the opportunities to grow that direct in fact business. But every other line of business through the first six months of the year in CGU is up. Now, Cincinnati Re, we think we're in an enviable position there as well in that it's an allocated capital model. We did not set up a separate company. They do not have their own balance sheet. They're writing on Cincinnati Insurance paper. What we ask of Cincinnati Re is just to try to peg the capital that's needed for each risk that they write, and then that they get a hurdle rate on that that is an attractive return on a risk-adjusted basis for us, or they do not have to deploy the capital. There is no pressure in Cincinnati Re to grow. But they are growing, I think nicely, and we're looking at that more with a long hold, they'll be more opportunistic in that arena and say maybe we can so much in Cincinnati Insurance. And you look at the combined ratio there. It's been spectacular. They're profitable inception to date since we spun up. Cincinnati Re, they've changed their mix a bit over time, particularly in property cap, property retro. So they're able to react pretty quickly on these things. And, I think our runway for growth with Cincinnati Re is very solid too."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Steve Spray for any closing remarks."
},
{
"speaker": "Steve Spray",
"content": "Thank you, Jason. Thank you for joining us today. We look forward to speaking with all of you again on the third quarter call."
},
{
"speaker": "Operator",
"content": "The conference is now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cinf | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, and Welcome to the Cincinnati Financial First Quarter 2024 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Dennis McDaniel, Investor Relations Officer. Please go ahead."
},
{
"speaker": "Dennis McDaniel",
"content": "Hello, this is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our first quarter 2024 earnings conference call. Late yesterday, we issued a news release on our results along with our supplemental financial package, including our quarter-end investment portfolio. To find copies of any of these documents, please visit our investor website cinfin.com/investors. The shortest route to the information is the Quarterly Results link in the Navigation menu on the far left. On this call, you'll first hear from Chairman and Chief Executive Officer, Steve Johnston; and then from Executive Vice President and Chief Financial Officer, Mike Sewell. After their prepared remarks, investors participating on the call may ask questions. At that time, some responses may be made by others in the room with us, including President Steve Spray; Chief Investment Officer, Steve Soloria; and Cincinnati Insurance's Chief Claims Officer, Marc Schambow; and Senior Vice President of Corporate Finance, Theresa Hoffer. First, please note that some of the matters to be discussed today are forward-looking. These forward-looking statements involve certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules and therefore is not reconciled to GAAP. Now, I'll turn-over the call to Steve."
},
{
"speaker": "Steve Johnston",
"content": "Good morning, and thank you for joining us today to hear more about our results. In short, we are off to a great start. Our first-quarter results reflect the success of our initiatives to continue balancing the profit and growth of our insurance operations coupled with strong investment income. Net income of $755 million for the first quarter of 2024 included recognition of $484 million on an after-tax basis were the increase in fair value of equity securities still held, representing about three quarters of the increase in net income. Strong operating results generated the rest of the increase. Non-GAAP operating income of $272 million for the first quarter nearly doubled last year's $141 million, including a decrease in catastrophe losses of $93 million on an after-tax basis. The 93.6% first quarter 2024 property casualty combined ratio was 7.1 points better than the first quarter of last year, including a decrease of 6.9 points for catastrophe losses. While our combined ratio for accident year 2024 before catastrophe losses was a percentage point higher than accident year 2023 at three months, if we exclude Cincinnati Re and Cincinnati Global, the ratio improved by 1 point. Accident year 2024 also improved on a case incurred basis. However, we increased incurred but not reported or IBNR reserves as we continue to recognize uncertainty regarding ultimate losses and remain prudent in our reserve estimates until longer-term loss cost trends become more clear. We are also pleased with other measures indicating good momentum in our operating performance. Another quarter of pricing segmentation by risk plus average price increases helped to improve our underwriting profitability, combining with careful risk selection and other efforts to address elevated inflation effects on incurred losses. Agencies representing Cincinnati Insurance, supported by our experienced and professional associates produced another quarter of profitable business for us. Our underwriters continue to emphasize retaining profitable accounts and managing ones that we determine have inadequate pricing based on our risk selection and pricing expertise. Estimated average renewal price increases for the first quarter continued at a healthy pace with commercial lines near the low-end of the high single-digit percentage range, excess and surplus lines in the high single-digit range. Personal auto in the low double-digit range and homeowner in the high single-digit range. Our consolidated property casualty net written premiums grew 11% for the quarter with what we believe was a nice mix of new business and renewals. I'll briefly review operating performance by insurance segment, highlighting premium growth and improved profitability compared to a year-ago. Commercial lines grew net written premiums 7% in the first quarter with a 96.5% combined ratio that improved by 3.9 percentage points, including 4.2 points from lower catastrophe losses. Personal lines grew net written premiums 33%, including growth in middle-market accounts in addition to private client business for our agency's high-net worth clients. Its combined ratio was a very profitable 93.9%, 18.6 percentage points better than last year, including 15.9 points from lower catastrophe losses. Excess and surplus lines also produced a profitable combined ratio of 91.9%, rising 2 percentage points from the first quarter a year-ago, along with net written premium growth of 7%. Both Cincinnati Re and Cincinnati Global continue to produce significant underwriting profit, reflecting our efforts to diversify risk and further improve income stability. Cincinnati Re's combined ratio for the first quarter of 2024 was an excellent 78.6%. That includes IBNR that we routinely carry for expected losses from reinsurance treaties. We believe our potential exposure for losses from the Baltimore bridge collapse is immaterial. Cincinnati Re's net written premiums decreased by 12% overall, driven by a shifting casualty portfolio mix in response to changing market conditions. Property and specialty premiums increased due to attractive opportunities in pricing. Cincinnati Global's combined ratio was also excellent at 69.8%, they again reported strong growth with net written premiums up 28%. Our life insurance subsidiary continued its strong performance, including first quarter 2024 net income of $19 million and operating income growth of 17%. Term life insurance earned premiums grew 2%. I'll conclude with our primary measure of long-term financial performance to value-creation ratio. Our first quarter 2024 DCR was a strong 5.9%. Net income before investment gains or losses for the quarter contributed 2.3%, higher overall valuation of our investment portfolio and other items contributed 3.6%. Next, Chief Financial Officer, Mike Sewell, will add comments to highlight other parts of our financial performance."
},
{
"speaker": "Mike Sewell",
"content": "Thank you, Steve, and thanks for all of you for joining us today. Investment income growth continued at a strong pace, up 17% for the first quarter 2024 compared with the first quarter of 2023. Dividend income was up 9% for the quarter despite net equity security sales for the first three months of 2024 that totaled $40 million. Bond interest income grew 21% for the first quarter of this year. We continue to add more fixed maturity securities to our investment portfolio with net purchases totaling $374 million for the first three months of the year. The first quarter pre-tax average yield of 4.65% for the fixed maturity portfolio was up 40 basis points compared with last year. The average pre-tax yield for the total of purchased taxable and tax-exempt bonds during the first quarter of 2024 was 5.79%. Valuation changes in aggregate for the first quarter 2024 were favorable for our equity portfolio and unfavorable for our bond portfolio. Before tax effects, the net gain was $602 million for the equity portfolio, partially offset by a net loss of $65 million for the bond portfolio. At the end of the quarter, total investment portfolio net appreciated value was approximately $6.6 billion. The equity portfolio was in a net gain position of $7.2 billion, while the fixed maturity portfolio was in a net loss position of $625 million. Cash flow continued to benefit investment income in addition to higher bond yields. Cash flow from operating activities for the first three months of 2024 was $353 million, up 41% from a year ago. Our expense management objectives include an appropriate balance between controlling expenses and making strategic investments in our business. The first quarter 2024 property casualty underwriting expense ratio was 0.7 percentage points higher than last year, primarily related to higher levels of profit-sharing commissions for agencies. Regarding loss reserves, our approach remains consistent and aims for net amounts in the upper half of the actuarily estimated range of net loss and loss expense reserves. As we do each quarter, we consider new information such as paid losses and case reserves. Then we updated estimated ultimate losses and loss expenses by accident year and line of business. For the first three months of 2024, our net addition to property casualty loss expense reserves was $233 million, including $272 million for the IBNR portion. During the first quarter, we experienced $100 million of property casualty net favorable reserve development on prior accident years that benefited the combined ratio by 5.0 percentage points. Almost every line of business had favorable development except for commercial casualty, which was unfavorable by just $254,000. We added reserves to several older prior accident years and reduced reserves for the three most recent accident years. On an all lines basis by accident year, net reserve development for the first three months of 2024 included favorable $184 million for 2023, favorable $24 million for 2022 and an unfavorable $108 million in aggregate for accident years prior to 2022. The unfavorable amount reflects our slowing the release of IBNR reserves for those older accident years. I'll conclude my comments with capital management highlights, another area where we have a consistent long-term approach. We paid $116 million in dividends to shareholders during the first quarter of 2024. We also repurchased 680,000 shares at an average price per share of $109.89. We think our financial flexibility and our financial strength are both in excellent shape. Parent company cash and marketable securities at quarter-end was nearly $5 billion. Debt-to-total capital continued to be under 10% and our quarter-end book value was a record high, $80.83 per share with $12.7 billion of GAAP consolidated shareholders' equity providing plenty of capacity for profitable growth of our insurance operations. Now, I'll turn the call back over to Steve."
},
{
"speaker": "Steve Johnston",
"content": "Thank you, Mike. As we previously announced, this is my last conference call as CEO. Effective at our Annual Meeting of Shareholders next Saturday, President, Steve Spray will add the role of Chief Executive Officer. As I've mentioned before, Steve is the right person to build on our decade of profitable growth. He understands the importance of our agency-centered strategy and the unique advantages it brings. I'm confident in his abilities to bring innovative ideas together with the hallmarks of Cincinnati Insurance to create opportunities for shareholders, agents and associates. I look forward to continuing to work with him as Chairman of the Board. As a reminder, with Mike and me today are Steve Spray, Steve Soloria, Marc Schambow, and Theresa Hoffer. Raghav, please open the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Charlie Lederer with Citi. Please go ahead."
},
{
"speaker": "Charlie Lederer",
"content": "Hi, thanks. Good morning. You gave some helpful color on your loss picks, but I'm curious, how should we think about your loss picks in commercial casualty? Have you made any changes to your view of loss trend just given the trajectory of the current accident year loss ratio and are you baking in additional caution? Should we expect you to hold a bit more of a buffer near-term given uncertainty?"
},
{
"speaker": "Steve Johnston",
"content": "Yes. We feel confident, Charlie, with the loss pick that we had, we are reflecting uncertainty. There's a lot of good going on in the commercial casualty with rates we feel exceeding our loss cost trends. However, for first quarter where there's additional uncertainty, we are recognizing that in our loss ticket."
},
{
"speaker": "Charlie Lederer",
"content": "Got it. Thank you. Maybe in workers' comp, it looks like pricing took an incremental step down in your initial loss ticket higher too. Is there anything in that pick, I guess, beyond pricing being down more or I guess, are you seeing anything there?"
},
{
"speaker": "Mike Sewell",
"content": "So, we're just continuing to see the same trends that we have been seeing with rates under pressure there, but also strong performance historically from the line. We are though recognizing the uncertainty that it comes with the rate decreases with a little bit higher loss pick for the current year."
},
{
"speaker": "Charlie Lederer",
"content": "Okay. Thank you."
},
{
"speaker": "Steve Johnston",
"content": "Thank you."
},
{
"speaker": "Mike Sewell",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from Mike Zaremski with BMO. Please go ahead."
},
{
"speaker": "Mike Zaremski",
"content": "Hi, thanks. In the earnings release, you talked about the underlying loss ratio for commercial improving 1 point, but you said excluding Cincinnati Re and Global. But was there a reason you pointed that out is what -- why did -- I'm not sure I may have missed it, why did the Cincinnati Re, Global underlying loss ratio increase so much?"
},
{
"speaker": "Steve Johnston",
"content": "Yes I think the point of pointing is out is we have the three segments commercialized, personalized, in excess of surplus lines. To get to the consolidated, you also have to add the other portion, which includes Cincinnati Re and Cincinnati Global. So, since the first three segments I mentioned had improvements, we pointed out those in the other segment. I will emphasize that things are going great for both Cincinnati Re and Cincinnati Global. I think one of the things that -- as we mentioned, we don't think we have material exposure to the bridge collapse in Baltimore. We have been shaping the Cincinnati Re book in a very positive manner in terms of derisking. And so I think one of the things that caused the attritional to go up if we compare it to the same quarter a year ago is that the mix has shifted to a little bit more of a pro rata or proportional reinsurance, which would have less risk margin in it. It would have a higher attritional pick, but there would be less volatility there. And so I think that would be driving what we're seeing there in Cincinnati Re, a very strong zero CATs for the quarter, 10.4 points of favorable development versus 7.7 of adverse a year ago. I think the $14 million in favorable development that we show, about $13 million of it came from 2023. With the full year combined ratio of 2023 at 77.7% in this first quarter at a strong 78.6%, this hard work in reshaping the book has really paid off. The inception-to-date combined ratio at the end of the year 2022 was 101.2 and with those two strong marks in the full year of 2023 and the first quarter here and now in just over a year, our inception-to-date is at 94.5. So I think the action is paying off and it does show a higher pick in the current action year, but I think it's a less risky portfolio at this point. I think the same thing for Cincinnati Global, but I don't know if you want to talk a little bit more about Cincinnati Global?"
},
{
"speaker": "Mike Sewell",
"content": "For Cincinnati Global, same thing, strong 69.8%. They have had three consecutive years now as a top quartile Lloyd's underwriter and while they've done that, they've been diversifying in terms of their footprint by product line, by geography, and they're also providing an additional avenue for access to Lloyd's for the agents that are appointed by CIC. So a lot of positive at CGU reflected with strong results. And again, it's pretty tough at Lloyd's to be top quartile three years in a row the way they've done. Also this quarter, zero CATs versus 11.1 a year ago. And then the reserve development is favorable by 25.6 points this year versus adverse by 3.2 a year ago. So I think in both of those businesses, there's a ton of positive going on. And we've only pointed it out so that the math would be easier as you saw the consolidated CLD, the commercialized department, the personal lines and the excess and surplus and then to add the other portion to get to the consolidated."
},
{
"speaker": "Mike Zaremski",
"content": "Okay. That's helpful color. And I guess would you say then because of some of the business mix-shift and since they read and we should be thinking about the underlying loss ratio structurally being maybe a little bit higher, but then -- but less potential volatility around the overall combined ratio at? Did I interject, did you guys want to say something else or I'll move on to my follow-up?"
},
{
"speaker": "Steve Johnston",
"content": "No, please move on to the follow-up."
},
{
"speaker": "Mike Zaremski",
"content": "Okay. Thanks. So just thinking about going commercial lines ex Reinsurance and Global. You've been on along this path of taking action to add, I guess, some reserves or just conservatism into your picks given the inflationary environment which you're -- clearly is persisting a bit. If I look at like overall top line growth and maybe I'll -- you can talk about the whole segment, but I'll just focus on commercial casualty because that's been one of the areas where inflation has been higher than expected. If I look at just overall top line growth, net premium written growth, now it's still not at I think your historical levels relative to the industry, but it has been ticking up a bit. And are you -- so given you're still in an environment where you seem to be kind of adding more IBNR, are you getting to a point, is pricing at a level or is the environment there where you want to start playing more offense? Or are we still kind of in the -- it's best to be cautious in terms of your top line growth."
},
{
"speaker": "Mike Sewell",
"content": "So yes, I think that we can balance the two. I think we feel good about our growth, double digit overall at 11%, really strong growth in Personal lines. And with each of our lines, we write it on a package basis for Commercial lines, and so there's going to be a little bit of variance between the different lines. But we think we are in a good place with our pricing, but we realize that you need to stick to adequate pricing. And you can't fall into a trap where if others are underpricing business that you follow that path. So we're going to maintain the discipline, charge the adequate rate on a on a risk by risk basis and we think that offers us plenty of opportunity to grow the company."
},
{
"speaker": "Mike Zaremski",
"content": "And one quick follow-up, and I might have asked this in the past, but within your commercial casualty, the US non-global and reinsurance portfolio, I believe you might think about things between small -- very small commercial versus mid versus large or maybe I'm incorrect, but just curious if you're -- now that you've had more time to reflect on results, it is -- doesn't the inflationary issues you have brought up, have they been emanating from any certain parts of the business mix other than just…"
},
{
"speaker": "Steve Johnston",
"content": "Yes, I think we're doing a good job of pricing adequately in all those areas. I do think and I pointed out on the calls before, you really do have to pay a close attention to the higher levels because there's a leveraged effect of inflation with every layer that you go up for a constant ground-up inflation rate, there'll be more or higher inflation with each layer as you go up because of the layer below inflating into the higher layer. But we've been on this for some time. We've got some really talented actuaries that are working with our larger risks and we feel we were addressing it early-on from the beginning and that we're in a good position across the board."
},
{
"speaker": "Mike Zaremski",
"content": "Thanks for the color."
},
{
"speaker": "Steve Johnston",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thanks very much. And our next question comes from Michael Phillips with Oppenheimer. Please go ahead."
},
{
"speaker": "Michael Phillips",
"content": "Thanks, good morning. In terms of personal auto, your comments, Steve, in the beginning, were pretty similar in terms of pricing from last quarter. You had a bit of an uptick back in the loss ratio there. I guess, can you remind us where you expect this year to kind of pan out in terms of just the profitability of personal auto and when you think your pricing will maybe peak and start to come back down? It looks like -- and you don't give it, but you're probably still above 100% combined ratio there. So when do you expect kind of profitability in personal auto?"
},
{
"speaker": "Steve Johnston",
"content": "I think we're in a good position. Personal lines across the board, it is sold a lot on a package -- in a package position. The first quarter was -- for current accident year was actually down a little bit from first quarter a year ago and pretty flat with the full year. So we feel we feel good about the pricing that we've been able to get-in auto, home and in the other lines. And we think it will reap benefits. And I think Steve's got a little to add-on."
},
{
"speaker": "Steve Spray",
"content": "Yes, thanks for the question, Mike. I think one of the strengths that we have going and it's been a plan we've been executing on, continue to work on for the last several years. So it's nothing new. But I think it's adding value to the company and to our agents is that we've become a premium or premier writer for our agents both in the middle-market space and in the high-net worth. And that gives us both product diversification as well as geographic diversification. High-net worth, while we write it everywhere, tends to be maybe a little more focused in certain geographies. High-net worth or private client is heavier on the property side. And then on the middle-market, we give geographic diversification as that book is primarily, I'll call it, a Midwestern, Southeastern part of the US book of business and it's heavier in auto. So we're getting one, being that much more important to each of our agents, being able to attract more of their business, but at the same time, get the diversification both geographically and by line of business."
},
{
"speaker": "Steve Johnston",
"content": "Yes, I think too, just the history of personal lines in general with the $795 million combined this year. Last year, we were over just a touch over $100 million and then it was what, the four prior years to 2023, we were under $100 million. So we've really -- I think we've demonstrated a history of being able to price personal lines pretty darn well across the spectrum as Steve mentions."
},
{
"speaker": "Steve Spray",
"content": "And then now I might add, we've got our -- we've got the E&S capability that we can provide solutions for our agents and their clients. And that's now active in nine states. So we just feel really good about all personal lines, the growth there, the momentum that we have. So, feel very bullish on personal lines."
},
{
"speaker": "Michael Phillips",
"content": "Okay, thank you. Next one is just back on the commercial lines and this is kind of a number-specific question. So, if it requires a follow-up, I'm happy to do so. But if I look at your claim -- reported claim counts that you give in your statutory data, for other liability, it's down significantly for 2023 accident year. I mean more so than the 2020 accident year COVID-related. So I don't know if there's a data thing there or not, but reported claim counts at 12 months or 15% down in other liability. I don't know if that's something that you've seen or expect or can you comment on that? Again, paid losses aren't, but the reported claim counts for GL, i.e., the liability are down significantly at age 12."
},
{
"speaker": "Steve Johnston",
"content": "Yes, they are. And I think that's very helpful in terms of the way we're underwriting the book. It is a severity issue that we're seeing there."
},
{
"speaker": "Michael Phillips",
"content": "So you recognize the frequency is down significantly then for other liabilities, Steve?"
},
{
"speaker": "Steve Johnston",
"content": "Yes, we do."
},
{
"speaker": "Michael Phillips",
"content": "Okay. All right. Thank you."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Greg Peters at Raymond James. Please go ahead."
},
{
"speaker": "Greg Peters",
"content": "Good morning, everyone. So the first question I'll focus on is just growth in the commercial lines business because it seems like you're -- when you look at the stats from a new business production, you're having a lot of success there. And I was wondering if you could give us some sense on how your quote to bind ratio is working or give us some parameters to think about it because I guess given the results, we'd expect some increased competition at some point that doesn't seem to necessarily be reflecting in your numbers."
},
{
"speaker": "Steve Spray",
"content": "Thanks for the question, Greg. Steve Spray. If you recall last year throughout 2023, especially starting the year, our new commercial lines business was under pressure really for that first six months and we were down quite a bit on the same over 2022. We were really executing on underwriting term condition, pricing discipline through that first six months. We stuck to our guns. I think some others maybe just had a little different view of the risk and our new business was under pressure. On the back half of 2023, we continue to see our new business improve. We stuck to our guns as well. We stayed disciplined in the pricing, the underwriting terms and conditions. Back half of 2023, new business really picked up. That is obviously -- that trend has obviously continued into 2024. The beauty of it is that like Steve said, we're a package underwriter, we look at every single risk on its own merits and we have the tools to price the business with predictive analytics for each major line of business, look at it by line of business and then for the total account. So I see runway still for new business and commercial lines in 2024, but like Steve said, the key is that we stay disciplined with our underwriting and our pricing and earn the business, not buy it."
},
{
"speaker": "Greg Peters",
"content": "Yes, that makes sense. So another topic that's come up that you guys have talked about is the concept of a multi-year policy that I know you guys use in certain lines of business. Can you give us an update on where you are with the three-year policies, which lines of business and has it increased as a percentage of your total book, et cetera?"
},
{
"speaker": "Steve Spray",
"content": "I mean, you may have to follow-up on that, which percentage has increased, Greg. But yes, this is the three-year policy in general, it's a differentiator for us. It's something that we have been very committed to for many years and remain committed today. I think it's even better that we write three-year policies today because we have the sophisticated segment and pricing that we do. So our underwriters, when they quote a three-year, whether it be new or renewal, just as a reminder, even though we have a three-year package policy, about 75% of the premium that we have in commercial lines is adjusted on an annual basis. So it'd be those accounts that are coming off of a three-year are actually renewing, our commercial auto, our commercial umbrella and then workers' compensation are all adjusted annually. It's really just the property, the general liability, crime, and the marine where that rate is guaranteed. Now, I will tell you this too. Our three-year policy on a loss ratio standpoint outperforms our one-year policy. So our underwriters are executing with our agents on the -- not only the science of underwriting, but the art and intuitively, they are picking our best business, our best price business to put on a three-year package and the results show that. So we're committed to it. Our retentions are much better on a three-year policy in the middle of that three-year policy. So I think that helps agents' retentions, it helps ours. It's an expense. It certainly helps on the expense side. And then I think most importantly, it shows our agents and it shows our policyholders that we're a company that is looking for long-term relationships. And we're committed to the three-year and we think it gives us an advantage in the marketplace."
},
{
"speaker": "Greg Peters",
"content": "Yes, the percentage question, just I feel like this would be the time to be using more of that in this market considering the market conditions. And so I was just curious if it's, from a commercial standpoint, we can take it offline, but that's where I was thinking -- what I was thinking about when I was asking for percentages."
},
{
"speaker": "Steve Spray",
"content": "Yes. Okay. No, I got it. That makes total sense. Greg. Yes, wherever we feel like we can get the adequate price on account, we are wanting to use our three-year package policy."
},
{
"speaker": "Greg Peters",
"content": "Got it. Thanks for the answers."
},
{
"speaker": "Steve Spray",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from Grace Carter at Bank of America. Please go ahead."
},
{
"speaker": "Grace Carter",
"content": "Hi, everyone. Looking at the commercial casualty core loss ratio, just given that it's a bit higher than it ran in the latter part of last year as well as the commentary on increased IBNR, I was just curious if that's primarily driven by GL or excess casualty or if it's a mix of both this quarter. And I was just curious if there is -- if you all could comment on how you're thinking about rate adequacy across both of those pieces of the book."
},
{
"speaker": "Steve Johnston",
"content": "I think it's kind of across the board, Grace. I do think that higher pick is something that we would do in the first quarter. Typically, we have run the first quarter a little bit higher than the full year prior just due to the newness of the accident year, but we feel very good. We feel very good about the way that we are our pricing the GL and really across the spectrum there, including the umbrella."
},
{
"speaker": "Grace Carter",
"content": "Thank you. And I guess on the commercial auto side, it looks like growth picked up a little bit this quarter. I was just wondering if that indicates that maybe you all are starting to add some additional units rather than just top line growth being primarily driven by rate. And just kind of curious on how you all are thinking about potential growth in that environment, just given that it has been such a challenging line for the industry for so long?"
},
{
"speaker": "Steve Spray",
"content": "Yes. Thanks for the question, Grace. Again, Steve Spray. It's a little bit of both. Candidly, it's -- we're still getting ranked through that commercial book and we are growing the new business. Again, we're a package writer. So we don't write monoline auto. That auto would come along with the rest of the package. And again, feel really good about the pricing that we have in commercial auto and our direction there. If you recall back, I think it was back to 2016, 2017 when we really undertook some real tough action on our commercial auto book, both in risk selection and then primarily in pricing, and really had commercial auto in a good place. Inflation came along and we had to -- we obviously had to work with that, but feel really good about where that commercial auto book is, both from a pricing risk selection and looking to grow that book as well along with our package business, again, risk-by-risk and adequate pricing."
},
{
"speaker": "Grace Carter",
"content": "Thank you."
},
{
"speaker": "Steve Spray",
"content": "Thank you, Grace."
},
{
"speaker": "Steve Johnston",
"content": "Thank you, Grace."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from Meyer Shields with KBW. Please go ahead."
},
{
"speaker": "Meyer Shields",
"content": "Great. Thanks so much. To go back to the Cincinnati Global and Reinsurance side of things, just I'm not sure I understand, when you talk about lower volatility, is that a function of less seasonality or less catastrophic exposure?"
},
{
"speaker": "Steve Johnston",
"content": "It would be less catastrophic exposure."
},
{
"speaker": "Meyer Shields",
"content": "Okay, perfect. The second question sort of related. Can you talk about what you're seeing in terms of the year-over-year, I guess, trend or the observed claim inflation rate for commercial property, is that decelerating at all compared to last year?"
},
{
"speaker": "Steve Johnston",
"content": "I think we still see inflation. We look at so much on a risk by risk basis that I don't know that I have a good number for you across the board on what we're seeing with inflation. And it's been a sticky thing in the inflation rates on insurance related items, building materials and wages and so forth have been higher than the general CPI. So we take a cautious view, but certainly the rate of the increase in the second derivatives has been slowing down."
},
{
"speaker": "Meyer Shields",
"content": "Okay, perfect. That's very helpful. And Steve, congratulations and thanks for everything."
},
{
"speaker": "Steve Johnston",
"content": "Well, thank you Meyer. it's been great."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes our question-and-answer session. I'd like to turn the conference back over to Management for any closing remarks."
},
{
"speaker": "Steve Johnston",
"content": "Thank you to everyone for their excellent questions and thank you for joining us today. We hope to see some of you at our shareholder meeting next Saturday, May 4 at the Cincinnati Financial Headquarters Office here. You're welcome to listen to our webcast of the meeting also available at cinfin.com/investors. Steve and Mike, look forward to speaking with you again on our second quarter call."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day."
}
] |
cl | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to today's Colgate-Palmolive 2024 Fourth Quarter and Year End Earnings Conference Call. This call is being recorded and is being simulcast live at www.colgatepalmolive.com. Now for opening remarks, I'd like to turn this call over to Chief Investor Relations Officer and Executive Vice President, M&A, John Faucher."
},
{
"speaker": "John Faucher",
"content": "Thanks, Betsy. Good morning and welcome to our fourth quarter and full year 2024 earnings release conference call. This is John Faucher. Today's conference call will include forward-looking statements. Actual results could differ materially from these statements. Forward-looking statements inherently involve risks and uncertainties and are made on the basis of our views and assumptions at this time. Please refer to our fourth quarter and full year 2024 earnings press release and related prepared materials, and our most recent filings with the SEC, including our 2023 annual report on Form 10-K, and subsequent SEC filings, all available on Colgate's website, for a discussion of the factors that could cause actual results to differ materially from these statements. This conference call will also include a discussion of non-GAAP financial measures, including those identified in Tables 4, 6, 7, 8 and 9 of the earnings press release. A full reconciliation to the corresponding GAAP financial measures is included in the fourth quarter and full year 2024 earnings press release and is available on Colgate's website. Joining me on the call this morning are Noel Wallace, Chairman, President and Chief Executive Officer; and Stan Sutula, Chief Financial Officer. Noel will provide you with some his thoughts on our results and our 2025 outlook and then we'll open it up for Q&A. Noel?"
},
{
"speaker": "Noel Wallace",
"content": "Great. Thanks, John, and good morning everyone, and thank you all for joining us today as we discuss our 2024 results as well as our outlook for 2025. Let me make a few points on 2024 before I tell you why we continue to be very confident in our ability to deliver against our goals for this year. I couldn't be prouder of the results of the Colgate team that they delivered in 2024, which drove strong growth and exceeded our initial financial guidance. Net sales of $20 billion in 2024, which is one year ahead of our strategic plan ambition. This was driven by our sixth consecutive year of organic sales growth either in line or ahead of our long-term target of 3% to 5%. We delivered high-single-digit organic growth in 2024 on top of high-single-digit growth in 2023. We delivered pricing and volume growth in all four quarters. For the year, we grew volume in every division and in every category. We're focused on driving household penetration, which we believe is the best way to deliver long-term sustainable growth. We had another year of increased advertising spending up 15% and up 130 basis points as a percentage of sales. This increase, which is on top of 19% increase in 2023 is driving significantly improved brand health. Our third consecutive year of global toothpaste category value share growth highlights that our strategy of driving category growth in order to drive market share growth. Our strategy to build and scale our innovation capabilities is paying off as well as the incremental sales contribution from innovation has risen by 45% from 2021 to 2024. We delivered gross and operating margin expansion despite significant foreign exchange headwinds and the increased spending on advertising, compensation and capabilities through another year of strong productivity, particularly for our funding the growth initiatives. Double-digit based earnings per share growth ahead of our initial guidance despite incremental foreign exchange headwinds on both the net sales line and in gross margin. Record operating cash and free cash flow, record cash return to shareholders along with continued improvement in our top tier return on invested capital. So another very strong year, but let me now move on to 2025. In 2025, we'll see many of the same challenges and opportunities. All through 2024, I have been speaking to you about how our strategy was designed so that we could deliver in 2025 and beyond by investing in future growth, building more flexibility into our P&L and strengthening our balance sheet. The strong investment levels behind advertising and innovation and the continued improvement in returns on that spending give us confidence in our ability to continue to drive volume through household penetration. The increased investment is also improving brand health. As I will discuss at CAGNY next month, higher brand health is the key to our revenue growth management strategy, which will be key to sustaining pricing growth in a less inflationary environment. We will deliver another year of strong innovation led by the re-launch of Colgate Total with superior new offerings in toothpaste, manual toothbrushes and mouthwash. Our investments in data, analytics and AI will also be key to driving pricing growth in 2025. We utilized our strong gross profit growth in 2023 and 2024 to invest ahead of the curve and capabilities, which also give us additional flexibility to control SG&A spending going forward. Our strong cash flow gives us additional leverage for EPS growth through debt paid out to lower interest expense or share repurchases, even as we continue to invest in our business for growth and productivity. So we enter 2025 confident in our strategy and in our ability to deliver consistent compounded growth to deliver on our guidance and drive strong total shareholder return. So with that, I'll hand it over to you for questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Dara Mohsenian with Morgan Stanley. Please go ahead."
},
{
"speaker": "Dara Mohsenian",
"content": "Hey, good morning guys."
},
{
"speaker": "Noel Wallace",
"content": "Good morning Dara."
},
{
"speaker": "Dara Mohsenian",
"content": "So just want a bit more clarity around the 2025 guidance relative to Q4, EPS guidance for all-in low-single-digit to mid-single-digit growth is pretty robust considering the onerous FX impact. So just what gives you confidence in such a strong implied local FX earnings growth? Number one. And then two, maybe we can drill down specifically into the OSG line. Obviously, that's a key driver of earnings growth. Q4 is weaker than we have seen in recent quarters, if you adjust for Argentina, the pet private label drag probably somewhere in that close to 4% OSG range, slower than the prior pace. So just as we think about the 3% to 5% guidance for 2025, maybe highlight your level of confidence relative to that Q4 result and maybe what the key points are of uncertainty are either positive or negative?"
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning, Dara. Thank you. So let me start off with the guidance. As I think I alluded to in my upfront comments, we continue to believe we are very well positioned to continue delivering consistent compounded dollar earnings growth. You've heard me talk about a lot about that over the last couple of years. That's reflected in our guidance and the strength quite frankly of the fundamentals that as you go through our P&L as well as the balance sheet. I've spoken many times to all of you about building flexibility into our plans and that was very much inherent as we looked at our 2025 strategy back in 2020. How do we get more flex into the P&L as we pivot to a much more growth mindset oriented organization. And that's exactly what we've done. So our top line focus will continue with balanced growth in both volume and price. And you've seen that consistently throughout the year in 2024. We believe we'll continue to deliver balanced growth in 2025. We saw volume and pricing growth across all of our categories this year, which is I think a terrific proxy for how we're building the health of those businesses moving forward. So in the context of 3% to 5%, we feel really good about that. We think it will continue to be at the top end of our peer group and it's reflected in the comfort we have in the health of the business overall. You look at market shares consistently up over the last couple of years. You look at the performance across multiple divisions being consistently up quarter-to-quarter. So the health of the business is there. If I move down to P&L, we continue to invest as I mentioned ahead of our capabilities. So we put a lot of money in the last couple of years in building capabilities that we think will allow us to sustain more consistent top line growth. We've reoriented the organization to really focus on dollar earnings growth and making sure that we're looking for ways to offset foreign exchange. No question that will continue to be a headwind, but we believe we've got more opportunities to offset that with other areas within the P&L. The strong cash generation is another area to look to. We've been consistent about building more cash, lowering our working capital to ensure that we have more flex across other areas below the operating margin line in the P&L. So overall, I think that underlying health of the business is in a really good place. Now, if I come back to your organic growth question, 4.3%, you look almost 5% in the fourth quarter, if you exclude private label, which we think is a more honest way to look at our business given the underlying base business being quite strong. And we think 5% in the current market environment is actually a really good number. Now we have plans to continue to develop the opportunities that we see ahead of us, but 5% in the fourth quarter, we feel pretty good about. Particularly on the volume side, almost 3% excluding private label, a little bit softer in some parts of Europe that we saw as we exited the quarter, particularly some of the softness we saw and continued softness in China behind our skin health business, but overall good volume growth. And we've been talking to you more about a normalization moving away from pricing growth in the P&L to more volume growth and that's consistent with what we've seen over the last couple of quarters. We did have less pricing from Argentina in the quarter, which we've talked about in our prepared comments. It was about 100 basis points less than we had in the first three quarters of the year, but we are still getting positive pricing and we've announced more pricing to offset some of the foreign exchange headwinds that we're seeing in Latin America already here in the first quarter. So if I come back to the underlying confidence that we have strong P&L flexibility, good balance sheet. The health of the brands is in a much better place than it's been. Market shares continue to inflect positively for the business. And overall, we're seeing a stabilization of the categories and hopefully we'll see the growth come back as we move through 2025."
},
{
"speaker": "Operator",
"content": "The next question comes from Peter Grom with UBS. Please go ahead."
},
{
"speaker": "Peter Grom",
"content": "Thanks, operator. Good morning, everyone. So I was just hoping to get some color on the gross margin performance in the quarter and kind of the cadence from here. Obviously, we weren't going to have sequential progress continuously, but it was the first time in a couple of years that hasn't happened. So I just would be curious how gross margin fared versus kind of your expectations. And then just looking ahead, I understand you expect another year of expansion, but just would be curious, if you could or it would be helpful if you could frame the path from here considering the exit rate? And then just within that, any color you can share on funding the growth just given what was a very strong year in 2024? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yes, good morning, Peter. Thanks. So let me just level set us here. We're up 70 basis points versus year ago with significant foreign exchange headwind. So again, another quarter north of 60% and I think overall we feel pretty good about that, slightly below where we were hoping given the transactional impact that moved through the P&L as we exited the quarter. But overall, the underlying margin driven by pricing, strong productivity through funding the growth continues to be very good. So we feel pretty good about where we ended up. And as I mentioned earlier, that we have taken some pricing in Latin America to begin to offset some of the foreign exchange headwinds we've seen. But let me turn it over to Stan, who'll give you a little bit more color on how we're thinking about the trajectory of gross margin and our confidence to be able to grow gross margin in 2025."
},
{
"speaker": "Stanley Sutula",
"content": "Thanks, Joel. So Peter, we mentioned that we did all four quarters above 60% and we're up 70 basis points in fourth quarter. So we're happy with the margin expansion. And as we look ahead, there are several items that I think will help us as we go to drive that margin expansion. One is simply going to be mix. As we grow Hill's and we grow Oral Care, we get a positive mix as those are two of our more profitable businesses. So you combine that with less private label, which has a very low margin, you get a mix benefit going forward. You mentioned our funding-the-growth program, our productivity program long established extraordinarily well run by the teams. We've been planning on this for many months now heading into '25. So I think we're off to a good start on funding-the-growth. One of the capabilities Joel mentioned as we've made investments in is in some of our new capabilities and we have revenue growth management what we call 2.0 as we go to drive better performance on our revenue growth management. We have good innovation pipelines across the business coming in. And I think the combination of those will help us with expanding margin in 2025. Now as private label slowly mixes off, you'll see that go through the year, but we are confident in the ability to expand margin in 2025."
},
{
"speaker": "Noel Wallace",
"content": "And then one other add, Peter, would be that we've seen a more moderating raw material environment. We'll watch that carefully. But relative to how we entered 2024, we seem to have better visibilities to where raw materials are going at this stage."
},
{
"speaker": "Operator",
"content": "The next question comes from Bonnie Herzog with Goldman Sachs. Please go ahead."
},
{
"speaker": "Bonnie Herzog",
"content": "All right. Thank you. Good morning. I actually had a question on your North America business. Pricing was negative last year and then segment volumes didn't necessarily benefit, I guess, in the back half of the year. So as we think about this year, how should we think about the contribution from price versus volume mix in North America? And then is it reasonable to assume that price contribution remains negative? And in that context, could you touch on the promotional environment and I guess how it compares relative to your expectations across your different categories in the market? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Thanks, Bonnie, and good morning. Again, as we talked about back in the second quarter and some of the price adjustments we made to the business, which we think have helped improve the underlying health and certainly some of the strong volume performance we've had in the US continue to filter through the third and the fourth quarter. We'll see that kind of taper away as we move through the back half of 2025, but those prices adjustments are there. I would say that both volume and price sequentially improved in the fourth quarter as we exited the year in North America. I would also remind everyone that the segmentation that we have now includes the skin health business in North America as of the third quarter that we added that in there. And we did see a lot of softness in volume and price coming out of our skin business in China, which has been pretty consistent theme throughout the year. But overall, North America, if you take the underlying business, Oral, Personal and Home Care performed quite well. We saw, as I mentioned, sequential improvement. We saw some benefits from some of the shipment timing that we had this year versus last year and the volume performance ex-skin was very strong across the North America business. But that being said, we do have more work to do. We're still continuing to look at our go-to market strategies and our investment posture in the US. We continue to believe it's a strategic growth opportunity for the company and we will continue to invest in that business. We have new leadership in place, which we're excited about some of the strategic thinking that's coming from behind that. The exiting of the year saw some green shoots particularly in some of the categories including toothpaste, liquid hand soap and dish, particularly in some of the latter categories, which had been a headwind to us in the first part of the year. So we feel good about where we are from a strategic standpoint and from a growth standpoint. So overall pricing will improve, particularly as we move through the back half of 2025."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrea Teixeira with JPMorgan. Please go ahead."
},
{
"speaker": "Andrea Teixeira",
"content": "Good morning. I just wanted to kind of like elaborate a little bit more if you can on the pricing front, what you're expecting on the FX driven pricing. You mentioned Latin America you took pricing. And if you are seeing anything in regards to some of the places where you have effects as well in Europe in terms of like how it fits into your guidance? And then related to that also on the volume, sorry, just to clarify, if it's mostly driven the volume components that you were seeing into 2025, where is going to be the most I mean the areas that you see the volume kind of like being positive on the algorithm from the 3% to 5% what's going to be the green shoots you're seeing? I'm assuming Hill's and some of the strength that you're seeing in Colgate Total as well. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Sure. Great. Good morning, Andrea. So let me take the pricing question first. Obviously, I talked about offsetting foreign exchange and we'll continue to see some opportunities across the world, particularly in Latin America. But there are other markets across Africa that we will be taking pricing to offset some of the foreign exchange headwinds that we see moving into the year. Europe on the other hand will continue its value oriented pricing strategy, which is very much driven by a significant improvement in our innovation and the quality of our innovation to drive more pricing and value back into the categories. That was successfully deployed back in 2023 and throughout 2024. So we'll continue to make sure that we're bringing pricing into the category through some of the value oriented initiatives that we have. And as Stan mentioned, that will continue to be a key theme for all of our divisions as we increase our innovation. You heard me talk about the incrementality we're getting from our innovation. So we feel we're in a much more solid footing relative to how we think about innovation and its ability to be accretive through our P&L both from a growth standpoint as well as a margin standpoint. In terms of volume, we'll continue to have balanced volume across the year. Now we've said that we expected a shift from a pricing driven algorithm and organic to a more volume driven organic, excuse me, more volume driven algorithm on organic and that's exactly what's happening. We're seeing that consistently across all of our divisions. A little softness on the Hill's category, but we've seen consumption start to improve as we enter 2025 on the categories. So that bodes well, but that's been a little softer, but we'll get into Hill's later, but an outstanding performance in a flat category. And ultimately we'll see that category hopefully inflect positive as we move through 2025, but volume will come across the board. Asia will continue to be a good volume contributor. Africa has been a great volume contributor and no question Latin America as well as North America. So it's going to be pretty broad-based across the board. If you look if you take a step back for a moment and look at our volume shares and again a testament to our focus on brand penetration, our volume shares continue to inflect very positively across most of the regions. So we feel very good about our ability to continue to drive penetration through some of the initiatives that we have. And largely that's driven by the underlying health of the brand, which are in a much better place than they were five years ago, given the support that we're putting behind the business."
},
{
"speaker": "Operator",
"content": "The next question comes from Kaumil Gajrawala with Jefferies. Please go ahead."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Hey, everyone. Good morning. Noel, you mentioned, you will talk about Hill's later, maybe we talk about it a bit now. If you could just talk a bit about the what's going on with volumes, particularly in Europe, is this something cyclical? Is there anything else changing? Just any more details would be useful. And then on RGM 2.0, perhaps just a little bit more on what that means, what you're able to do now versus what you were doing with RGM before? I think those would be helpful. Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yes, great. And good morning to you Kaumil. So again Hill's continues to really execute against the strategy that we outlined three or four years ago. So obviously the volume was impacted by the impact of private label. So about a 200 basis points impact from the drag on private label. So overall a 3% volume growth on that business in a roughly flat category right now, we think is very, very strong. I'll start off with market shares on Hill's consistently one of the fastest growing brands in pet specialty. We continue to see strong share growth across other channels, great e-commerce growth, back to growth on prescription diet, which had been a drag on the business historically and that bodes well for mix and margin. So overall, the business is in a very, very good place and the fundamentals in terms of how we're executing against some of our strategies. We talked about the segment opportunities that we see in small pet. We talked about the segment growth opportunities we've seen in cat as well as wet. We feel we're right on pace with where we expected to be and see more opportunities to continue to execute those volume opportunities as we move forward. And those are more higher ASP opportunities, which will translate through the P&L as well. The supply chain is in a much better shape as well. We've talked about making sure that we really optimize our network and we're doing exactly that. The Tonganoxie ramp up, which will be our most automated facility in the world continues to go as expected. So, overall, we're in a -- we feel like we're in a good place. The category was a little soft in Europe. We don't think it's anything unusual to be too worried about, but obviously we're very focused on make sure that we go after those under index growth segments where we're not getting our fair share, where we now have strategies in place and innovation in place to actually capture that growth and that will help us offset. So within the context of the overall category, we are outperforming most of our competitors and we feel very good about where the business is going and the trajectory of that as we move into 2025."
},
{
"speaker": "Stanley Sutula",
"content": "So let me pick up on the second part of the question around RGM 2.0 and you've heard us talk over the last few years about investing in capabilities. That's really what comes home to 2.0 and things like analytics and digital and data. We leverage those skills and those new capabilities to come into design our pricing strategy and market by product, our promotion strategy and timing. And we've seen some really great returns and customer feedback around those. So it's really taking an already talented workforce here enabling them with new capabilities and new skills that allows us to be more effective. When you combine that with innovation that we bring to market, it's pretty powerful end market. So we're comfortable that RGM is going to continue to contribute both to margin and to top line."
},
{
"speaker": "Operator",
"content": "The next question comes from Kevin Grundy with BNP. Please go ahead."
},
{
"speaker": "Kevin Grundy",
"content": "Great. Thanks. Good morning, everyone."
},
{
"speaker": "Noel Wallace",
"content": "Good morning, Kevin."
},
{
"speaker": "Kevin Grundy",
"content": "Noel, I was hoping to comment. Good morning, Joel. On advertising levels broadly. So you guys have done an outstanding job here over the past couple of years of increasing A&M levels. Of course, that's been funded by gross margin increases. But now with the things slowing down a bit, the expectation is that advertising and marketing levels are going to be relatively flattish year-over-year, right? So said differently maintained as a percent of sales. So how will you potentially weighing as you're putting the plan together, further increasing A&M levels as a percent of sales to the extent you could accelerate top line growth, further gain market share relative to margin and earnings growth expectations, just because the returns you've been getting in recent years have been so strong and further increasing. So broad context, I think on that front would be helpful. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, great, Kevin. I think the top line comment here is that we are very focused with a lot of our tech platforms and the work that we're doing around programmatic media personalization through data to really optimize and continue to find ways to be more precise with our spending that we've obviously gotten in a much better place than we were years back as you mentioned up 9% this quarter on top of 80% in the year ago. So we're in a much, much healthier place. And if you take all of the metrics that we use to assess brand health, which ultimately is the most important proxy and whether your advertising is working or not. And we continue to see very strong inflections on the strength of our brands around the world. We do have unique opportunities in certain parts of the world to continue to improve that, but in general a much better place than we've been. We're being far more deliberate with our advertising spend. And what I mean by that is more choiceful on the opportunities that we see in terms of driving category growth and growth for the Colgate franchise. And so we've been, I think, quite successful in earmarking money to certain parts of the world and in certain categories where we're seeing a much better ROI. I can't get into a lot of specifics, but you heard us back talk over the last couple of years on how we're using data analytics and our digital transformation has really unlocked a lot more efficiency in our spend and our ROIs have continued to improve sequentially. So as we move into 2025, it's really about continuing to make sure we're optimizing the growth and the spending that we've had and be more precise and tactical with how we think about using that money or more strategic on how we use that money across the board. So it will be efficiency, technology and making sure we find ways to optimize that spend in the areas where we're going to get the best return on investment."
},
{
"speaker": "Operator",
"content": "The next question comes from Bryan Spillane with Bank of America. Please go ahead."
},
{
"speaker": "Bryan Spillane",
"content": "Hi. Thanks, operator. Good morning, everyone. So just, I guess, we'd like to get your perspective on two quick things. One, Noel, just trying to put the 3% to 5% organic sales growth forecast for '25 in the context. Is this where does that stand relative to kind of where category growth is as we're exiting 4Q. So one just kind of your growth rate expectations relative to the category geographies? And then the second, just since because it's topical within the headline tariffs, I think in the prepared remarks you talked a bit about evaluating once you know but as we're thinking about tariffs, just because we're all going to try to put some probabilities on it and run some things through our model, just some basics that we should be paying attention to as we're thinking about this topic, just relative how size it could be, I don't know. Anything you could give us as an input would be helpful. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, good morning, Bryan. Great, I'll take the first part of the question and I'll let Stan talk about a lot of the great strategic work that we've been doing over the last couple of years to truly optimize our supply chain for more resilience and potential disruption. So if I take the category growth rates right now, we've seen I think the good news is we've seen more of a stabilization. We saw some falloff in the categories as we move through. I think the additive impacts of inflationary pricing over the last year and a half, but we've seen a more stabilization of the categories and which is good news. So categories in general, the categories in which we compete are growing 2% to 4%. So relative to our organic algorithm of 3% to 5%, we will be outpacing the categories and hopefully continuing to drive brand penetration and share growth. So I think the overarching comment is we've seen some stabilization in the categories based on some of the falloffs that we had seen in the third quarter and into the early part of the fourth quarter. And we have, we believe the right innovation, the right pricing and mechanisms in place to continue to outpace the categories."
},
{
"speaker": "Stanley Sutula",
"content": "Good morning, Bryan. On tariffs, as we said in the commentary, we've not included any potential incremental tariffs in our '25 guidance, but we've tried to put the tariffs in context of our long-term supply chain strategy. So primarily we aim to have local manufacturing as a cost of shipping some of our products across long distances can be material. We spent the last few years building much more flexibility into our global supply chain, not necessarily about building more capacity, but rather making better use of the existing capacity and alternative sourcing as well as standardizing formulas across the markets. So importantly, we've invested meaningfully in our US supply chain, almost $2 billion over the last five years between investment in our Oral, Personal, Home Care business, along with the purchase of pet food capacity, the opening of our Tonganoxie wet pet food facility. We've increased the number of our US based manufacturing facilities by more than 40% over that time. So material investment into US capabilities. And let me give an example of some of our improved flexibility. While we had available machine manual toothbrush capacity outside of China in '21, we were limited in which SKUs we could actually produce in which plants. We can now produce more SKUs at more plants. So we have the same amount of capacity, but we can meet more customer and consumer needs from more geographic locations. And this philosophy gives us better flexibility as we enter a period with potentially higher tariffs. And we also have additional co-man capacity to provide flexibility. Now we do produce some of our products for the US in Mexico, primarily toothpaste, and we're working on potential mitigation plans, which can impact both raw materials and finished products. On raw materials, we import a limited amount of raw materials, predominantly specialty type ingredients like vitamins and amino acids. And as you would expect, we're planning for multiple scenarios, because it's not just the tariff that may be on Mexico or Canada or China, it's the impact of retaliatory tariffs that would also come into play on those supply chain. So we're looking at very tactical short-term, mid-term and long-term if necessary actions. But until we get more clarity, we have not included anything in our guidance."
},
{
"speaker": "Operator",
"content": "The next question comes from Olivia Tong with Raymond James. Please go ahead."
},
{
"speaker": "Olivia Tong",
"content": "Great. Thanks. Good morning. I want to talk through what you expect to be the volume implications of the pricing you're planning to take given the decel in volume in Q4. If you could talk to order of magnitude on the LatAm pricing, whether you've already implemented this. And if you're planning to price in other regions or whether the competitive or macro dynamics make that more difficult to push through. And then just you talked about advertising and being up -- being flat to up. What about promotion and your ability, if necessary, to pivot between advertising and promotion? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning, Olivia. Thank you. So let me take the latter part of the question first. The promotional spending has been, I think, quite constructive. We have seen some pockets of increased competitive activity. India was one where we saw heightened competition in spending in the fourth quarter. You probably saw that in the press release from the India results. We've seen some heightened competitive activity in South Africa as well. But more or less pretty constant across the quarter. US continues to be quite constructive, no significant changes there. So on balance, I would say the promotional environment continues to be as we would have expected, with some isolated pockets of increased activity, which we addressed in our statements earlier. So overall we feel we're in a pretty good place. But my expectation is you continue to move from a pricing to a volume environment, you may see more promotion. But we plan for that in our guidance and plan for that in our plans for 2025. Relative to Latin American pricing, as I mentioned, we've announced some pricing already in Latin America relative to some of the foreign exchange headwinds and we'll continue to watch that very carefully. We did not anticipate another significant devaluation in Argentina this year in our guidance or in our numbers. That may or may not happen. We will adjust that accordingly. I think it's worth saying that despite the significant foreign exchange headwinds we saw in Argentina, we did grow dollar earnings in Argentina, which I think is a great proxy to our ability to offset some of the transactional impact that we see as we move through foreign exchange. As I mentioned earlier, Europe is a little bit more challenging to do that. So we pivoted from price increases to really driving meaningful innovation that can drive value in the categories and ultimately drive some accretion on the margin line and the pricing line. And we'll continue to adopt that strategy overall."
},
{
"speaker": "Operator",
"content": "The next question comes from Sergio Matsumoto with TD Cowen. Please go ahead."
},
{
"speaker": "Sergio Matsumoto",
"content": "Hi. Good morning. It's Sergio Matsumoto. I'm with Rob Moskow's team. Noel and Stan, in Latin America, how does the current macroeconomic headwinds like inflation is impacting the demand of the category? And with the new administration in the US, how does that change your operations in the local countries in terms of any pricing changes that you might make or innovation?"
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning, Sergio, thanks for the question. So as you well know, we've been in Latin America for 75 plus years. In fact, I'll be going down to Mexico in June to celebrate our 100 year anniversary in Mexico, which is a great milestone for us and for the Mexican company, which has been one of our most successful businesses in the world given our long-standing presence in those markets. Overall, we have dealt with a significant amount of volatility in Latin America over the last couple of decades. And so we're accustomed to obviously both political and economic disruptions and our ability to offset that with meaningful innovation and execution against the fundamentals that will ultimately drive category growth and our business. We've seen that consistently throughout this year as well. Latin America performance continues to be very, very strong. It slowed a little bit in the fourth quarter, but that was more due to some of the pricing that I mentioned earlier that was in the year-ago number in Argentina were through the first three quarters that we didn't necessarily have in the fourth quarter this year. But if I take our two biggest markets and characterize those perhaps in terms of categories and how we're doing, Mexico and Brazil, we had good quarters for both of those businesses. I'll start with market shares. Market shares are absolutely terrific in both of those markets. Volume and value shares are up. Overall, in Latin America, we had 8 of 10 countries up or flat in market share. Nine or 10 of those markets are up or flat in volume. So overall, the underlying health of the business continues to be very strong, and we're outpacing the categories in terms of our consumption. So from the perspective of categories, we saw a little slowdown, as we talked about in the third quarter around Mexico. But that business seems to have stabilized and we've seen better consumption as we've entered 2025. So overall, we think we're in a good place, but we're not immune to, obviously, the continued volatility around foreign exchange and the movements in terms of statements that are made with various countries. So we'll continue to execute against what we can control and that's the fundamentals of the business and making sure that we have flexibility through the P&L."
},
{
"speaker": "Operator",
"content": "The next question comes from Christopher Carey with Wells Fargo. Please go ahead."
},
{
"speaker": "Christopher Carey",
"content": "Hi. Good morning, everyone. You had mentioned some competitive activity in different markets globally, China joint venture, India, Africa, Eurasia. You didn't mention North America, but there's been some pricing investments. Can you expand a bit more on some of the end-market competitive activity you're seeing with some specificity on specific markets that you called out? Thanks so much."
},
{
"speaker": "Noel Wallace",
"content": "Sure. Good morning, Chris. It's not unusual in terms of the heightened competitive activity as some of the manufacturers, particularly local players, are chasing more volume in their categories. We've been very selective on where we're going to address that, and we'll be sure to make sure we protect the health of the brands as we do that. But it was very isolated to a few markets around the world. India was probably the most notable with a significant increase in competitive activity in the urban space particularly in the modern trade where we saw a multitude of competitors discounting more to drive volume. We addressed some of that, which was reflected in the quarter. But we anticipate India will stabilize and get more rational as we move through the balance of the year. We've got good innovation plans and good focus on really driving some retail strategies that we think will allow us to offset some of that competitive activity and continue to drive share market and drive category growth. Turkey and South Africa were more isolated to some competitive activity there. We don't necessarily see that sustaining itself through the year, but we're well prepared as we mentioned in the guidance to address that if we need to. So overall, there's nothing terribly unusual. As I mentioned earlier, where we see a more constructive promotional environment, Europe would be an area where you might see heightened competitive activity, but we're seeing that be pretty consistent and we're growing significant market share in Europe as well. So we feel we're in a good place. Again, if you see more competitive promotion activity, the most important aspect for us is the underlying health of the business in a place we can continue to launch innovation to drive value and drive market share growth both in volume and in dollars and we're consistently seeing that, particularly in our Oral Care business around the world."
},
{
"speaker": "Operator",
"content": "The next question comes from Steve Powers with Deutsche Bank. Please go ahead."
},
{
"speaker": "Stephen Powers",
"content": "Hi. Great. Good morning, everybody. I guess I wanted to ask about just the base case shape of the P&L in 2025. It's great to see the call for another year of gross margin improvement and at least stable A&P investment. But I guess I'm curious as to how much of the expected underlying operating income improvement is going to be driven by that gross margin versus SG&A reductions and SG&A efficiencies. And then within that sort of what I'm assuming is increased focus on SG&A. Do you think you're going to have enough flex to keep up other elements of investment? You talked about innovation investment, but digital, data analytics, talked about AI. Those have all been, I think, fruitful pockets of investment the last couple of years. Can you keep that up in 2025? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Hi. Good morning, Steve. Thanks. So again, I think the top line comment here is yes. While we've front-loaded a lot of that investment in '23 and '24, so we feel we're in a really good place, not necessarily having to play catch-up, there's going to continue -- we're going to continue to raise the bar and ensure we find ways to invest for the long-term health of the business, particularly around capabilities. And we have some exciting things underway in the data space, in the technology space as well that will continue to, we believe, drive more productivity through the P&L. But Steve, I come back to what we've been talking about and what was anchored in our 2025 strategy when we launched it six years ago. And that was ultimately getting all line items in the P&L in a place to give us more flexibility. And we're going to continue to really focus on doing that. There will be ebbs and flows in certain areas of the business that we have to address, but we need to have flexibility to go after the growth and fund that through various line items in the P&L. So from a capital structure in terms of where we put money, from a capability standpoint. It's really meant to go up and down the P&L as well as the balance sheet to ensure we have ways to continue to drive top-tier shareholder value. And we're going to do that with the consistency of performance and the health of the brands is an underpinning to that. So overall, we feel pretty good about where we are across the P&L. There will be some ebbs and flows as we move through the year. The year is an artificial construct as we say, we will continue to go after the opportunities as we see them. But in the absence of not having flexibility, that becomes very, very difficult to do. And we've shown, I think, over the last couple of years that having ways to flex certain aspects of the P&L and the balance sheet is the best way to drive long-term sustained growth."
},
{
"speaker": "Stanley Sutula",
"content": "The only thing I'd add there is, as we look at the entire P&L and the balance sheet, while we drive productivity, it's not just a cut for cut's sake. We actually spent a lot of time in our budgeting process on resource allocation, both dollars and people, and where do we want to reallocate to drive performance in the business. And that hits every line of the P&L. And then our balance sheet as we drive better payment terms, better net working capital efficiency, it gives us the ability to reduce debt, invest back in the business, which when you look at that holistically is the flex that we've talked about in managing this day-to-day. But we're confident in our ability to deliver on our guidance for '25."
},
{
"speaker": "Noel Wallace",
"content": "And I think the best proxy for that, at least that I shout a lot from here in New York is our return on invested capital. And that's really ensuring that we're using shareholder money in ways to drive the best return and to have the ROIC back in the 35%, 36%, I think, is a good example of us being very selective, as Stan says, to drive spending where we're going to get the best return on that investment."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Lieberman with Barclays. Please go ahead."
},
{
"speaker": "Lauren Lieberman",
"content": "Great. Thanks. Good morning. Noel, since you referenced 2025 strategy, we're starting 2025. So I was curious if you could talk a little bit about, I guess, thoughts on the next leg? Will you be announcing a kind of 2030 strategy? And maybe what are some of the areas that you think you would add to that list? What are areas where you still have opportunities to keep pushing on the things that have really been working? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Great. Good morning, Lauren. Thank you. I'm smiling here because we're on the eve of announcing our 2030 strategy that we'll be going through the organization with here in the next couple of months. We've been working tirelessly over the last year to really fine-tune that. We've taken the Board through that. And so we're quite excited. I mean, I think overall, the discipline around strategic planning in the company and I give the team tremendous credit for the work around that, has been excellent, and making sure that we continue to remind ourselves on the opportunity spaces that we have and the potential for continued growth to be sure that we're investing ahead of the curve in order to get there. And so that's exactly what we'll do as we unveil the 2030 strategy. Now there's always a temptation to throw out what you've had and put something new. I think the line that I would leave you with is consistency is really important to us. Execution and focus is really important to us. And the things that we've outlined as we launched our 2025 strategy about the growth mindset, about better innovation, about productivity up and down the P&L, about continued gross margin expansion, about investing in the health of our brands and optimizing our spending efficiency, all of that will be consistent as we move into the 2030 plan. There are areas that we think we can continue to dial up and sharpen. Innovation will be one of those, making sure that we continue to deliver the great incrementality that we're getting through the innovation. You heard me talk about the 45% more incremental sales coming from new products than we had historically. That's a big, big driver. You've heard me talk about in previous meetings that we've reoriented our incentive systems to get more after incremental innovation. So it's not just launching innovation for the sake of launching innovation, it's making sure it's driving incrementality to the category and to Colgate. So innovation will continue to be a big focus. Data and AI, we're excited about all the investments that we've made, both in training our organization, but really on the business use cases where we see the most -- best ways to optimize growth and efficiency through the P&L. That will be an interesting focus for us as well. And ultimately, as you look at the health orientation of our products, we will continue to rely heavily on our professional orientation and our ability to drive premiumization and loyalty behind strong endorsements and advocacy of our brands."
},
{
"speaker": "Operator",
"content": "The next question comes from Robert Ottenstein with Evercore ISI. Please go ahead."
},
{
"speaker": "Robert Ottenstein",
"content": "Great. Thank you very much. First, just a quick follow-up. You called out in your prepared remarks increased price competition in China. So I was wondering if you could elaborate on that. And then my main question is on the Total relaunch. I'm wondering if, first, you can kind of size that compared to other relaunches, just so we have a sense of magnitude in importance. How are you defining success on the relaunch? Maybe some early reads in Latin America? And also perhaps what you may be doing differently on the marketing side to make it successful? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning, Rob. Thank you. Let me just clarify. We didn't -- I don't believe we mentioned anything about increased competitive pricing in China specifically. We talked about obviously some softness perhaps on our Darlie business, which I'll address in just a moment. But the increase in heightened pricing is really in Asia was specifically related to India. And that's where we've seen most of the aggressive pricing. Overall, China, I would say, on balance, that the pricing environment is pretty stable. And our performance there is, quite frankly, quite good. We delivered positive organic growth in the quarter and that is with the Colgate business because it continues to operate extremely well. The Colgate business alone was up high-single-digit organic in China in the fourth quarter. And as you see that in comparison to a lot of our peer group, we feel we're executing extremely well with the new strategy that we've put in place three years ago. Now the Darlie business continues to be a challenge, although it's -- we feel we're getting better. We still have opportunities for some go-to-market changes in 2025. And we'll address that accordingly. But overall, we feel China will continue to be a slow growth, although we seem to be outpacing the category and our competition in many respects. But China continues to be difficult in the short to medium-term. But long-term, again, we value China and India as strategic growth opportunities for the company. China will put more or less $300 million of incremental middle-class consumers into the market by 2030. India will more than double that, probably $600 million to $700 million. So again, real long-term growth opportunities, so important to keep the health of the business and the investment profile in a place that we can obviously leverage that as we move forward. Total launch specifically on Total, Rob. We launched it in the fourth quarter in Latin America and we're in the midst of rolling that around the world. Latin America would be our best proxy. It is driving terrific share growth for Latin America. We've seen great performance across our core markets from the Latin America launch. We're rolling that out across Asia and North America and Europe as we speak. It is a meaningful upgrade in our formula, again, intended to really speak to prevention and the importance of prevention, which is obviously a key trend in the marketplace amongst consumers and looking for superior prevention in what they're asking for in a toothpaste. And we really elevated the focus on the science aspects of Colgate Total and getting a better formula into the market than we've had before across not only the toothpaste, but the toothbrush and the mouthwash, and creating real opportunities for category growth and regimen claims. So overall, we're very excited about the early signs that we're seeing in Latin America and intend to overly translate that across the world."
},
{
"speaker": "Operator",
"content": "The next question comes from Korinne Wolfmeyer with Piper Sandler. Please go ahead."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Hey, good morning. Thanks for taking the question. I'd like to just get a little bit more color on the pet nutrition business for 2025 and kind of like the cadence over the next four quarters that we should expect both from the portfolio rationalization, innovation, pricing, et cetera? Any color on that would be helpful. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning. Again, the Hill's, as I mentioned earlier, the fundamentals of the business are really, really strong. Now we've seen, obviously, we've talked about a little bit of slowdown in the category, but that's stabilized, certainly not getting any worse. And we continue to execute extremely well in that category environment with market shares continuing to grow volume ex-private label up nicely, and we'll continue to see that, we believe, trajectory as we move through the balance of 2025. I'll let Stan talk a little bit about the private label impact as we think about 2025. But if I take just the underlying business, again, very focused on segment growth opportunities for the business, I mentioned. We obviously have a very strong dog and cat business that we need to excel in small paws or the small dog segment, which is the fastest-growing part of the market. We need to excel in the wet segments. We have a real focus on that. And we obviously need to get back to more sustained growth in Europe. But overall, the business continues to perform well. We operate a portfolio in a diverse mix of countries around the world. We have the ability to pull on those markets. I think our largest market, North America, continues to execute extremely well, had a good quarter in the fourth quarter. And we expect nothing unusual from the Hill's business as we move into 2025."
},
{
"speaker": "Stanley Sutula",
"content": "Look, I think the Hill's business is really well positioned, and it's based on really good execution by the team. They have done really well in a flattish category that we think will slowly improve through time. But the new innovation that they have coming to market, the wind-down of private label and the improved expansion, we think both will drive top line, but also, importantly, will drive margin expansion for that business. And I think they're in a nice position where they have enormous opportunities in numerous areas to go after to continue to expand. And I was just down at the VMX conference, which is the veterinary conference, with the North America team and extraordinarily well received down there with nearly 30,000 vet and vet techs attending that conference. And the Hill's booth was very well attended with great innovation and explaining the value that we bring. We've also invested over the last several years into our pet nutrition center and the science behind our diets, which I think will continue to bring that innovation to market. So I think Hill's is really well positioned heading into '25. We've got market expansion opportunities both in the US and abroad and a science-based profession driven product set."
},
{
"speaker": "Noel Wallace",
"content": "Yes. And if I can just add one more point is that we're seeing the margin inflection there. So you had talked to us a lot over the past couple of years about margin performance at Hill's. And what we've seen now is that margin has truly begun to inflect positively. And that's not just the private label mix. That's really on the underlying business. It's some of the mix improvements that Noel had talked about in terms of prescription diet, wet, et cetera. So as Stan mentioned, from a bottom line standpoint, the inflection is there and it really gives us the confidence that we can continue to invest back in this business."
},
{
"speaker": "Operator",
"content": "The next question comes from Mark Astrachan with Stifel. Please go ahead."
},
{
"speaker": "Mark Astrachan",
"content": "Thanks and good morning everybody. I wanted to stay on the Hill's business for a minute. Broadly, it seems like there's been a bit more volatility in the pet food category than I think maybe people would have anticipated. Years ago, you talked a little bit about volatility. In this quarter, we saw a little bit of that kind of coming out as we lapped COVID comparisons, but whether it's pet adoption or the decreased usage of pet food periodically, which doesn't seem to make a ton of sense. I guess could you just opine a bit on what you think is adding to the category volatility? Is it all pricing that's been taken? And just more of a broader comment I guess specific to the US, maybe you could also just elaborate on how you think about the performance of the Hill's business by geography, if you don't want to give specifics, just broader strokes between US and international. And then just talk a bit about the competitive environment. There's clearly been some at least smaller kind of niche year categories becoming more mainstream. And how do you think about the adoption of that and the impact on your business over time? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Good morning, Mark. Thank you. So I think the importance here is staying in our swim lanes on this one. We see the fastest growing part of the category continued to be science based premium pet nutrition, and we're outpacing the category in that regard and helping to drive significantly more value into our retail partners. So the innovation that Stan talked about will continue to be focused on scientific, therapeutic variance and innovation that continue to drive a differentiation and real value orientation back to the pet owner moving forward. Yes, there's been some stabilization in the category. The category is flat. We mentioned that we're growing. We still see, as we look at it, yes, we'd like to see that start to inflect positive, which we expect will probably come towards the back half of 2025. But the segments that where we want to grow continue to afford significant upside potential for our business and our ability to continue to drive volume and price and profitability through the P&L. And I've talked about those segments. So we're very focused on that aspect. A lot of noise in the category, a lot of different things happening in the category. But strategically, the growth spaces and the swim lane, so to speak, where we want to compete, we continue to see nice growth opportunities for the business and sustain profitability as we've improved, as Stan and John mentioned, the underlying fundamentals in the P&L are in a much better shape than they were years back."
},
{
"speaker": "Operator",
"content": "The last question today comes from Filippo Falorni with Citi. Please go ahead."
},
{
"speaker": "Filippo Falorni",
"content": "Hi, good morning everyone. Noel, you talked about building flexibility not only on the P&L but also on the balance sheet. So just curious on capital allocation and increased appetite potentially for share buybacks considering the share level. And then on M&A, big picture, can you remind us kind of your strategic areas of focus and parameters for M&A? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks, Filippo. So again, our prioritization around capital allocation is investing back behind the business to drive efficiency and growth. And again, I'll come back to the return on invested capital, we're seeing a great return as we invest back in the business and our ability to drive more top line growth and more savings through the P&L. Second, the share repurchases and dividends. You've seen the strong numbers. I'll let Stan maybe talk to that in just a moment. But what you've seen, obviously, our focus on driving top Tier TSR, not only through the growth of the earnings, but our ability to continue to find ways to reward our shareholders through our dividend policy, et cetera. So overall, we'll continue to focus on strong working capital cash generation to allow us to buy shares where appropriate and to continue to invest in our dividend based on Board approval. But overall, we feel like we're in a much better place to make sure we're providing different levers to drive shareholder return on a consistent basis."
},
{
"speaker": "Stanley Sutula",
"content": "When we go through our annual budgets and our execution, we have a theme that underlies all that, and that's growth, margin and cash. So cash is a fundamental part of how we run each of the businesses. And you've seen that drive in cash flow achieving $4.1 billion in operating cash flow, a record for us. But that gives us the ability to allocate those resources. And as we look at that, that stayed the same, as Noel said, which is invest back in the business. That can come in multiple forms. Return to shareholders, and then M&A, where we see the right opportunity that's aligned to our strategic direction because that helps give us a north star for where we want to invest and maybe what parts of the portfolio that might be better off somewhere else to drive long-term value for us. And you saw this year that we actually did increase our share buybacks. We did $1.1 billion net and return to shareholders was up over 20% year-to-year. And we have a long-standing dividend that we believe is competitive. And when we think about capital allocation, it starts with delivering the cash to enable that. And we're pretty comfortable with where we are. Proud of the team for a great ROIC and the ability to drive that into '25."
},
{
"speaker": "Operator",
"content": "The last question today comes from Edward Lewis with Redburn Atlantic. Please go ahead."
},
{
"speaker": "Edward Lewis",
"content": "Yes. Thanks very much. Just looking at the European performance with the balance of 2024. And I thought it was notable to see you delivering both positive volume and positive price. I appreciate the move of skin into North America probably helps a bit there. But still, I thought that's quite a change from what we were accustomed to see. I know you don't necessarily split out where the marketing spend is going, but how much of the incremental marketing support has gone into Europe? And how much then does that give you the confidence to be able to sustain these accelerated growth trends as we go forward?"
},
{
"speaker": "Noel Wallace",
"content": "Yes. Good morning, Ed. Thank you. Listen, I'm glad we're finishing up with Europe, because what a terrific performance they had in 2024 and another strong fourth quarter coming off of a strong year-to-date before that. Organic growth across all hubs for the quarter. Yes, we've seen some of the inflationary pricing we see, but we are getting pricing, as you mentioned, balanced pricing and volume growth in the quarter. I think a testament again to the real focus on our RGM analytics and how we're maximizing our promotional spend in those markets. Likewise, a really strong innovation, pipeline of products in '24, and you'll see that again in 2025 and our ability to drive more value oriented back into the categories, more price orientation. So that drives our price and the category at the same time. Good operating profit and margin performance is critical to sustain the advertising. Our advertising to sales was up about 220 basis points. So again, driving a lot of the brand health measures that we have. And I think what's most pleasing is the record market share performance we saw in Europe, particularly behind our Oral Care business, both on Colgate and Elmex. We're now up 300 basis points in market share versus where we were in 2016. And the shares as we exited the fourth quarter were at a record high particularly in some of our key geographies. So we feel very good about our ability to continue to drive organic growth in that market and drive operating profit growth given the health of the business. And that will be driven by innovation and a sustained level of advertising across multiple categories in Europe."
},
{
"speaker": "Noel Wallace",
"content": "So with that, thank you very much for your questions again. Let me end where I started, which is a profound thank you to the Colgate team. Surpassing $20 billion in sales for the first time in our 217 year history is an important milestone for the company. The continued health of the business and the continued improvements we've seen up and down the P&L and in our balance sheet is a real testament to the incredible organization of people that we have working day in and day out in an extremely volatile world out there. So I thank them. And I look forward to seeing everyone down in Florida, CAGNY."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's call. You may now disconnect."
}
] |
cl | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to today’s Colgate-Palmolive 2024 Third Quarter Earnings Conference Call. This call is being recorded and is being simulcast live at www.colgatepalmolive.com. Now for opening remarks, I’d like to turn this call over to Chief Investor Relations Officer and Senior Vice President, M&A, John Faucher."
},
{
"speaker": "John Faucher",
"content": "Thanks, Betsy. Good morning, and welcome to our third quarter 2024 earnings release conference call. This is John Faucher. Today’s conference call will include forward-looking statements. Actual results could differ materially from these statements. Please refer to the third quarter 2024 earnings press release and related prepared materials, and our most recent filings with the SEC, including our 2023 annual report on Form 10-K, and subsequent SEC filings, all available on Colgate’s website, for a discussion of the factors that could cause actual results to differ materially from these statements. This conference call will also include a discussion of non-GAAP financial measures, including those identified in Tables 4, 6, 7, 8 and 9 of the earnings press release. A full reconciliation to the corresponding GAAP financial measures is included in the third quarter 2024 earnings press release and is available on Colgate’s website. Joining me on the call this morning are Noel Wallace, Chairman, President and Chief Executive Officer; and Stan Sutula, Chief Financial Officer. Noel will provide you with some thoughts on our results and our 2024 outlook. We will then open it up for Q&A. Noel?"
},
{
"speaker": "Noel Wallace",
"content": "Thanks, John, and good morning, everyone, and thanks again for joining us, as we report another strong quarter of top line and bottom line performance. Our strategy of delivering more impactful core and premium innovation, increasing our advertising spending and scaling capabilities to drive improved brand health and higher household penetration is paying-off through strong volume-led organic sales growth. You're seeing this best represented in the fact that we have delivered volume growth in all six divisions for the second straight quarter with 3% growth in developed markets and 4.6% growth in emerging markets. It won't be every division every quarter, but we believe our geographic breadth and category mix will enable us to better weather volatility over time, whether that's from economic, geopolitical or other factors and deliver organic sales growth in line with our long-term targets despite difficult comparisons. This will be well considered in our plans and it's why we've been talking about building our business model to deliver sustained, profitable growth even as category growth decelerates as pricing growth recedes. Our commitment to reestablishing our gross margin is paying-off in gross profit dollar growth even as we lap more difficult comparisons. We have used this gross margin expansion to continue funding the investment in advertising and capabilities, enabling us to deliver best-in-class volume growth, which is driving strong organic sales growth. And we believe the flexibility we have built into our P&L gives us the ability to turn that organic sales growth into consistent compounding earnings per share growth to deliver top tier TSR over the long-term. And with that, I'll open it up for questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Dara Mohsenian with Morgan Stanley. Please go ahead."
},
{
"speaker": "Dara Mohsenian",
"content": "Hey, good morning."
},
{
"speaker": "Noel Wallace",
"content": "Good morning, Dara."
},
{
"speaker": "Dara Mohsenian",
"content": "So I just wanted to drill down into North America. NA pricing was down significantly for the second quarter in a row, you’d warned us about that last quarter. But just take a step back and help us understand the competitive environment you're facing and what your strategy is from a pricing standpoint? And how much volume payback you think you're getting, given a muted result in the quarter, albeit with some timing caveats? And just how that business is set up going forward as we look forward to 2025 and beyond? And hopefully, this isn't cheating, but I wanted to slip in a second question on Pet, which is mostly North America actually. But the Hill's performance is really striking relative to industry trends. Can you just talk about the sustainability of low-single digit Pet pricing going forward, given that difficult industry pricing environment and the market share gains with your volume performance, again, in light of that difficult industry environment? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Good morning, Dara. Thank you. So North America, structurally, we came in exactly where we more or less expected, a little soft on the volume, which I'll explain in just a moment. But what we're seeing is as category growth decelerates a little bit as expected and what we talked about in the second quarter. Volumes returning, but not necessarily as fast as we would like, but I think there's more normalization on the volume line. We expect that to continue to inch up moving forward. Pricing was in line with Q2, as you mentioned, and as we talked about in the second quarter with similar adjustments that we expect to continue as we move through the balance of this year into the first quarter. I talked about volume being a little bit softer than it was expected. This was, as we mentioned in the prepared remarks, due to shipment timing on a couple of orders. We had the benefit of some promo moves from the third quarter, which we'll see a little bit more in the fourth quarter. And as you've noted that we've -- with the skin health business now in the North America, we obviously had the impact of lower skin health volumes, principally driven by China and a little bit of reduction due to some e-commerce business that didn't come through in the quarter. But overall, more or less where we expected. The team is very focused on obviously setting ourselves up for a really strong '25, a strong innovation growth plan that we have in place. And we'll see, obviously, the volume start to inch back as we've seen the category start to normalize more. But overall, the good news is, we've been able to weather some of the softness in North America with really strong broad-based growth across the business. You talked about Hill's coming in exceptionally strong. It was a strong performance for Hill's in the quarter. Strong volume, which was really encouraging given the impact of lower private label. So you take the private label up, we were up mid-single digits on volume and a really strong margin performance on the business. And we've been consistent with what we've articulated in the past, which is that we want to continue to reinvest that margin into driving category growth, and that's exactly what we're doing. A little bit of pricing that came through in the quarter. And we think we've got the ability as ag prices move around to take some pricing given the strength, again, of the brand in the market. We're gaining market share. We're the fastest-growing brand, global brand in pet specialty and neighborhood pet stores. So we feel good about where we are. We're continuing to expand that business into segments that we weren't aggressively competing in below, specifically wet. So overall, we feel very good about where the Hill's business is, and our ability to continue to drive strong, sustained growth behind strong advertising levels."
},
{
"speaker": "Operator",
"content": "The next question comes from Filippo Falorni with Citi. Please go ahead."
},
{
"speaker": "Filippo Falorni",
"content": "Hey. Good morning, everyone. So Noel, I wanted to ask you some initial perspective as you start thinking about next year. I know you're not going to give guidance today, but you mentioned you feel confident in your ability to be in the long-term algorithm on a multiyear basis. So as you think about cycling those tough comparisons, what are the areas of the business that you expect could accelerate? Is it more innovation -- contribution from innovation and be better volume in developed markets, or maybe the pet food business? Just any perspective on how you're thinking about cycling those comps and areas of the business that could accelerate? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks, Filippo for the question. We've been talking for, I think, the better part of three years now on how important it is to invest in the long-term capabilities that we think are going to be essential to drive sustained growth. And I really attribute that -- ability to do that to the flexibility that we've built into the P&L. So what we're focused on right now is elevating and accelerating innovation, particularly H2 and H3. We think we have a continued very strong new product grid moving into '25 and '26. We've built gross margin flexibility into the P&L that allows us to invest back behind the business, that advertising level, we will continue to do that. That's the way you improve brand health and drive long-term sustainable share growth. You've seen the share growth really inflect over the last couple of years, as you’ve seen global shares, particularly in toothpaste and toothbrushes continue to move upwards. That's a reflection of the innovation and the sustained growth that we have -- the sustained advertising growth that we have in the P&L. So a lot of the same, Filippo, continuing to invest back behind the business, drive household penetration where we're getting much better with the analytical work that we're doing to understand where those growth opportunities are, building per capita consumption in those markets where we see real opportunities, driving our brand through advocacy. So all the things that we've been talking about, clearly will play out in '25 and into '26."
},
{
"speaker": "Operator",
"content": "The next question comes from Robert Moskow with TD Cowen. Please go ahead."
},
{
"speaker": "Robert Moskow",
"content": "Hi. Thank you. I want to know about Europe. Obviously, a very strong quarter, and a lot of your peers have been delivering strong results in Europe as well. But one of your peers said not to expect this on an ongoing basis. So I wanted to know if -- what's driving it? What were your market shares like, in Europe during the quarter and what do you expect going forward?"
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks, Robert. Again, a great quarter for Europe. My congratulations to the team out there which is doing an exceptional job really focusing on the fundamentals. We've clearly put significant investment back into Europe, which we're seeing really play out in that sustained top line growth. Volume growth was terrific. We're getting a little bit of pricing. Pricing, we're not immune to the challenges of pricing in Europe. But the good news is, we move into '25 with much stronger market shares, good penetration across our categories, and a very strong level of advertising that's improved brand health. So again, very consistent with the theme that we've been talking about, reinvest behind those growth opportunities. Our Oral Care shares are at record high levels now. We continue to see growth opportunities there, particularly building penetration amongst very specific targets. The advertising levels across the business, not just in Oral Care or coming back in. So we're seeing more broad-based growth across the European business. But we're not immune to some of the softness and challenges that always seem to plague the European market long term. But the good news is the business is in very good shape. Gross margins are at very high levels. Advertising strong and market shares have been reflected very positively."
},
{
"speaker": "Operator",
"content": "The next question comes from Bonnie Herzog with Goldman Sachs. Please go ahead."
},
{
"speaker": "Bonnie Herzog",
"content": "Thank you. Good morning."
},
{
"speaker": "Noel Wallace",
"content": "Good morning, Bonnie."
},
{
"speaker": "Bonnie Herzog",
"content": "Good morning. I wanted to ask about your emerging markets business. Organic sales growth has been strong in these markets, but most of its been driven by pricing to offset FX pressures. And I guess, as a result, this isn't necessarily translating into significant growth on a net basis. So I guess, I'd be curious to better understand how you're thinking about these businesses, and ultimately, how we should think about the contribution of volume mix going forward?"
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks, Bonnie. Listen, the emerging market numbers were terrific. Even ex-Argentina, very positive volume and positive pricing ex-Argentina. So we're encouraged very much so. Some of our larger markets, particularly Brazil, India and Mexico continue to perform very, very strongly. And if you look long-term strategically, this is where the growth is going to come from. I mean, there continues to be per cap opportunities, premiumization opportunities in those markets, which we think we're executing very well. I'm sure, we'll get into some discussions on Latin America, but they continue to perform exceptionally well despite some of the choppiness that we've seen in some of those markets, particularly Mexico in post-elections. But overall, the emerging market strategy that we have in place continues to deliver. So you go across the board, Asia, strong performance this quarter, particularly China. Our Colgate China business performed exceptionally well. India strong. Africa, Eurasia, despite some of the volatility of that division is going through, again, quite strong. So we think the refocus on some of the real basic fundamentals that we had to put back into the business on driving household penetration, making sure we’re looking at the premiumization opportunities, getting gross margin back into the P&L has allowed us to get a lot more flexibility in targeting some of those markets. Now as you well know, there’s significant volatility in emerging markets. We’ve seen some of the exchange rates move negatively over the recent periods, and we’ll have to adjust accordingly to that moving forward. But overall, we feel very good about it, but we’re not immune to some of the economic and political issues that I outlined earlier that impact those markets. But overall, the underlying performance is kind of right where we’d like to see it."
},
{
"speaker": "Operator",
"content": "The next question comes from Kevin Grundy with BNP. Please go ahead."
},
{
"speaker": "Kevin Grundy",
"content": "Great. Thanks. Good morning, everyone and congratulations on the really strong quarter and results year-to-date. Stan, I was hoping maybe we could pivot to gross margin. Again, strong in the quarter. We're seeing the pricing contribution start to step down here commensurately with lower level of cost inflation. Funding the growth continues to be quite good, has been for a very long time at the company. Without giving guidance for next year, can you maybe just help us think about the building blocks and how you're thinking about gross margin development over the next 12 months or so? And then relatedly, what that may mean as you're thinking about reinvestment further down the P&L? Thank you for that."
},
{
"speaker": "Stanley Sutula",
"content": "Hey. Good morning, Kevin. Thanks for the question. So gross profit, we're very pleased with the gross profit margin here in third quarter. And candidly, it was better than our expectations, up 270 basis points year-on-year and improved sequentially. As we've disclosed before, we continue to see raw material inflation, and you saw that in our gross margin roll forward. Also, we're going to wrap around on even tougher compares here on a year-on-year basis in Q4. So as we think about the components, I think the teams have done a really nice job of looking and driving, funding the growth to drive productivity, which will help us on the margin. And then openly, we also get benefit from volume. So as the volumes have been increasing, we get the ability to get more overhead absorption, and that's always a benefit when we think about the variances. Now as Noel talked about earlier, we expect that the pricing contribution will mitigate over time. So we're not going to give '25 guidance here. But I think if you look at our history, you would see that we drive funding the growth. We have a great program here to drive that productivity over time. And that funding the growth, combined with revenue growth management, will help us balance out that P&L. The model we continue to expect, which would be gross margin dollars will drive that profitable growth. We'll invest that back in the business through innovation, through advertising to deliver both top and bottom line."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Lieberman with Barclays. Please go ahead."
},
{
"speaker": "Lauren Lieberman",
"content": "Great. Thanks. Good morning. I was just curious, if you could talk a little bit about the philosophy on advertising and reinvestment spending. Like, how high can you go? Is there a point at which there's sort of a diminishing rate of return? So whether it's not about '25, but let's call it '25 and beyond, as you've created this flexibility, Stan just spoke to ongoing productivity programs, funding the growth continues. So how do you think about that spending and making sure it's still coming back with that same ROI and it's not diminishing? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Good morning, Lauren. Thank you. We've talked about for quite some time. And the fundamental strategy within the company is obviously building that flexibility so we can reinvest in building our brands. I mean we've got great penetration opportunities. We've got brand equity and health opportunities. And ultimately, that's how you drive sustained growth over the long-term, is making sure that consumers understand our product benefits and are excited about using our products. And so we find -- as you see through the volume line, particularly, and we have a lot of internal measurements to assess ROI. But if you take it at the simplest level, continuing to drive volume growth and broad-based penetration around the world is the most important benchmark for us to ascertain whether our advertising is working for us or not. How high is high? We continue to assess this on a geographic basis. Are we getting the returns? Do we need to move money, which is new for us from one division to another where we're seeing better returns on that. I talked about Europe earlier. We're seeing exceptional return on investment with our advertising investments, particularly in Oral Care. We obviously have the flexibility to now put some more money into the North America business, which I think will benefit from that. But overall, we're getting better at understanding what's working for us. And particularly, as we look at some of the work we're doing around analytics and using AI to really improve our digital impact, that's going to have a better ROI for us moving forward. I would very much like to find even more efficiency in the advertising P&L. That will be a primary focus for us as we move into '25 and '26, is really beefing up the analytical capabilities we have around our media buys and making sure that we're really understanding what's working for us on a much more fluid basis than we've had before, so we can make decisions on an intelligent basis as quickly as possible. So overall, we're pleased with the advertising investment. We've been able to now support more of our brands broadly across the business, that is certainly helping drive overall health. And most importantly, again, we're seeing good penetration numbers and good premiumization opportunities through some of our innovations. So overall, we feel good about that. We're going to continue to invest as long as we see the top line and penetration moving."
},
{
"speaker": "Operator",
"content": "The next question comes from Kaumil Gajrawala with Jefferies. Please go ahead."
},
{
"speaker": "Kaumil Gajrawala",
"content": "I'd like to follow up on that a little bit. I think it was interesting when you said better at some of the things that are working. Can you maybe just talk about some of the changes that you've made, maybe it's in being tactical on the advertising versus longer-term brand building? If you could just maybe get into some of the tweaks because when we see such a good result, especially, in some markets where CPG peers have struggled. It feels like there's a lot more going on, and if you could just give a little more detail on what's behind that, I think it would be helpful."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Sure, Kaumil. Thank you. Listen, over the last three or four years, our team here in New York, working really closely with our operating heads, has spent a significant amount of time in the strategy of the company. And what that really entails is making sure that we are collectively working together on prioritizing where we see the biggest growth opportunities. Historically, I’d say, we were a bit democratic in our spending. We’re now much more strategic and we are able to pinpoint where we’re getting the best ROI, where we see the best growth opportunities. And the division presidents aren’t afraid to move money around within their divisions and across divisions to ensure that we’re putting our money in areas where we’re going to get the best return for that. And that clearly is demonstrated through the volume growth that we’re seeing across all six divisions. I think it really comes down to not only just Oral Care and Pet Health and Skin Health, but now looking at opportunities both in the Personal Care businesses, the classical Personal Care businesses. Bodywash had a great performance in Europe this quarter. They’re supporting some relaunches with great innovation and advertising. Likewise, we’re seeing some great opportunities in Home Care across Latin America, which had a nice Home Care result in the quarter. So it’s broad-based support and it’s making sure strategically that we’re very thoughtful about where we’re putting the money in terms of geographic. The second aspect of that is exactly how we spend our money. The media environments become far more complex. There are various platforms to choose from. We’re being very selective and focused on how we spend that money. It’s easy to get enamored with a lot of shiny objects out there in terms of media opportunities, but we’re focused on where we can build reach and build the frequency accordingly to build brand health. And the digital teams here in New York, helping to share best practices around the world and getting that ROI up, specifically in the digital area across different mediums, has really paid out nicely for us."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Carey with Wells Fargo. Please go ahead."
},
{
"speaker": "Chris Carey",
"content": "Hi, good morning. Can you expand a bit on what you're seeing in Latin America? You made a comment about Mexico and the elections, but in the prepared remarks there was also a comment about stabilizing and still positive. So just what's the direction of travel in Latin America, specifically Mexico and perhaps Brazil? And then just connected to that, you talked about some currency volatility and needing to respond in different ways. How do you think about pricing in this market, specifically, if the macros are stable, but maybe not as strong as they were a year ago? Just any thoughts on how you'd approach strategy in these markets over the 12 months? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Sure, Chris. Thank you. Good morning. So again, as you mentioned, really strong performance in Latin America, notably against tougher volume comps. We did expect some slowdown in organic sales growth, and that's what we're seeing, but very much in line with our expectations. So we feel very good about that. And the underlying health of the business, i.e., specifically market shares, Latin America had a terrific quarter. Pleasingly, if you look at that business on a two year stack basis, volume has increased sequentially for four consecutive quarters. So despite the fact that there's a lot of volatility, we're seeing volume come back into the categories. And you'll remember that we took significant pricing in those geographies over the last two years. So to see volume come back as quickly as it did and sustained is important. Now post elections, we've seen some choppiness in Mexico, particularly around the category that may be more of a normalization. We're going to have to watch that carefully and make sure that we're thinking about our spending accordingly in that market. But we've got a really strong innovation plan. You saw in the prepared remarks, we've relaunched Colgate Total, which is a very significant business across Latin America and affords us a very important opportunity to continue to drive premiumization. But behind, what we think is the best formula that we've ever put in the market on Colgate Total and one that we are very excited about seeing the results of that across Latin America. But again, pricing up ex Argentina. So if foreign exchange continues to move against us, the strength of the brands and the support that we put behind that business, we think we can take more pricing in those markets to help offset that. But we're not immune to some of the sluggish and the foreign exchange that hits those markets, as you well know. I talked about Mexico at Barclays. And overall, I think we continue to have a very strong performance there. But the sluggishness that we're seeing across some of the categories as we ended the quarter, we need to watch that carefully. And I think, again, the team is very well positioned to execute based on what we see. So overall, good. Brazil, a terrific quarter for Brazil despite obviously some -- a little bit of uncertainty in those markets that continues to plague them, but I feel good about what we're seeing coming out of Brazil across the rest of the region. The performance continues to be quite strong. This is the team that knows how to execute in volatile environments, knows how to continue to drive penetration and premiumization. So I feel pretty confident that while – despite the lack of aggressive pricing, given the inflationary pressures, we will still get some foreign exchange pricing in the business over the subsequent quarters."
},
{
"speaker": "Operator",
"content": "The next question comes from Olivia Tong with Raymond James. Please go ahead."
},
{
"speaker": "Olivia Tong",
"content": "Good morning. Thank you. I wanted to ask you broadly about affordability given the macro environment, particularly in North America, but I think this is relevant to all markets. And as consumers continue to scrutinize your spending, can you talk about some of the initiatives that you have that help with respect to either promotional plans or at mid-tier price points with product? Just sort of thinking about the broader picture and how consumers are thinking about their total basket spend and actions that you're taking to maintain, if not grow share in that backdrop? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks. Good morning, Olivia. So again, let me come back to strategy. Our strategy has been to accelerate our innovation, particularly on the premium side of the business, which providing value add benefits to the big core businesses that we have around the world, supporting that with advertising and ultimately, getting the brand penetration and share growth. Our volume shares performed well in the quarter in general across the world. Likewise, our value shares. We saw, obviously, toothpaste performed quite well in that regard. So overall, again, the consumer may be a little bit challenged, particularly in North America, it's making sure that we continue to dial up our innovation and provide real added value for -- across the multiple price tiers in which we compete. The other aspect of that is making sure that you are very thoughtfully thinking about your promotional cadence and how you promote your digital coupon strategy, your paper coupon strategy, your promotions, on-pack promotions, your price pack architectures. All of those are critically important in making sure that we have the analytics to really determine what's going to drive category growth for our retailers and continue to drive performance for our business. I was just reviewing the other day some incredible work that we're doing with some of the retailers in the U.S. with real AI and analytics around our promotions and seeing great results for that. So I think the point is, yes, the environment is a little bit more competitive. Coupon redemption rates are up. Promotions seem to be more or less in line, which I would say, normalized. Still not back to the pre-COVID levels, which is good, but more or less normalized. And ultimately, it’s making sure that we’re spending our money as thoughtfully as we possibly can to get the best ROI. But I would say a more normalized consumer, slightly higher promotional redemption rates behind coupons. But across the world, it’s pretty consistent in terms of where we were post COVID."
},
{
"speaker": "Operator",
"content": "The next question comes from Robert Ottenstein with Evercore ISI. Please go ahead."
},
{
"speaker": "Robert Ottenstein",
"content": "Great. Thank you very much. Terrific results, Noel. So if you, I think, stand back and listen to at least three or four of the questions, I think the underlying question is, why are you guys doing so well in so many places? And it's -- and I think is it just that, hey, you're spending more -- you can spend more money, you've got the data, so you're spending it in the right places. And that's kind of a very broad sort of the answer. But what I'd like to do is drill down a little bit more on that point and see -- and maybe just talk about Oral Care. How much of your success is driven by technology, by the whitening initiatives and then marketing that or other specialties? Just trying to get a sense of things that can drive sustainable, continued market share gains that go beyond just spending more money in marketing. And I know that's going on, but I just want to give you the chance to talk about that a little bit more. And then also, if we had the time, looking at what you're doing in China, which is just -- you're just being much more successful than anybody else at this point and how that model applies to that very tough market. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Great. Good morning, Rob. Thanks. Thanks for the question. So again, it comes back, I think, with just consistency of performance in our focused categories around the world and our ability to really dial in on where we see the growth opportunities. We've spent a lot of time talking about building capabilities. And I really want to emphasize that because you don't necessarily see the immediate impact in the quarter, but those capabilities are all intended on building long-term, sustainable health behind our business. So it's innovation. It's digital, It's our advertising return on investment. It's our data acquisition and using data to drive better decision-making. It's making sure that our innovation across H2 and H3 is where it needs to be. Making sure the core is where it needs to be. Making sure that we're addressing new channel behaviors. But it's all the basics that we've been talking about and making sure then that we invest accordingly. And we had to get the middle of the P&L addressed to do that. So we deliberately took a lot of pricing over the last three years to get our categories where they needed to get to. And then ultimately, that is paid out in allowing us to really invest consistently behind our brands. And we measure internally our brand health, the health of our equities, and they are in a really good place, and that's what we want to continue to build. Now we're not immune to what everyone is talking about. Clearly, we're going to see some divisions take a step back. But the breadth of our business and our geographic footprint, we believe, allows us to weather some of these -- the volatility that you're seeing referring to Better than Most, and we want to continue to do that. But we can't be complacent. We need to build more capabilities and sharpen those as we move forward. We need to continue to address the opportunities we see in certain geographies where we think there's real growth for us there. But again, it's a deliberate, thoughtful approach to this business. We're going to be consistent. We're not going to necessarily try to hit home runs, a lot of singles to take a sports analogy. But making sure that we do that in a way that drives broad-based growth over time. So again, a lot of the strategy, Rob, particularly on Oral Care. To your question, we think the focus on premiumization, the great new product innovations that we brought on whitening adjacencies, we now have Colgate Total rolling out in Latin America with some significant new innovation behind the core. You heard about some of the great technology that we're bringing into Max Fresh across India and some of the Southeast Asia markets, that will continue to roll out. So again, the stepped-up innovation and resources that we're putting behind that will ultimately play out. On China specifically, it should be said that we had some pretty easy comps. But that being said, our China business continues to perform really, really well. I'll talk to Colgate first and then the Hawley & Hazel business. The Colgate business continues to do very well, up high single digits, driven primarily by premiumization. Great innovation across the calendar moving forward. We're improving our brand health behind some of the investment that I referred to. And overall, we're getting a good mix of volume and pricing against tougher comps on the Colgate side. Hawley & Hazel, as you know, has come out of quite a few quarters of challenged growth. We're starting to see that come back nicely, which is good, but not where we need to be yet. So we still have room for opportunity. We are looking at our go-to-market approach on Hawley & Hazel moving forward. That team is really deliberately thinking about how we want to be structured over the next couple of years to ensure that we can continue to invest in a very competitive market and drive sustained volume and value growth for the business. But overall, pleased with the China performance, but we’re not immune to the slowdown that we’re seeing across that business. But we think the consistent performance behind our innovation and supporting those business will drive sustained growth moving forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrea Teixeira with JPMorgan. Please go ahead."
},
{
"speaker": "Andrea Teixeira",
"content": "Hi, good morning. My question is what was the exit rate for organic sales growth in the quarter and what is embedded in your guidance for Q4? Because even if the guidance raise is a wide range. And Noel, from your tone on this call, it seems that you're supposed to keep the pace of 6% globally. So in other words, if you current trends continue, is that the way we should be thinking, that the top of the range would be that embedded around 6%? And if I can squeeze a clarification on Hill’s. Can you comment now on the potential for more international expansion with more capacity into 2025? Thank you for both."
},
{
"speaker": "Noel Wallace",
"content": "Great. Andrea, good morning. Thank you. Listen, we don't guide by quarter, so I don't want to get into the specifics. But I do think we're -- we feel pretty good about the underlying health of where the quarter came in. So overall, we're good. And as I said in my upfront comments, we think we're positioned for consistent growth. But we're not, again, as I mentioned, immune to some of the issues that many of the CPG companies have talked about throughout the earnings season. But that's reflected in our guidance. And I think you see that in our numbers and the guidance for itself in terms of where we think we’ll be. Obviously, we’ve seen a little slowdown, a little move in foreign exchange. We’ll see ultimately where the categories unfold as we exit the year. But overall, we feel like we’re in a pretty good position. On Hill’s capacity, that is continuing to obviously allow a lot of good things on the Hill’s business. It’s allowing us to build more flex in the middle of the P&L. We continue to find ways to truly optimize that supply chain and build more positive variances to those factories. Secondly, it’s allowing us to obviously expand into higher growth segments in the wet segment, which we saw a nice growth in the wet business in quarter and continuing to drive overall share in that segment. So it’s giving us a lot more flexibility. There’s more work to be done. We’ll continue to obviously be very, very diligent about how we think about allocating volumes across the world and addressing some of the growth opportunities that we see, particularly internationally. But overall, a terrific quarter and the supply chain team at Hill’s is doing just an exceptional job integrating the new facilities and finding ways to really optimize the network."
},
{
"speaker": "Operator",
"content": "The next question comes Bryan Spillane with Bank of America. Please go ahead."
},
{
"speaker": "Bryan Spillane",
"content": "Thanks, operator. Good morning, everyone. So I have just maybe one point of clarification and then a question. And the clarifying, Noel, I think earlier you talked a little bit about gross profit dollars and gross dollar profit growth. And I think it's maybe created a little bit of a question about whether there's a signal here that the focus maybe more shifting to gross profit dollar growth versus gross margin percentages. And I know you've had a view on that in the past, so if you could just sort of clarify that? Just is there any sort of message that you're trying to send or we still leave gross margin expand?"
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Let me maybe throw it to Stan, Bryan. No message whatsoever here. We could -- as I think we've been quite consistent, we understand the importance of gross margin, both gross margin percent and gross margin dollars. Encouragingly, in the quarter, we saw both and that's important for us. But again, as we strategically look at the growth opportunities, whether it's innovation, geographically, we're thoughtfully thinking through exactly how the impacts on gross margin will be. But ultimately, what we're looking for is our ability to continue to drive gross margin dollars to invest in the business. And it's hard to get there without gross margin percent. We're not just going to chase volume to drive dollars is what I'm saying, it has to be very deliberate choice. But let me give it to Stan, he can provide a little bit more color."
},
{
"speaker": "Stanley Sutula",
"content": "Yeah, Bryan. So first of all, it is obviously a combination of the two. And if you think about the business, we have -- you saw a great margin improvement in a number of businesses, particularly in Hill's. And as we look, the only part we're trying to -- point we're trying to make is how we deliver that margin improvement in those -- in that dollar growth is going to shift. So pricing will be less of a benefit, volume has been a help here going in and productivity will continue to be a driver as we look at that. But obviously, as we look at both margin and dollars it's a combination of both. And that is part of our overall business model on how we drive the investment back into the business and deliver top and bottom line growth."
},
{
"speaker": "John Faucher",
"content": "Bryan, if I can just add one point to Stan's point. The bottom line growth piece, key, right? We need EPS growth in dollars, right, because that's what creates long-term TSR at the top end of our peer group. So we talk about organic sales growth, but we're focused on driving dollar-based sales growth. We talked about driving gross margin percentage, but we also know we need to drive those gross profit dollars to drive EPS growth in dollars to drive TSR. So it's a very thoughtful way to look at it, but as Stan said, you need both to drive that bottom line growth."
},
{
"speaker": "Operator",
"content": "The next question comes from Korinne Wolfmeyer with Piper Sandler. Please go ahead."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Hey, good morning. Thanks for taking the question. I'd like to get a little bit more clarity on some of the dynamics that were going on in North America in the quarter. I mean it sounds like some shipments were pushed from Q3 to Q4. Can you just clarify what that was due to? And then the pullback in the eCommerce, what that was attributable to? And then how should we be thinking about some of the macro dynamics in Q4, especially in the U.S. as some retailers are talking about pulling back into orders? Thank you."
},
{
"speaker": "A – Noel Wallace",
"content": "Yeah, Korinne. Thank you. Again, we talked about three specific things. Obviously, there’s some shipment timing that moved from third to the fourth quarter, that was just due to some disruptions in our network and ultimately getting that order out in time. But ultimately, it will move into the fourth quarter. But nothing systemic there that we feel would be reoccurring. The eCommerce issue was specifically on the skin health business. We’ve seen a little – obviously, there’s some softness coming out of Asia, specifically China. But this one was more specific to the U.S. market, where we saw some of our big online retailers pull back a little bit on orders at the end of the quarter. We think those were inventory adjustments more than anything. But in any case, we need to watch that carefully and see if that’s going to be sustained or not moving forward. And overall, the macro dynamics in the North America, I would say, more stabilization. We haven’t seen anything deeply unusual on the promotion side. I think the percent sold on promotion is more or less pretty consistent. Still not back to where it was, as high as it was, pre-COVID. So overall, I would say more normalization, as I did mention, a little higher redemption rates coming through on couponing, and a little bit more broad-based activity in terms of the number of promotions. But overall depth and proportion to what we’ve seen in the past seems pretty normalized right now."
},
{
"speaker": "Operator",
"content": "The next question comes from Steve Powers with Deutsche Bank. Please go ahead."
},
{
"speaker": "Steve Powers",
"content": "Hey, thanks. Good morning. I wanted to ask Noel on Skin Care. I guess, first, just mechanically and following up to Dara in North America, are you able to quantify how much of a drag the restatement was on growth in that segment this quarter to the extent that it was? But then more generally, I guess, you've talked a little bit about it, but maybe could you expand on what you're seeing in skin care trends across key markets because I'm assuming there's a good deal of variability. And do any of the reporting structure changes that you've made this year carried with them give some strategy with respect to how you approach Skin Care or skin health opportunities longer term? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks, Steve. So overall, let me just generalize. North America was, with the order changes and the skin, if you take skin out was closer to flat for the quarter. But I'm not going to quantify any more specifics on that. But specifically around the skin sector, I think you've heard from others, there's been some sluggishness, particularly in Asia. Likewise in Europe, and to a certain extent in the U.S. as well. So we're not necessarily immune to that. But what we have been doing very specifically is we are thinking about that business quite differently. We brought in some outside talent, somebody with over 20 years’ experience at L’Oreal. We’re getting very clear and articulate about what we – where we want to compete and how we want to compete in that space. We feel very good about that organization now being much more centralized here in the U.S. in order to drive global decisions from the center and making very deliberate choices on how you invest and where we invest. We had to clean up some of the market expansion opportunities there that we didn’t think were sustainable for the business. But overall, the economics and long-term health aspects of where we see that business growing continue to be very favorable. And we’re encouraged, obviously, by the long-term strategy. We’ve got some short-term issues with, obviously, Asia and some of the softness that we’re seeing in some of the European markets to address. But overall, again, we feel the strategy we’re putting in place will get us back to the sustained growth that we expect."
},
{
"speaker": "Operator",
"content": "The next question comes from Mark Astrachan with Stifel. Please go ahead."
},
{
"speaker": "Mark Astrachan",
"content": "Thanks. Good morning, everybody. I wanted to go back to U.S. Oral Care and kind of ask more of a deep dive question there. So as we look at the market trends over a long period of time, there were four or five quarters where it was actually growth '22 to '23 (ph). But largely, it's been in a decelerating or share loss situation going back quite a long time. I guess the question is, what contributes to that period of outperformance? What has contributed to this state of back to share loss? And maybe if you kind of like a deep dive on what you think competitors are doing well, where they're gaining share? Where do you think Colgate could do a better job from a share perspective and how do you broadly kind of think about it? Because I know there's a lot of thought innovation around this total relaunch is to refocus on whitening, and yet, the general trajectory remains kind of where it is? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Thanks, Mark. Listen, overall, shares are roughly flat, down 20 basis points on toothpaste and up on toothbrushes. And clearly, we’ve seen some impact of our refocus on some of the untracked channels that we’ve had over the last couple of years and seeing good performance in those untracked channels. So overall, business is good. It’s not exactly where we want it right now, and we’re very focused on getting the innovation strategy dialed up. We’ve got to get the premiumization side of that business addressed. We’ve got strong core businesses that we’re seeing benefited as you see the consumer to a certain extent, some of the consumers trading more into the mid-tier. But overall, it’s getting the premiumization side of the business addressed moving forward. And we’re very focused on that in the strategy. Toothbrush business continues to perform very, very well. So again, putting more investment into that market, getting the innovation right, executing the fundamentals around distribution and shelf sets, all the basics that we think are necessary. And the plans that we have in ‘25 were some of the big core relaunches that were not privy to talk about, we think we’re set up for stronger success moving forward. We’ve seen some, again, choppiness with some of the retail environments, particularly the drug class of trade, where we hire shares, has struggled to drive traffic and turn in their retail environment. So we’re having to shift accordingly. But we still feel the channel long term provides a growth opportunity for us, but you’ve seen some sluggishness in that retail environment in the short term."
},
{
"speaker": "Operator",
"content": "Our last question today comes from Edward Lewis with Redburn Atlantic. Please go ahead."
},
{
"speaker": "Edward Lewis",
"content": "Yeah. Thanks very much. I guess just looking back when you launched your sort of new strategy a few years ago. You talked about the core product of CPG doing a lot around that. You talked about adjacent categories. And you also talked about adjacent channels, the opportunities there. And just looking at the results today, I mean, we've seen the success for a number of years now on eCommerce in China. But how much of the channel mix changed in regions like, say, Latin America and Asia, ex-China relative to where it was before? And how much is that helping the success you're seeing with the premiumization strategy?"
},
{
"speaker": "Noel Wallace",
"content": "Yeah. Good morning, Ed. Thank you. Interesting question. It's back on the channel expansion. I mean the initial focus on that was predominantly eCommerce, but we identified real unique opportunities in the expansion of very innovative discount formats around the world. The expansion of the club store format in certain parts of the world, you're seeing club stores particularly in Asia, and more specifically, China, grow quite significantly a couple of years. So it's making sure that as we think strategically around where we want to invest, we're investing in those retailers that are going to drive long-term growth for the business. And we've been very quick to adopt to new formats. And that's been one of the successes we've had here in North America when we initially guided to the Dollar Stores decades ago and ultimately, we've got strong leads there. But it's making sure that we are working with our retailers, all of our retailers to bring products to drive innovative growth for their sectors. And that's the key focus for us, category growth across all channels. And making sure that as we see new retail environments come on stream, that we're thinking very thoughtfully on how to do that in a way that drives growth for our retailers for the category and for the whole market. So I think it's just being very attuned to what we're seeing in the markets. You're seeing a lot of very innovative things happening at the retailer level. I think that's to be expected given some of the challenges in the move to eCommerce. So there's big box retailers that are having to change their shopping experience. And we're very much working in tandem with them to ensure that we have the products they need, the price pack architectures and configurations that they need in order to drive excitement at the shelf."
},
{
"speaker": "Operator",
"content": "This concludes the Q&A portion."
},
{
"speaker": "Noel Wallace",
"content": "Thanks. Thanks to everyone. Again, a strong quarter. We're having a good year so far through three quarters. Net sales were up 4.5%. Organic, up 8.5%. With again, a very strong balance between volume at 3.3% and pricing at 5.2%, and EPS double-digit on a year-to-date basis. And importantly, getting that flexibility across the income statement and the balance sheet. But this is the hard work of Colgate people all around the world aligned to our growth strategy and executing extraordinarily well. So thanks, everyone, for the questions today, and thanks to all the Colgate people for delivering a strong quarter."
},
{
"speaker": "Operator",
"content": "The conference is now concluded. Thank you for attending today's call. You may now disconnect."
}
] |
cl | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to today’s Colgate-Palmolive second quarter 2024 earnings conference call. This call is being recorded and is being simulcast live at www.colgatepalmolive.com. Now for opening remarks, I’d like to turn this call over to Chief Investor Relations Officer and Executive Vice President, M&A, John Faucher."
},
{
"speaker": "John Faucher",
"content": "Thanks Drew. Good morning and welcome to our second quarter 2024 earnings release conference call. This is John Faucher. Today’s conference call will include forward-looking statements. Actual results could differ materially from these statements. Please refer to the second quarter 2024 earnings press release and related prepared materials, and our most recent filings with the SEC including our 2023 annual report on Form 10-K and subsequent SEC filings, all available on Colgate’s website, for a discussion of the factors that could cause actual results to differ materially from these statements. This conference call will also include a discussion of non-GAAP financial measures, including those identified in Tables 4, 6, 7, 8 and 9 of the earnings press release. A full reconciliation to the corresponding GAAP financial measures is included in the second quarter 2024 earnings press release and is available on Colgate’s website. Joining me on the call this morning are Noel Wallace, Chairman, President and Chief Executive Officer, and Stan Sutula, Chief Financial Officer. Noel will provide you with some thoughts on our Q2 results and our 2024 outlook. We will then open it up for Q&A. Noel?"
},
{
"speaker": "Noel Wallace",
"content": "Thanks John, and thanks for joining us this morning. I look forward to taking your questions in regards to our strong Q2 results. As part of our ambition to deliver consistent compounded earnings growth, we have talked about the importance of driving balanced organic sales growth - all six divisions, all four categories, and with a combination of volume and pricing growth. We have re-vamped our innovation model, leveraged our global strength across price tiers, invested in marketing spend, and scaled new exciting capabilities across the organization, all of which is driving brand health and household penetration. This is particularly important given the pricing we have taken over the past few years. Our return to mid single-digit volume growth this quarter, including growth at both Hill’s and Hawley & Hazel highlights some early success from this strategy, and this is well timed. We are returning to strong volume growth as gross margins are expanding, which will drive the incremental gross profit that funds the investment in brands and capabilities while still delivering compelling bottom line growth. We’re also using data and analytics tools, including AI, to track the effectiveness of these activities as we look to further optimize the return on our increased spending. This is a topic we’ll be discussing more over time. With this combination of increased penetration and the continued success of our revenue growth management strategy, we have the plans in place to drive consistent, balanced top line growth. We combine that with the benefits of operating leverage, productivity and cost discipline to turn that into consistent compounded earnings per share growth. Along with strong cash flow to fund investment, dividends and share repurchases, we believe this leaves us well positioned to drive top tier TSR. Our recent results show the strength and effectiveness as we continue to execute against this strategy, and with that, I’ll open it up to questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question and answer session. [Operator instructions] The first question today comes from Peter Grom with UBS. Please go ahead."
},
{
"speaker": "Peter Grom",
"content": "Thank you Operator, and good morning everyone. Noel, I was hoping you could give us a deeper understanding of the levels of investment and what drives the confidence that the changes you’ve made over the past several years can sustain this improvement we’ve seen. Obviously from an outsider perspective, it seems to be working given the market share is in the mid single digit volume growth today, but just as you look ahead, how do you sustain this momentum and continue to build household penetration from here? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yes, thanks Peter, and first of all, happy birthday!"
},
{
"speaker": "Stan Sutula",
"content": "Happy birthday!"
},
{
"speaker": "John Faucher",
"content": "Happy birthday Peter!"
},
{
"speaker": "Peter Grom",
"content": "Thanks guys."
},
{
"speaker": "Noel Wallace",
"content": "So let’s get into the heart of the strategy, which I think we’ve been pretty consistently communicating over the past few years, and that’s really getting the middle of that P&L in a place where we could have a lot more flexibility to invest behind the brands. That investment certainly is helping to drive the strong volume performance, but more importantly household penetration, which ultimately drives category growth and market share. It’s keeping that flexibility in the middle of the P&L, allowing us to pinpoint the advertising in areas where we see real growth. The international exposure of our business obviously is giving us opportunities to allocate money in regions and areas where we see great growth opportunities, and that was delivered in the quarter with category growth across all of our categories and all of our divisions. Keeping those investment levels where they are, continuing to find ways to drive the effectiveness of that investment likewise is very important. As I’ve mentioned before and as you saw down at CAGNY, we’re using AI and other tools to really drive improved ROI. We’re getting much better at our innovation - that’s certainly helping drive that consistent growth around the world, and the execution of the strategy, we think is far better than it has been in previous years. Overall, keeping the flex in the middle of the P&L, strong gross margins, and allocating that in areas around the world where we’re seeing real opportunities for growth, we think will drive sustained, consistent compounded growth moving forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Dara Mohsenian with Morgan Stanley. Please go ahead."
},
{
"speaker": "Dara Mohsenian",
"content": "Hey guys."
},
{
"speaker": "Noel Wallace",
"content": "Hey Dara."
},
{
"speaker": "Dara Mohsenian",
"content": "Just wanted to focus on the long term top line growth opportunity in Hill’s from here on the volume and pricing side. First, maybe just on volume, you’ve added a lot of capacity in the last couple of years, you’ve also got a lot of areas you’re still under-penetrated in, in theory internationally - wet foods, small paws, etc., so just some perspective at this point as we look out over the next three to five years, is there incrementality in volume as you pursue these areas more aggressively, and how should we think about that? Then on pricing, obviously you’ve had very strong penetration increases, market share gains on the Hill’s business. In theory, that should support higher pricing over time, but you’re also in a category environment with industry trade-down in pet and probably a tough CPG environment in general for pricing, so how should we think about pricing going forward? Can you take consistent pricing, maybe to recapture some of the margin compression if you strip out the higher marketing in recent years, and just how would you juxtapose that sort of internal momentum versus the external environment in terms of your ability to take pricing longer term, looking out over the next few years?"
},
{
"speaker": "Noel Wallace",
"content": "Thanks Dara. You know, clearly a great quarter for Hill’s, a strong performance across the board, quite frankly, and we’re particularly pleased with the strong volume in light of the significant pricing we’ve taken historically. I’ll come back and talk about pricing in a moment. But obviously ex-private label, to see the strength of the volume and the pricing move through the P&L is extremely encouraging, particularly given the advertising investment that we’ve put into the business, which continues to strengthen the brand. I think what’s important to call out in the quarter is the real inflection on the margin line, strong gross margin, strong operating margin, and this is a reflection, I think of getting more volume running through the business and obviously seeing the leverage move through the P&L. But if I take a step back again and characterize the marketplace, clearly as we’ve talked about before, low household awareness and low brand penetration overall of the Hill’s business clearly supporting the strong advertising investment, and we’re seeing that delivered in the quarter - penetration up, market share’s up. We’re were one of the fastest growing global brands in some of the pet specialty stores this quarter, so again I think a reflection of the upside potential we still have. When you look at segment opportunities, we’ve talked about that in the past, obviously wet an area that we’re under-indexed in, clearly seeing the ramped up capacity we have in wet delivering better penetration, better growth, better execution in stores as we’re getting more wet SKUs on the shelf. That’s obviously translating into more upside potential as we consumers obviously shifting into those categories. Overall, we think the balance of the business is where we want it, and we’re continuing to invest aggressively to drive that household penetration. You couple that with a really strong innovation pipeline, we see that in the first half of this year and we see that moving into ’25 as well, so we think quite frankly the flywheel of the business is working very effectively for us right now. Low penetration, low awareness, we’re working on that and getting more effectiveness in our advertising spend, which we’re increasing, and importantly getting the gross margins and operating margins back to where we’d like them is allowing for the increased gross margin dollars to invest behind the business. International, likewise - we’ve talked about the opportunities that we still see globally in the long term to take this brand around the world. We’re very focused on the big core markets right now, but long term we see opportunities to expand into new markets. The last I’d say is obviously the mix between Science Diet and Prescription Diet, we saw a good inflection on Prescription Diet this quarter - that’s been deliberate, that’s been a function of partly due to the capacity expansion that we’ve had has allowed us to get more diets on the shelf, allowed us to provide more sustained, consistent deliver to the vet professionals on the Prescription Diet business, and we saw a good mix benefit of that in the quarter as well, so overall we’re pleased with it. The category is a little soft right now, as you mentioned, as household starts come down, but as we see hopefully the U.S. economy starting to show some vibrancy, or at least for a softer landing, we think that will bode well for us. Pricing is an opportunity, given the strength of the brand. We’ll continue to take pricing where we have necessity to do that. The good news is we’ve seen a little bit of flattening on commodity pricing in the Hill’s business, which is excellent for us as we get that pricing we’ve had historically. We’ve seen the benefit of a more moderate inflationary environment on input costs, and we get more leverage through the P&L as we see the volume come back. So overall, we feel like we’re in a good position to sustain that moving forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Filippo Falorni with Citi. Please go ahead."
},
{
"speaker": "Filippo Falorni",
"content": "Hi, good morning everyone. I wanted to ask about the North America business - great to see the volume return to solid growth, but you also called out a more promotional environment, so maybe one, you can talk about the general promotional environment in your categories from your competitors and private label? Also from a cycling standpoint, I know last year you were cycling lower promotional levels. Is it fair to think that’s going to continue in Q3 and then by Q4, you’re going to have a more normal comparison from a promotional level? Any color on the balance between pricing and volume in the back half for North America would be helpful, thank you."
},
{
"speaker": "Noel Wallace",
"content": "Sure, thank you Filippo. Overall, organic growth in North America was roughly in line with our expectations, albeit more volume, which was really pleasing - I’ll come back to that in just a moment, and a little less pricing than expected, although as you rightfully point out and as we said in the prepared commentary, this was due to comparisons with the year ago. If you remember, really strong pricing in the second quarter, high single digits - I think it was around 9%. We talked about it in the call in the second quarter last year, the fact that we perhaps may have pulled back a bit too far on promotions. We saw some of those promotions come back in the quarter this year, particularly in one retail environment where we didn’t promote at all in the year-ago period, a little bit of mix change between some of the higher price retailers to lower price retailers also impacting price. But pleasingly on the volume side, which we think is very important for us in North America right now, we saw great improvement, and what was particularly encouraging there is we saw household penetration as a result of that. We’ve talked a lot about that over the last four quarters, the importance of driving household penetration, and the North America numbers are terrific. Market share is more or less flat in value, but up quite considerably on the volume side - that reflects, I think, a much more targeted approach and a thoughtful approach in how we’re utilizing promotional dollars to be very effective and prudent without going too far down the trap of over-promoting. But right now, we feel we’re in a very good place with that. We did see some of the retailers lean in. There’s been a little bit more lift on promotional coupons, a little bit higher but expected as we move through the quarter, and we expect that to continue through the balance of the year. As I continually say, at least if you look outside of scanner data, our non-Nielsen business continued to track at multiples higher than the Nielsen tracked channels, so again really, really pleased with the overall context of how the quarter we delivered. We’re going to watch the pricing carefully, but encouraged to see the volume coming back quite nicely."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrea Teixeira with JP Morgan. Please go ahead."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you, good morning to all. My question is on Europe - obviously nothing short of impressive that you capped your [indiscernible] there, but with that, some of your peers have been calling a broader deceleration similar to what has been happening in the U.S., so wanted to see if you are--as you exit the quarter and as you negotiated some of the shelf space and [indiscernible] in Europe as well, and how you just described some of the shifts into the channels in the U.S. into the low income or more affordable channels, or discounters, are you seeing this happening in Europe or just as you said, your pricing ladders and your innovation has been able to sustain momentum there, and how we should be thinking to the back end. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, good morning Andrea. Much around the latter, obviously. I think we have seen some shift in the retail environments there, but again we’re through the negotiations and I think what’s particularly pleasing in Europe is the breadth of the innovation across price tiers and the breadth of innovation across various channels. That’s allowed us, in our view, the deliver that sustained very strong growth. What’s particularly pleasing is obviously the balance between pricing and volume there. We’ll see pricing obviously come down as we lap some of the strong pricing we took last year, but the volume coming back into the P&L at such healthy levels was particularly encouraging for the business, and that’s reflected in market share and in household penetration, as I said. The market share on toothpaste is at record high levels. I think the balance and effectiveness we have between the Colgate and the Elmex and Meridol brands is really taking stride now in the sense of getting that promotional mix right between the three brands, and we’re seeing likewise on the home care and the personal care brands, some of the innovation coming to the market and drive good sustained growth. Overall, a great performance for Europe. We’ll watch it in the back half, but right now we think the sustained market share growth that we’ve had across all of our categories is going to bode well for the back half, and the volume coming back in across multiple price tiers is a good indication that we’re in a good place to set us up for a strong back half as well."
},
{
"speaker": "Operator",
"content": "The next question comes from Robert Moskow with TD Cowen. Please go ahead."
},
{
"speaker": "Robert Moskow",
"content": "Hi, thanks for the question. Noel, you mentioned sequentially higher commodity costs as the year progresses, and I was wondering if you could help us quantify it or tell us, is it material enough that you would have to make any kind of pricing actions, and if so, where would the hot spots be?"
},
{
"speaker": "Noel Wallace",
"content": "Yes, let me let Stan get into the details, but strategically, obviously we think with the pricing that we’ve taken and strong productivity moving through the P&L, particularly with the volume starting to inflect much more positively, we think we’re set up well for the back half. We will see some inflationary commodity increases, at least in terms of where commodities are in the back half, but nothing that gives us tremendous concern, particularly given the strong margin profile that we have across the business and where we’re seeing the growth. Let me have Stan give you a little bit more color there"
},
{
"speaker": "Stan Sutula",
"content": "Thanks Noel. What we saw in the first quarter, we talked about coming out was that we had general easing on commodities, but as we’re looking into the back half of the year, we do see some raw material inflation in commodity costs, as well as an impact from transactional FX. As we think about the components of that, there are some pieces here that are going through, but we do feel confident in our ability to offset those with funding the growth and productivity. I don’t see the need, unless they move more dramatically, to take large incremental pricing. In addition on our margin as we look, even anticipating these, we expect that our second half gross margin should be up year on year at levels probably more similar to Q2, so overall I think the teams keep a good eye on this. We look at it on a forward basis, we’ve already locked in a significant proportion of Q3 and we’ll look at that obviously in Q4 as we go ahead, so while we’re aware of it, we feel pretty well positioned."
},
{
"speaker": "Noel Wallace",
"content": "Yes, the one unknown there is probably foreign exchange, and you’ve seen that obviously move a bit against us in the last three weeks, particularly the Latin currencies, so we’ll have to watch that carefully, but we’re on it."
},
{
"speaker": "Operator",
"content": "The next question comes from Kaumil Gajrawala with Jefferies. Please go ahead. Excuse me, Mr. Gajrawala, your line is open. Okay, we’ll go to the next questioner. The next questioner is Bonnie Herzog with Goldman Sachs. Please go ahead."
},
{
"speaker": "Bonnie Herzog",
"content": "All right, thank you. Good morning everyone."
},
{
"speaker": "Noel Wallace",
"content": "Hey, good morning Bonnie."
},
{
"speaker": "Bonnie Herzog",
"content": "Good morning Noel. I’m just curious to hear if you’ve seen any noticeable changes in consumer behavior in any of your key markets, especially from the low income consumer; and then if so, what initiatives have you guys been implementing to ultimately offer more value for consumer to drive this faster volume growth that we’re seeing? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, thanks. I think overall, quite constructive around the world, and that’s obviously reflected in the strong volume growth, and likewise the penetration and market share growth; but overall, constructive. I think a lot of the strategy that we’ve put in place over the last couple years, and that’s innovating against some of our big core businesses and making sure that we’re deliberate about the innovation by retail environment, has played out well relative to ensuring that those consumers looking for more value-oriented offerings, that we have that disposable opportunity in our portfolio, and we’ve seen that. I think outside of the U.S, the consumer has been quite constructive. We’ve seen a little bit more price value shopping in North America, but nothing too unusual right now, but we’ll have to watch that carefully as we move through the back half of the year. As I mentioned earlier, we’ve seen a little bit more volume on deal coming through North America, but nothing that’s not in line with historical numbers, quite frankly. Overall, U.S., watchful; Europe seems to be okay; Latin America, again you’ve seen the really strong volume growth over the last three or four quarters despite significant pricing, and so we’re seeing a good consumer environment there. Africa, Asia, Eurasia, strong, again good volume growth, and pleasingly starting to see some good volume growth coming back out of Asia and India specifically, which is encouraging."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Carey with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Chris Carey",
"content": "Hi, good morning."
},
{
"speaker": "Noel Wallace",
"content": "Morning Chris."
},
{
"speaker": "Chris Carey",
"content": "I just wanted to go back to the North America business, specifically around volume and investment posture, so just two parts to this. I guess first, the negative pricing in the quarter, is there a way to dimensionalize how much of that you think is the year-ago compare versus, say, actions that you’re taking in market a bit more offensively? Then just from a volume perspective, when does this volume number feel sustainable going into the back half? I know you have some compare dynamics in Fabuloso and in hand soap, but at the same time, I think in your prepared remarks you called out double-digit volume growth in toothpaste, which was quite a bit ahead of what we can see in the consumption data, so I’m just wondering if they’re both timing and also durable dynamics that you see in Q2 as we go into the back half. Thanks for those two."
},
{
"speaker": "Noel Wallace",
"content": "Yes, let me start with, I guess, the volume numbers overall. We feel obviously good strong growth in the quarter, largely toothpaste driven, but we saw it across all categories, which is terrific. We expect that to continue as comparisons in North America will be favorable for us in the third quarter and in the fourth quarter, so volumes should continue to track well. Let me get into a little bit of dimensionalizing the pricing. As you said, most of it was the comp, as you recall we had 10% price in Q1, 9% price in Q2 last year, and we talked specifically, as I mentioned earlier, that we may have pulled back a little bit too much on promotions in the second quarter, so the comparison was obviously very, very favorable, and we needed to get the promotion cadence back to where we need to. We had one particular retailer, as I mentioned, that we had pulled out of last year that came back online this year, which was encouraging to help drive some of the strong volume growth, but again I think the promotional cadence that we’ll see will be--or the pricing will be somewhat consistent with where we were in the second quarter as we move through the back half of the year, off a very strong year in 2023. Overall, what’s most encouraging is to see the elasticity there as we put a little bit more pricing in the market relative to coupon and promotion. We’re obviously seeing a great return on that relative to volume. Encouraging likewise, gross profit percent and gross margin dollars were up in North America, which is allowing us to continue to invest strongly behind the business, and we are encouraged by that particularly as we move in the back half of the year."
},
{
"speaker": "Operator",
"content": "The next question comes from Olivia Tong with Raymond James. Please go ahead."
},
{
"speaker": "Olivia Tong",
"content": "Thanks, good morning. I wanted to go back to Latin America, given that continues to be a very strong driver of your total company growth - obviously very strong volume, very strong price. But you called out Brazil and Mexico, so can you talk about what you’re seeing, any incremental concerns within the macros there, your sense of how the consumer is behaving in those key markets, as well as some of the other countries given the overall resonating of the growth in Latin America? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, great. Thank you Olivia. We’re encouraged in our two largest businesses, LatAm and Hill’s, both delivering really strong quarters, particularly at the EBIT line - LatAm up 50% on EBIT, Hill’s up 20%, so getting the big businesses growing at that level is encouraging for us. LatAm obviously continues to be such a consistently strong performer for us. Organic sales growth was strong, we saw good volume growth across all of our businesses. Every country was positive in volume with the exception of Argentina. This was led by Brazil, which was high single digits, which is really, really strong, and four quarters of mid-single digit volume growth in LatAm, so overall a pretty good consumer environment. I would say Brazil seems to be quite strong. Mexico slowed a little bit in the quarter, we’ll have to watch that carefully, but the rest of the region performed quite strongly. Oral care, as you mentioned, really strong performance, our market shares were up 90 basis points across the division, volume shares were up likewise across the division, so encouraged by that. The strong marketing and innovation that we put in, in the first half seems to be taking hold, so we think we’re well set up for continued, consistent growth as we move through the back half. I would characterize the consumer environment as pretty good, and the innovation that we have, particularly at the premium side, seems to be taking hold on whitening and some of the core re-launches seem to be driving some good success in terms of household penetration. So overall, we’re encouraged by LatAm and continue to believe it will be a great growth driver for us moving forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Steve Powers with Deutsche Bank. Please go ahead."
},
{
"speaker": "Steve Powers",
"content": "Hi guys, good morning. Thank you. Noel, I was hoping we could talk about pricing more broadly. It’s been a topic already, but it’s been the number one focus that I’ve heard from investors today, and really not just for Colgate, not just for North America, but for the industry at large, given what we’ve seen and heard from others, where arguably pricing is coming down faster than might have previously been expected, at least in significant pockets. It’s not hurting your performance today - you know, volumes and gross margins are great, strong reinvestment in the middle of the P&L, as you discussed. But I guess the question is, if the direction of travel is lower on pricing, again not just for Colgate but for the competitive set, is that volume and full P&L performance sustainable, and how do you think about that?"
},
{
"speaker": "Noel Wallace",
"content": "Yes, well listen, we know the market’s been focused on getting back to volume growth, but we’ve consistently talked about, and I talked about it certainly at Deutsche Bank in Paris, on the importance of that growth being balanced, that we were going to continue to focus on the strong revenue growth management principles we have in place, the price pack architecture work that we’re doing, and the necessity to continue to get pricing in the P&L. Now, as the inflationary environment becomes more benign, obviously we’ll see some foreign exchange transactional pricing that needs to go into the P&L, but we’re going to continue to be very focused on finding ways to drive some balanced pricing through the P&L, and we think we’ll continue to see that obviously in the back half of the year across most of our divisions. As I mentioned earlier, our revenue growth management capabilities are very, very strong right now, and that’s encouraging for us, to find ways where we’re seeing less inflationary pricing, to find ways to optimize category growth from a dollar standpoint. But we’ve talked about it consistently that we would see particularly this year inflect more towards volume than pricing, but that being said, the 4.2% pricing that we generated in the second quarter continues to be very, very strong in the context of the marketplace. I think that talks to the strength of our brands and our need to continue to offset some of the inflationary pressures that we saw in the business. So overall, we’ll see pricing in the second half come--be a little bit lower than where we were in the second quarter, but given the levels of raw material inflation and the benefit of FTG, we still feel good about where we are from a gross profit standpoint."
},
{
"speaker": "Operator",
"content": "The next question comes from Bryan Spillane with Bank of America. Please go ahead."
},
{
"speaker": "Bryan Spillane",
"content": "Hey, thanks Operator, and good morning everyone."
},
{
"speaker": "Noel Wallace",
"content": "Morning Bryan."
},
{
"speaker": "Bryan Spillane",
"content": "First, I just wanted to extend a happy birthday to Peter Grom - we all love Pete. Second, just a question, I guess, as we go into looking at the first half and going into the balance of the year, and thinking about just as we fill in our models, kind of the base that we’re using for ’24 for next year. I guess Noel, you’ve had upside in the first half, and I think last year there was some reinvestment, and I think as you started this year, you also spoke a bit about a bias, right, to balance the driving earnings growth but at the same time taking the opportunity when you have it, right, when things are good and you’ve got upside to reinvest. Can you give us a sense of just maybe the scope of reinvestment that’s occurred in the first half, and then as we’re thinking about the second half, would that be your bias? Have you identified potential areas to spend some money back that you hadn’t planned, and then finally in that, as we’re thinking about that for a base for ’25, is there anything we should consider with regards to the level of investment in ’25, whether this would be a good base off ’24? Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yes, thanks Bryan. Again, very consistent with what we’ve spoken about in the past, and that is getting the flexibility in the middle of the P&L to give us the opportunities to really direct advertising in areas where we’re going to get the best return on that investment. With the continued growth in gross margin dollars with the strong top line growth, that affords us that flexibility around the world, and at the same time, as I’ve mentioned, we are all over trying to improve the ROI of that spend in terms of getting more bang for the buck and being very deliberate in terms of how we approach the advertising, not increased advertising for the sake of increased advertising. The ROI culture that we’re implementing across the organization is very, very strong. Our intention is to continue to invest where we see a return on investment, and we see real opportunities for continued volume growth opportunities, particularly around household penetration and to build brand awareness, and we’ll continue to invest opportunistically where we see those opportunities. I don’t think there will be anything changing in the back half of this year. Our intention is to continue to invest behind the business and drive that top line consistently to drive the bottom compounding growth that we’ve talked about over the last three or four quarters."
},
{
"speaker": "Stan Sutula",
"content": "Bryan, just to add onto that, if you look, I think we’ve demonstrated a good track record here with our ROIC back over 33%. We’re on a mission for consistent, compounded EPS growth, and we’ll make those investments where we see the ROI, and I think our track record is pretty good here. We’ll look to continue that going forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Robert Ottenstein with Evercore ISI. Please go ahead."
},
{
"speaker": "Robert Ottenstein",
"content": "Great, thank you. First, a quick follow-up, just on North America. Given that you’re returning to historical or normal promotional levels, would it be fair to say that you don’t expect any kind of particular competitive response? Would just love to get color on that. Then my bigger picture question is it seems to us, and I think we see it in your results, that the consumer, at least certain groups of consumers are more willing perhaps than in the past to pay up for innovation and performance, perhaps more than pre-COVID levels. Is that in fact something that is true, that you’re seeing? Why would that be the case, and is it perhaps in combination with better communications on your part in terms of making clear exactly how the performance is better, and maybe what’s driving that better communications? Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, good morning Robert, thank you. Again, I think the overall promotional environment is constructive. As I mentioned, we may have pulled back a little bit too far last year as we pulled promotions out to get some pricing in the categories, and we’ve simply re-balanced that to, more importantly, probably match promotional pricing than certainly to lead it. Our intention is not to lead the category on a promotional cadence that can’t be sustained. Overall, we feel like it’s more or less consistent with where we are. We’ll continue to be very prudent and mindful on where we invest those dollars, and making sure that we see the volume and the gross margin where we need it to be to continue to sustain what we want to focus on, which is strong advertising building the brands and leveraging the strong innovation pipeline that we have. Now if I extend onto innovation, clearly we will continue to operate with a real focus on the premium side of the business, and we’re seeing great results from that across most of our divisions, where some of our premium innovation, particularly in whitening, now with the re-launch of Total going into Latin America, obviously Elmex and Meridol at the premium side with some of their innovations, we’re seeing great inflection on the premium side of the business. If you couple that with the strong core business innovation that we’ve had - Max Fresh in India, a great example of that, we’re seeing great core innovation that’s driving real value oriented points of difference versus our competitors, and that’s what we’ll focus on, making sure that consumers are willing to trade up based on the real strong proposition and the big selling idea behind that. We’ve talked about the science and the superiority of our brands, and we’re really trying to incorporate that much more into our messaging, to your point, to get the messaging stronger and the content delivery stronger. Overall, it’s a combination of all of what you discussed, making us be focused on ensuring that we have the innovation pipeline and the pricing in place to continue to sustain that strong top line growth."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Lieberman with Barclays. Please go ahead."
},
{
"speaker": "Lauren Lieberman",
"content": "Great, thanks. Good morning. I know you just mentioned Elmex and Meridol on the last question, but I wanted to ask a bit about that three-brand strategy in Europe and get just maybe a bit of an update on how you’re managing channel reach, if you’ve taken those more premium brands beyond the pharmacy channel in Europe, more countries that have been added maybe in the last few years that we’ve kind of lost sight of, and how applicable that strategy in particular may be to other markets, because I think I recall that you were launching one of the premium brands in Latin America a few years ago. I’m just curious if that’s progressed at all. Thanks."
},
{
"speaker": "Noel Wallace",
"content": "Yes, thanks Lauren, and you’re absolutely right - we launched Elmex in Brazil, and I’ll come back to that here at the end of my answer. But overall, it’s been a very deliberate strategy for us to really flex our portfolio far more than we have done historically and making sure that we’re capturing what are the unique needs and the consumer journey in the marketplace, and what are the growing parts of the category and particularly the therapeutic side of the category, which is where we were not seeing the level of growth that we needed. Using Elmex and Meridol particularly across Europe to capitalize on that growth has been very successful. You combine that with the strong focus we’ve had on whitening and multi-benefit in Total, as well as the Optic across the world, that gives us a unique combination of offerings to both the retail environments that we compete in as well as the consumer. The retail environment, we’ve been very disciplined about how we take Elmex and Meridol around the world, first and foremost. We’ve been very deliberate and selective on what markets we’re going to put that into, we’re not going to put it in for opportunity’s sake alone. We’re going to be strategic about where we do that, particularly where the pharmacy channel is strong and the therapeutic benefits are growing, and we have a unique offering to go get some of our competitors in that space. We’re going to be very selective on how we continue to take that around the world, but we will take it to new markets around the world where we see that opportunity. The point is, I think, getting the balance between Elmex, Meridol and Colgate right, and Europe has been a great test market for that, where we’re seeing very significant incremental growth across the whole entire franchise by being very focused on where we’re going to take those brands and how we advertise them. So overall, we feel good about that. Professional was the other aspect, and really focusing on the professional heritage of the Elmex and the Meridol brands. We’ve been very deliberate about going back to the profession, educating them on the science and the key point of difference behind the Elmex and the Meridol brands, and that’s certainly led to stronger endorsement levels from the profession, which obviously improve the premium-ness of the brand and the loyalty that we have behind those franchises. Oh, and you had a question in regards to--let me come back on LatAm, Lauren, quickly. Brazil was where we decided to take that brand - again, a very strong pharmacy class of trade, where we were not seeing the incremental growth that we wanted just with the Colgate franchise. We came in with the Elmex brand in LatAm, launched it in pharmacies in Sao Paulo only, and then decided to expand that based on the success that we had around the country, and we’ve seen that drive very significant incremental share in the pharmacy class of trade, so a great combination of portfolio offerings to the pharmacist in terms of being high end therapeutic with the Elmex brand, and making sure that we had the core offerings for the pharmacist as well with the Colgate brand, so it’s been a great combination for us to leverage that portfolio. We’ll use that as a proxy as we think about new markets around the world, but again a very consistent and disciplined go-to-market strategy, only launching in pharmacy, building the brand through the profession, and then finding ways to potentially democratize that brand as we move forward, but we’re going to be very deliberate and very cautious as we do that to ensure that the brand is well established and well seated in the marketplace, based on its credentials."
},
{
"speaker": "Operator",
"content": "The last question will come from Mark Astrachan with Stifel. Please go ahead."
},
{
"speaker": "Mark Astrachan",
"content": "Yes, thanks, and good morning everybody. I wanted to ask a couple of questions, one more of a clarification on the North America commentary and the shift to lower priced channels. We can see in the scanner data these days the shift to Costco and Amazon, as an example, and the growth is eight, nine times what it is in the legacy tracked channels. Are you referring to those as lower priced channels? If not, I guess I’m curious what’s driving the growth. It’s been there for at least a number of quarters now, so what’s driving the share shift into those channels? Then separately, unrelatedly on Prescription Diet and your commentary around the supply chain flexibility increasing shelf space and volume, we started to see some of it in the pet specialty channel, but you still have a sign up there that says you need to have a prescription to buy the product, so I guess I’m curious how that works in terms of to get on shelf, you increase brand awareness and it sort of sells from there, and if you could provide just the mix of the Prescription versus the rest of the business, that’d be helpful too. Thank you."
},
{
"speaker": "Noel Wallace",
"content": "Yes, thanks Mark. Let me take the retail channel. This has been, I think, nothing new here, quite frankly. I wouldn’t say it’s been a huge inflection in terms of shift. You’ve seen the non-tracked Nielsen channels consistently growing faster than the tracked Nielsen channels, and there is a value play there obviously with some of the club offerings. But overall, I think all the channels are looking very, very carefully at their value proposition and the price pack architectures and finding ways to ensure that there’s a value orientation back to the consumer without losing, obviously, the great pricing that’s come through the P&Ls or the categories over the last couple years. I don’t anticipate those shifts will be anything different moving forward. We’ll continue to see, I think, more consistent with where we’ve been in the past, and we’re well prepared to continue to capitalize on those shifts. But the encouraging aspect is growing the Nielsen tracked channels as you’ve seen, as I mentioned earlier, the strong volume share growth that we’ve had in the Nielsen tracked channels. We’re encouraged by that -it suggests that obviously the innovation and the value proposition that we’re offering to our trade customers to grow their categories continues to be quite solid. On Prescription Diet, again a great opportunity for us to continue to grow the Prescription Diet business. We’ve talked about it in the past, where the Prescription Diet opportunity with only--less than 5% of pets are using a therapeutic nutrition today, and while our studies show, as you’ve heard me saying--talk about in the past, that 80% of pets can benefit from the therapeutic nutrition, so we’re very focused on making sure pet specialty, our vet partners, etc. have the plethora of offerings that we bring to the market, and the increased capacity that we have with Tonganoxie coming online and allowing us to optimize our network and provide more of our offerings to the retail environment on a consistent basis is playing out quite nicely for the brand, getting more of those recipes into pet specialty and neighborhood pet stores, as well as making sure we have consistent supply to our veterinary professions, where they recommend and provide that recommendation to their pet owners has been terrific for it, so we will continue to make sure that offering expands and making sure that we continue to look for ways to increase the mix towards Prescription Diet, which is a real benefit for the pet owner."
},
{
"speaker": "Operator",
"content": "This concludes the Q&A portion of our call. I will now return the call to Noel Wallace, Colgate-Palmolive’s Chairman, President and CEO for any closing remarks."
},
{
"speaker": "Noel Wallace",
"content": "Well, thank you all for joining us today, and I just want to applaud all the Colgate-Palmolive team around the world for the exceptional efforts to deliver strong top and bottom line growth. Importantly, we’re doing that while we’re building capabilities we need to stay strong moving forward, so that’s terrific work by all the team. But I remind us, as always, that we’re only halfway through the year and we still have a lot of work to be done, so thanks to everyone and appreciate the great discussion this morning."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today’s call. You may now disconnect."
}
] |
cl | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to today's Colgate-Palmolive's First Quarter 2024 Earnings Conference Call. This call is being recorded and is being simulcast live at www.colgatepalmolive.com."
},
{
"speaker": "",
"content": "Now for opening remarks, I'd like to turn this call over to Chief Investor Relations Officer and Executive Vice President, M&A, John Faucher."
},
{
"speaker": "John Faucher",
"content": "Thanks, Betty. Good morning, and welcome to our first quarter 2024 earnings release conference call. This is John Faucher. Today's conference call will include forward-looking statements. Actual results could differ materially from these statements. Please refer to the first quarter 2024 earnings press release and related prepared materials and our most recent filings with the SEC, including our first quarter 2024 quarterly report on Form 10-Q and subsequent SEC filings, all available on Colgate's website, for a discussion of the factors that could cause actual results to differ materially from these statements."
},
{
"speaker": "",
"content": "This conference call will also include a discussion of non-GAAP financial measures, including those identified in tables 3, 5 and 6 of the earnings press release. A full reconciliation to the corresponding GAAP financial measures is included in the first quarter 2024 earnings press release and is available on Colgate's website."
},
{
"speaker": "",
"content": "Joining me on the call this morning are Noel Wallace, Chairman, President and Chief Executive Officer; and Stan Sutula, Chief Financial Officer. Noel will provide you with some thoughts on our Q1 results and our 2024 outlook, and we will then open it up for Q&A. Noel?"
},
{
"speaker": "Noel Wallace",
"content": "Thanks, John, and good morning, everyone, and thanks for joining us to discuss our strong start to 2024. I would like to make 2 points today on why we think we are well positioned to continue to drive shareholder value through delivering consistent, compounded earnings per share growth."
},
{
"speaker": "",
"content": "The first is the importance of balanced top line growth. You've heard me speak over the past several years of our focus on delivering balanced organic sales growth, growth in all of our categories, growth in all of our divisions and growth in both volume and pricing. That's what we did this quarter. We delivered organic sales growth in all 4 of our categories, all 6 of our divisions and volume and pricing growth on a total company basis. The balance allowed us to deliver on a base business, 6% net sales growth on top of 6.5% net sales growth in Q1 2023 despite a nearly 4% headwind from foreign exchange."
},
{
"speaker": "",
"content": "The focus on balance between pricing and volume growth allowed us to deliver solid volume growth this quarter, even with the continued volume softness in China and the expected headwind from lower private label growth as we transferred more Hill's volume into our Pet Nutrition manufacturing network. Oral Care, Personal Care and Home Care each grew volume in the quarter with volume growth of 3% for all 3 categories combined."
},
{
"speaker": "",
"content": "Our revamped strategy and increased advertising spending have allowed us to drive growth across a greater percentage of our portfolio and our focus on core innovation is keeping our biggest brands relevant and vibrant in consumers' minds. We still have work to do, but our balanced strategy continues to yield results, including continued growth in our Global Oral Care shares, which leads me to my second point, which is flexibility in the P&L. Our focus on revenue growth management and driving our Funding-the-Growth initiatives enable us to achieve a 60% gross margin in the quarter despite significant headwinds from transactional foreign exchange."
},
{
"speaker": "",
"content": "Our commitment to productivity in the middle of the P&L allowed us to drive 30 basis points of overhead leverage while still continuing to invest in strategic capabilities like digital, data and analytics, all topics we discussed at CAGNY, and prudent balance sheet management allow us to deliver 18% base business earnings growth despite the year-over-year increase in interest expense and the impact from devaluations around the globe."
},
{
"speaker": "",
"content": "And most importantly, despite an expected mid-single-digit negative impact from foreign exchange, we're guiding to mid- to high single-digit base business earnings per share growth. And we're doing this in the context of meaningful increases in brand investment that will set the stage for growth in the future. This is a testament to the ability of our team to consistently execute our strategy and seize growth opportunities while also preparing to better withstand the inevitable headwinds of running a global business."
},
{
"speaker": "",
"content": "So with that, I'll take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question today comes from Steve Powers with Deutsche Bank."
},
{
"speaker": "Stephen Robert Powers",
"content": "So really exceptional business performance this quarter, more or less on all fronts. But I wanted to drill down into your organic growth guidance raise for the year. It seems about half of that, that 2-point increase is being driven by inflationary pricing as an offset to FX and fair enough on that. But there also seems to be at least a point beyond that attributable to upside that you're seeing in real terms across the portfolio."
},
{
"speaker": "",
"content": "So I'm curious if you could expand on where that upside is coming from versus your prior expectations. And if you'd say more of that is being driven by category growth or it's more being driven by your own market share momentum?"
},
{
"speaker": "Noel Wallace",
"content": "Great. Thanks, Steve. I'd come back to the points I made in my upfront comments around balanced organic sales growth. I mean we're getting really good quality coming through on the volume line. You saw the 1.3. That was with the headwind of private label that we're obviously exiting on the Hill's business. and strong pricing across the board, mid-single-digit pricing ex the impact of Argentina. And as you point out, we're seeing nice share growth consistently around the world that's driving obviously that top line organic growth and the top line sales growth. But we're most pleased with, I think, is the balance we're getting both on volume and price. We're able to still get pricing, not just inflationary pricing, but we still have pricing going through the categories, particularly in some of the markets where we've had more inflationary impact from raw materials."
},
{
"speaker": "",
"content": "Hill's would be a good example of that. We took some more pricing in the first quarter. The pricing has obviously led to good value accretion in the category and allowed us to drive some value shares. The other important point is we've seen really good momentum in our volume shares. The U.S. had good growth on volume share in toothpaste. We've seen consistent volume share growth, both in Europe and in Latin America across our portfolio."
},
{
"speaker": "",
"content": "So it's really broad-based across the strategy that we're trying to execute, balanced volume, balance price, good initiatives through the innovation that we're putting into the market. And then importantly, is the continued robust investment. We're seeing that really pay out in terms of driving not only category growth in the markets where we're spending, but most importantly, allowing us to grow share in the categories where we're spending money."
},
{
"speaker": "",
"content": "So overall, it's, I think, a reflection of the strategy and a reflection of the balance that we have across both price and volume."
},
{
"speaker": "Operator",
"content": "The next question comes from Melanie Schultz with Evercore ISI."
},
{
"speaker": "Robert Ottenstein",
"content": "Robert Ottenstein here. Noel, let's kind of maybe do a deep dive on Oral Care. Can you talk a little bit about the market share trends by region? And more -- a little bit more specifically, are you gaining share more from other international players that may have more similar type of products or local players that are maybe more idiosyncratic? And what are the key drivers to the share growth. Is it more the fact that you're increasing share of voice? Or are there particular product areas like whitening that are really engaging consumers now more than they did in the past."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks, Rob. It's a little bit of all of what you've just said. So overall, really pleased with the growth and the acceleration of market shares globally. You saw that -- in the prepared remarks. You saw that in some of the slides that we provided, particularly on the Whitening segment. And it's really a function of the strategy that we've been executing for the last couple of years and really starting to see the fruits of all that effort."
},
{
"speaker": "",
"content": "So the growth is coming, obviously, from a good growth in Europe, which we talked about, we're at record shares in Europe, that's a balance between Colgate and our therapeutic brands of elmex and meridol, so good spending behind those businesses. And we're seeing, obviously, that translate into good share growth, particularly in some of the big markets across Europe."
},
{
"speaker": "",
"content": "Likewise, we're seeing the benefits of that deployed across Africa, where we've launched some of those high-end therapeutic brands as well. North America, the scanner data has been improving as you've seen. But the shares will continue to be a bit choppy there as we move forward, given some of the strategic changes we've taken with some of the drug class that trade on the promotional environment. Latin America had growth in both value and volume. That was driven both from, I think, the mix and diversity of our portfolio across Latin America, both at the high end and at the entry price point, given the breadth of portfolio offerings that we have there, and obviously, the increased spending that we're putting behind some of the good innovation."
},
{
"speaker": "",
"content": "So it's really broad-based, good spending, good innovation, across the board and importantly, a credit to the teams and their execution on the ground. And so we see that obviously continuing as we continue to hold investment through the balance of the year, and that share growth is coming from both the multinational competitors as well as local competitors. So broad-based across the board. We're pleased with where we are. We have more work to do, particularly in North America, but overall, a good performance."
},
{
"speaker": "Operator",
"content": "The next question comes from Peter Grom with UBS."
},
{
"speaker": "Peter Grom",
"content": "I had a question on the gross margin performance. And just kind of how to think about the path from here. We've kind of seen the sequential margin progression over the last 6 quarters or so. But in the prepared remarks, you touched on certain costs will increase as you move through the year. So just any thoughts on how we should think about the gross margin progression from here would be helpful. And then just within that cost savings, any commentary you can share in terms of how we should be thinking about funding the growth is in the context of a very solid start to the year."
},
{
"speaker": "Noel Wallace",
"content": "Great. Let me talk about more conceptually strategically, and I'll let Stan handle some of the more specifics on your question. So overall, as we think about the year unfolding, as we've talked about, I think, quite consistently, we'll see pricing start to ladder down as we move through the balance of the year, although we will get inflationary pricing, we still have some pricing that we're taking in some markets."
},
{
"speaker": "",
"content": "And I would say we're deeply pleased with the revenue growth management efforts that we have around the world and the -- what that's delivering for us in terms of pricing in the market and driving category value."
},
{
"speaker": "",
"content": "You've seen, obviously, the impact on raw materials in the first quarter. We'll start to see that elevate a bit more in the back half. And obviously, the significant impact from transactional due to the foreign exchange headwinds that we face. That being said, we feel very good about the guidance that we provided, strategically about growing gross margins in 2024. We'll get that through, obviously, the funding the growth efforts that we have, good mix in terms of how we're deploying some of our therapeutic brands around the world. Taking pricing where we need to take to offset particularly inflationary foreign exchange and obviously, a very focused on the middle of the P&L, making sure we continue to get leverage there."
},
{
"speaker": "",
"content": "So overall, strategically, we feel good, but we'll see pricing ladder down. It won't have as much impact in the year to go as it just had in the first half, but overall, we feel good about where we are. Stan?"
},
{
"speaker": "Stanley Sutula",
"content": "Yes. So I'd pick up that -- look, we're very pleased with the margin performance in Q1, up 310 basis points year-to-year and improved sequentially. We had a slight benefit from Argentina, but the overall underlying margin improvement was quite good. We've guided for margin expansion for the year, and we're confident we can deliver. There's a couple of headwinds in here and tailwinds. We talked about the modest raw material inflation, as you've heard from others as well. We expect that will slightly escalate as we go through the year."
},
{
"speaker": "",
"content": "And then we've all watched FX. FX, the transactional impact has been bouncing around, but that will be a headwind as we go into the year as well. On the tailwinds, Noel mentioned earlier, we've got great revenue growth management programs in place globally, and we're seeing the benefit from all of those. And we have a proven track record on our funding the growth. We had a very good start to funding the growth. We've got a very good pipeline for funding the growth and the teams, I think, have that dialed in here as we go forward."
},
{
"speaker": "",
"content": "And then importantly, we've talked about the return to volume growth. And in that, we get some scale benefits and leverage as that volume flows through our manufacturing facilities. So overall, we expect to expand margin. You'll see that on a year-on-year basis. I think as you think sequentially, that will be more modest, but we expand margin for the year, and the efforts around RGM and FTG will be able to compensate for the headwinds that we see in FX transactional and raw materials."
},
{
"speaker": "Operator",
"content": "The next question comes from Filippo Falorni with Citi."
},
{
"speaker": "Filippo Falorni",
"content": "So Noel, you mentioned in the prepared remarks for the Hill's pet food business that you're expecting sequential volume improvement throughout the year. Maybe can you give us some color on the puts and takes with the less impact from private label volumes in top line? And also, just any sense of the contribution from innovation expansion into wet pet food and any color on the trajectory of the business, would be helpful."
},
{
"speaker": "Noel Wallace",
"content": "So as we said in the prepared remarks, really pleased with the performance at Hill's in the quarter in what's a pretty tough operating environment. Volume was closer to flat ex the impact of private label and that was sequentially up, which is good. And we had very good pricing, as we discussed, coming out of the year in 2023 and our need to continue to offset some of the agricultural inflation that we saw in the back half of '23 moving into '24."
},
{
"speaker": "",
"content": "Category volume overall has been a bit sluggish in the category, but I think what's most important is to see that the sluggishness has been more of a decline in treats and a little bit of conversion from wet to dry, and that's obviously important for us to think about as we strategically move some of the bigger part of our businesses, which are in the dry segment going forward."
},
{
"speaker": "",
"content": "Really importantly, though, is the fact that we generated really strong share growth in the first quarter of the year behind the Hill's business. We're cross up in pet specialty, up in neighborhood pet, penetration continues to grow. We had both share growth in our Science Diet business as well as Prescription Diet. And I think this is a reflection of the continued strategy that we're deploying, great innovation, great partnership with pet specialty in terms of driving their categories and making sure that we have ample advertising to talk about the science-driven nutrition that we provide to the market."
},
{
"speaker": "",
"content": "So overall, we feel very good about where the Hill's business is, that business grew high single digits ex the impact of private label. So we feel we're well positioned, but we're not immune to some of the sluggishness in the category. But again, as we've talked about in the past, we have low brand awareness and low brand penetration. So a lot of upside to continue to go after as we execute our strategy."
},
{
"speaker": "Stanley Sutula",
"content": "The only thing I'd add there is that the investment in capacity has also enabled us to bring in some product that was being co-manufactured before, which improves reliability and delivery and also will improve our margins over time."
},
{
"speaker": "Noel Wallace",
"content": "And to your point on, Filippo, on wet, obviously, there's some opportunities for us as we're very low indexed in wet. And particularly in segments like cat, where there's a lot of wet food consumed, we have an opportunity to leverage the new manufacturing that we have and get more formulas into the market and obviously, more growth for the business."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrea Teixeira with JPMorgan."
},
{
"speaker": "Andrea Teixeira",
"content": "Noel, we spoke to the underlying volume growth in all regions and your revenue growth management definitely sets you apart, but can you comment on how you see the consumer behavior, in particular in the low-end consumer in the U.S. and China, which seems to be a concern to some of your peers."
},
{
"speaker": "",
"content": "And you have historically protect your price points and keeping consumers in the category, but I would love to see the examples that you may highlight by your team in the U.S. and in China and how they've been using this portfolio management to barbell between affordability and premiumization."
},
{
"speaker": "Noel Wallace",
"content": "Yes. I think as we've talked about, thanks for the question, the consumer has been quite constructive. I mean, we've seen obviously the significant inflation move through the category over the last year. We expected that we would see a return to volume growth as inflation became more benign and as pricing started to stabilize in the categories, and that's principally what's happened. Interesting to note that as you take the aggregate of our categories, by and large, the categories are still negative. So the volume growth that we had and delivered in the quarter, which suggests obviously, that we're growing good volume share. And I think that's a reflection of the broad-based strategy that we're deploying."
},
{
"speaker": "",
"content": "One, we have good innovation at the top end of the category, particularly on the therapeutic side, whether that's in whitening, in the premium side, whether that's the Total Plaque that we've launched, whether that's therapeutic with meridol and elmex as well as a lot of big core innovation. We talked about the fact that a lot of our big core portfolio, particularly in toothpaste, is at that entry or mid-price level. And so we've spent a lot of time innovating at the core to ensure that we keep those brands vibrant and we offer consumers real value and real benefits as they come into the category or they're trading down from mid-price to perhaps entry."
},
{
"speaker": "",
"content": "You've seen some of the sluggishness in China, to your point, come from the rural segment. Clearly, that consumer is a bit more challenged in China right now. The premium segment continues to be quite robust. But our Darlie franchise is well positioned longer term, we think, to continue to leverage some of the rural softness that we're seeing in the category and make sure that we drive share."
},
{
"speaker": "",
"content": "The Colgate business had a terrific quarter in China. And that's, I think, a reflection of the move to the premium side of the business as we've really gone a lot more on to e-commerce with premium offerings, but overall, we're seeing, I think, a balanced consumer. The key is making sure that we're providing the reasons to use our products and the advertising that we're executing across the market is very, very important to, one, justify the price increases that came through the category last year, but really to drive trade-up in the categories to ensure consumers see the real value and science-driven benefits of our products in our portfolio."
},
{
"speaker": "Operator",
"content": "The next question comes from Bonnie Herzog with Goldman Sachs."
},
{
"speaker": "Bonnie Herzog",
"content": "I had a question on your ad spend, which is one of the highest as a percentage of sales among your peers. Noel, you touched on this, but hoping you could talk a little further about your strategy to continue to increase spend. And then ultimately, what you believe is the right level of marketing spend moving forward as well as maybe opportunities to improve ROI."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks, Bonnie. I'll start with the end of your question, which is we're seeing terrific ROI in the business. And I think that's translated into the results in the quarter. Obviously, good volume growth, helping to -- certainly above the category, share growth pretty consistently around the world in both value and volume. We're seeing our premium innovations take share, and we're obviously spending a disproportionate amount of our advertising to drive premiumization and category value."
},
{
"speaker": "",
"content": "You heard Diana talk at CAGNY about I think a lot of the discipline that we're putting into our media spend on using data and analytics to really justify the spend everywhere we are, drive more personalization and return on that investment. So again, we're very pleased with the increase in advertising and ultimately what it's delivering."
},
{
"speaker": "",
"content": "As I mentioned in my upfront, what's also terrific for the business right now is the broad-based spending we have on the portfolio. And what I mean by that is we've moved from exclusively Oral Care and Pet, which was getting a significant amount of spend over the last couple of years to making sure that some of our strong brands around the world are getting their fair share of the advertising, and we've seen a great return on that investment."
},
{
"speaker": "",
"content": "Europe would be a great example of that. We're spending behind our Personal Care business in Europe. Sanex is just an extraordinarily strong brand there, the spending behind some of our innovations driving good share growth and good execution in store. So overall, that's having a pretty systematic impact on the business, and we're pleased with the results that we're getting."
},
{
"speaker": "",
"content": "Moving forward, as I've said, consistently, I think, over the last 3 or 4 quarters, we will continue to invest in this business for the long term and building brand saliency and keeping our brands vibrant is the best way to driving that consistency."
},
{
"speaker": "Operator",
"content": "The next question comes from Olivia Tong with Raymond James."
},
{
"speaker": "Olivia Tong Cheang",
"content": "I wanted to ask you a little bit about your organic sales guide for the rest of the year. Obviously, contextually understand why you wouldn't flow the 10 points continuing. But why would organic sales decelerate as the comp fees? Presumably, you're getting more pricing? Clearly, we understand that this is a very dynamic environment, but would love to get a little bit more color in terms of your expectations for the rest of the year because it sounds like you're very bullish on innovation, on pricing capabilities, and volume acceleration, et cetera. I would appreciate a little bit more color there."
},
{
"speaker": "Noel Wallace",
"content": "Sure. Thanks, Olivia. So clearly, some of the comps get more difficult as we go through the year to go. We took obviously a lot of pricing. We'll see that pricing become more benign or slow in the back half of the year that will -- to be determined how much of that comes back into volume. The good news is the first quarter and some of the success that we saw in the fourth quarter, give us confidence that the volume is returning as we expected. The elasticities are in line with as we expected."
},
{
"speaker": "",
"content": "So we feel pretty good about where we are. Again, I think the biggest differentiator here in terms of how we think about is we're only in the first quarter. There's a lot of economic uncertainty out there in terms of what's happening. We still see foreign exchange being a headwind. That will certainly have an impact as we have to take pricing in some markets. Interest is going to stay stubbornly high. We expect through the balance of the year."
},
{
"speaker": "",
"content": "So overall, we're still early in the year, very confident in the guidance we've provided and the strategy that we're executing, but we want to make sure we maintain operational flexibility through the balance of the year to ensure we continue to execute the strategy that we've been communicating to drive consistent compounded earnings share growth."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Carey with Wells Fargo."
},
{
"speaker": "Christopher Carey",
"content": "One quick follow-up on gross margin and then a question on North America. So on gross margin, I think there was an expectation that Q1 would be down quarter-over-quarter relative to Q4, clearly, very strong delivery in the quarter. Stan, you mentioned a bit of benefit from Argentina. Or are you seeing better developments elsewhere, whether that's in commodities, perhaps some of the new pricing on Hill's or maybe you're over-delivering on productivity. So just maybe contextualize what seems to have come in a bit better there?"
},
{
"speaker": "",
"content": "And just on North America, it was the best volume growth in nearly 2 years. I realize Fabuloso was a benefit there. But Noel, you also mentioned needing to work on market shares. Can you maybe just help us understand the underlying momentum of the business right now and how to think about this going forward?"
},
{
"speaker": "Noel Wallace",
"content": "Sure. Thanks for the question. Let me take the North America and then I'll let Stan jump into some of your questions around gross profit. Overall, the strategy in North America that we're executing, we feel good about it. We've been very focused, as we've talked about before on improving the middle of the P&L, getting gross margins back to where they needed to get to, getting operating margins where they need to get back to and reinvesting that into the business in order to drive market shares."
},
{
"speaker": "",
"content": "The value shares, as I mentioned, we have been a little bit choppy and will continue to be a little bit choppy for the reasons I stated earlier. However, we are seeing better execution of our innovation and our promotional strategies, and that's helping to drive nice volume share in the quarter, both across toothpaste, which was up nicely and toothbrushes from a volume standpoint."
},
{
"speaker": "",
"content": "So again, we feel good about that, and we still have a lot of work to do across the business, as we've talked about on prior calls, and I've got great confidence in Jesper and his team and the strategy that we're deploying with real patience because we know it's going to take some time, but we feel in the long term, we're going to end up in a much better place from that."
},
{
"speaker": "",
"content": "The other thing I'd say is that non-Nielsen business in the North America business continues to grow at multiples of the Nielsen business. And obviously, that's not captured in the market share. So we feel good about overall health in the business, but we'll consistently continue to drive the opportunities that we see in the Nielsen-based accounts."
},
{
"speaker": "Stanley Sutula",
"content": "And Chris, your question on the sequential margin improvement, first of all, I'm pleased with that sequential margin improvement. Argentina was a little bit less of a headwind. And as you watch that FX, it's been very volatile. We've taken actions to address it, including sourcing changes, pricing changes et cetera. And then the team candidly executed really well."
},
{
"speaker": "",
"content": "I mean we get a little bit of scale benefit from volume we get some improvement from RGM and the funding the growth was great execution starting the year. So we love the start to the year, and we know FX is going to continue to be volatile, not just in Argentina but in many areas around the world. So a solid start to the year, slightly better than we anticipated on a sequential basis, but pleased with the progress."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Lieberman with Barclays."
},
{
"speaker": "Lauren Lieberman",
"content": "I was wondering if you can talk a little bit about Europe. Numbers were super strong. A little bit of context around where you're seeing particular areas of strength and volume would be great. And then just any recent thoughts on private label Unilever brought up yesterday seeing a little more incremental pressure from private label in Europe. So I was just curious to hear your perspective on that as well."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks, Lauren. A great quarter for Europe. And again, a terrific execution from the team on the ground. Overall, really, really strong with growth across the vast majority of our business, and it wasn't just Oral Care, it was pretty broad-based. And obviously, as you saw, volumes inflected positively given that we're still getting pricing in the category."
},
{
"speaker": "",
"content": "So pricing will ramp down as we move through the balance of the year. The big change, I think, is our investment strategy in Europe. We see real opportunities for growth, particularly in the Oral Care and Personal Care segment, as we execute some of the innovations that we have there, the meridol and elmex shares broad-based across Europe are at record levels and growing really, really nicely."
},
{
"speaker": "",
"content": "Again, that is a shift in strategy and what's nice is we're getting the complementary growth on the Colgate side of the business, particularly as we're more focused on the whitening opportunity that we have. So a great portfolio of brands that we're leveraging, we think, more strategically around the region. So the market shares overall look pretty good."
},
{
"speaker": "",
"content": "In terms of private label, as you know, private label has higher penetration in Europe than it does anywhere else in the world. We have seen some acceleration in some of the home care categories, whether it's dish liquid or fabric softeners or floor cleaners, but that being said, we continue to have good growth across our business, particularly as we -- as I mentioned earlier, broadened the investment strategy across a wider array of our brands in Europe."
},
{
"speaker": "Operator",
"content": "The next question comes from Bryan Spillane with Bank of America."
},
{
"speaker": "Bryan Spillane",
"content": "Stan, just had a couple of questions just related to cash flow. One, I don't know -- maybe I missed it, but if we have a guide for capital spending for the year? And then I think you refinanced or you funded a maturity in the middle of the quarter with commercial paper, just kind of curious there, did you just looking to pay it down? Or will you look to refinance that or term it out at some point?"
},
{
"speaker": "",
"content": "And then maybe just more broadly, as you're thinking about cash flow given where exchange rates have moved, interest rates have moved, just any other thoughts on how we should be thinking about like free cash flow conversion this year and uses of free cash flow."
},
{
"speaker": "Stanley Sutula",
"content": "Yes. Bryan, thanks for the question. So first, we're pleased with the cash flow performance, a really solid start for the quarter. We're down a little bit year-over-year, but I remind you, last year was a terrific cash quarter, and this was really driven by receivables, which were impacted by the timing of Easter. In fact, we've looked at the first couple of days of the quarter and that collection period completely brought DSO back in line. So we're very comfortable with that."
},
{
"speaker": "",
"content": "So our cash profits really have been helped from the top line growth. And the net working capital execution, I was very pleased with what the team accomplished here in first quarter, particularly around inventory. So even with the Red Sea challenges and building up a little safety stock in certain areas, great execution on inventory. We saw the inventory days improve, DSO strictly timing."
},
{
"speaker": "",
"content": "In regards to your question on CapEx, we had said previously that we expect CapEx as a percent of sales to be lower than last year. And it's really driven by [ Tide ] and Oxy, kind of coming online and that investment dollar is dropping off. If we look at our leverage, the strong cash flow and execution has allowed us to bring our leverage using the S&P methodology down to 1.8x, so an improvement from year-end."
},
{
"speaker": "",
"content": "And to your point, we did pay back a bond here in first quarter of $500 million, and we did that with CP and 2 reasons. One, we had very good strong cash flow; and two, at some point, we expect interest rates will come down, though that appears to be sliding further out to the right, and that will help us keep our fixed floating back in balance."
},
{
"speaker": "",
"content": "So again, as we look at cash flow, strong performance and as we think about that, it kind of goes back into the capital allocation, and I think you've seen that manifest ourselves in our strategy, that capital allocation hasn't changed, invest in the business, and you're going to see CapEx go up and down, we're investing in advertising. Return to shareholders, we had a dividend increase, and you saw our share buyback in the quarter and then M&A, where we look at options to improve our overall portfolio."
},
{
"speaker": "Noel Wallace",
"content": "Yes, Bryan, the only thing I would add is, again, picking up on the theme of flexibility, it's not only flexibility throughout the P&L, but it's having a really strong balance sheet that gives us the flexibility to deploy capital as we see the best return on that investment. And I give Stan and the finance organization huge credit and the discipline that they're bringing around the world to ensure that the cash generation continues to be robust."
},
{
"speaker": "Operator",
"content": "The next question comes from Mark Astrachan with Stifel."
},
{
"speaker": "Mark Astrachan",
"content": "I wanted to go back to North America and the outperformance of these untracked channels. We can now start to see in some of the data, the distinction between the new and the legacy channels, and it's pretty stark in your business, in particular, Hill's specifically, but overall, there's just a lot more growth in those channels, I guess that they're smaller."
},
{
"speaker": "",
"content": "But curious on your take on what is driving that, that exceptional outperformance. And how sustainable is it in terms of these other places like Costco, Amazon, et cetera, that's contributing to that growth overall, and I'm specifically looking to at Hill's, which is really doing quite well in those new channels."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks. So again, we've been talking about that for quite some time, and that has been, I think, a reflection of the strategy that we've talked about for 3 years, which is core adjacencies and channels and getting back to real focus and understanding the consumer journey across all of the markets in which we compete has been fundamental to making sure that we have strategies to capture and deploy our investments in areas where we think we're going to get the best return for that."
},
{
"speaker": "",
"content": "And some of these emerging channels that are not captured by Nielsen are very, very important, whether that's hard discount stores in parts of the world. Whether that's the club store environment, where the value pack in large sizes continue to be a big growth driver, whether that's the ease and convenience of shopping online and some of the digital execution and understanding the digital shelf and the discipline that we brought to that, that ultimately is being seen through the success that we're having in those alternative channels."
},
{
"speaker": "",
"content": "We don't anticipate that, that will change. I think as some of the classical brick-and-mortar retailers really up their game, and we're certainly seeing that across the U.S. markets where the big players are certainly becoming far more sophisticated and progressive with their offerings and their shopper experience. We're partnering with them to ensure that we're -- our brands are involved in that journey that they're on, and making sure that we're bringing our digital capabilities to the entire omnichannel environment and making sure that Colgate and the brands that we offer at the forefront of that."
},
{
"speaker": "",
"content": "So it's, again, shopper journey the experience that the shoppers are getting, the value orientation on some of those channels and our ability to be much more targeted with some of our spend, and that's particularly related to the online retailers."
},
{
"speaker": "Operator",
"content": "Next question comes from Brett Cooper with Consumer Edge Research."
},
{
"speaker": "Brett Cooper",
"content": "A question for you on the competitive environment and outlook. It would appear to date that promotional activity and competition hasn't ramped to the extent that some of your peers and some of your large peers are looking to accelerate growth via reinvestments. So would love to hear first whether that assessment on the environment is accurate generally. And then your perspective on whether there's enough opportunity to elevate category growth via things like household penetration growth, premiumization and share gain to net higher levels of growth? Or is all of this reinvestment just the new cost of doing business?"
},
{
"speaker": "Noel Wallace",
"content": "Yes. Thanks, Brett. What's interesting is you're seeing -- I think you're hearing that a lot of the competitive set has focused on building healthy category growth, and that's two ways: one, with increased media investment and the second is with increased innovation. We have not seen a fundamental shift around the world to more volume sold on promotion. It's still below where we were pre-COVID. Now as volume becomes the important aspect here, you may see some players move to that strategy of doing more promotions. But overall, the category has been very constructive in terms of big players spending money on media, driving value to the categories through innovation, and offerings that are differentiated in the marketplace. And so it's incumbent upon us to ensure that our innovations continue to drive real value to the category and the differentiation in a very competitive market and making sure that we're using the analytics and the data that we have to drive balanced promotional strategies in the categories."
},
{
"speaker": "",
"content": "We'll be competitive where we need to be. I mentioned we've made some difficult decisions in the U.S. business to not chase a lot of deep down in promotions, particularly in certain retail environments that will have a short-term impact on the Nielsen shares, but long term, we feel we're going to deploy that money in an effective way. And again, it's making sure that we continue to drive saliency of our brands and the health of our brands long term, and we do that through media and innovation, not necessarily through promotions."
},
{
"speaker": "Operator",
"content": "The next question comes from Alejandro Zamacona with HSBC."
},
{
"speaker": "Alejandro Zamacona Urquiza",
"content": "Just a kind of follow-up on Latin America. So given the strong organic sales growth in the last few quarters, what should we expect going forward? I mean, to what extent the consumer is willing to continue to accept meaningful price increases without giving up volumes."
},
{
"speaker": "Noel Wallace",
"content": "Yes. Again, let me contextualize Latin America. Obviously, a really strong organic sales growth quarter, with and without Argentina, there was good volume growth across every single hub led by Brazil, which was up double digits. If I take the last 4 quarters of Latin America in terms of volume, 0.5, 5.4, 8, and 6.2. So again, very consistent with what we talked about."
},
{
"speaker": "",
"content": "Our ability to get pricing early in the market has allowed us now to see the volume return to the categories and ultimately into our business. Our marketing is really strong and innovation is very strong on the ground, and so we feel very good about where we're seeing. And that's been translated into really positive share growth for the business."
},
{
"speaker": "",
"content": "So ex Argentina, very good organic growth. Organic up significantly in the region. I think you saw double-digit growth in Brazil, which has been terrific. Oral Care, particularly has been really strong in the quarter. That was up double digits, excluding Argentina. Shares in value and volume up. It's been quite some time since we saw both of those move in the right direction, and again, a reflection, I believe, of the strategy of increased investment and making sure that we have a breadth of offerings in that market."
},
{
"speaker": "",
"content": "That is a market that's accustomed to inflationary pricing across many of the markets in which we compete. Being key for us is making sure that we continue to advertise strongly in the markets, and we bring real innovation across the entire portfolio that keeps the categories vibrant, allows us to work with our retailers to drive category growth and hopefully capture share at the same time."
},
{
"speaker": "",
"content": "So overall, we think Latin America is well positioned for continued growth, and we like what we're seeing there."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Noel Wallace, Colgate's Chairman, President and CEO, for closing remarks."
},
{
"speaker": "Noel Wallace",
"content": "Great. Well, thanks, everyone, for joining the call today. Obviously, we're really pleased with the quarter and how we've gotten off to a strong start that we believe sets us up for continued sustainable growth moving forward and generating that long-term algorithm that we've been talking about for quite some time for our shareholders."
},
{
"speaker": "",
"content": "Let me particularly reach out to all of the Colgate employees around the world for their incredible dedication and resilience and their hard work in really executing a strategy around the world and for getting us off to a great start. So thanks, everyone. We'll see you and talk to you soon."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
clx | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to the Clorox Company Fourth Quarter Fiscal Year 2024 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our prepared remarks, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin your conference."
},
{
"speaker": "Lisah Burhan",
"content": "Thanks, Jen. Good afternoon and thank you for joining us. On the call today with me are Linda Rendle, our Chair CEO and Kevin Jacobsen, our CFO. I hope everyone has had a chance to review our earnings release and prepared remarks, both of these are available on our website. In just a moment, Linda will share a few opening comments and then we'll take your questions. During this call, we may make forward-looking statements, including about our fiscal 2025 outlook. These statements are based on management's current expectations, but may differ from actual results or outcomes. In addition, we may refer to non-GAAP financial measures. Please refer to the forward-looking statements section, which identifies various factors that could affect such forward-looking statements, which has been filed with the SEC. In addition, please refer to the non-GAAP financial information section of our earnings release and the supplemental financial schedules in the Investor Relations section of our website for reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures. Now I'll turn it over to Linda."
},
{
"speaker": "Linda Rendle",
"content": "Thank you for joining us today. Our fourth quarter fiscal year 2024 results reflect the continued advancement of our strategy to strengthen our competitive advantage, accelerate profitable growth and set up our company for long-term success, all while navigating a recovery from the cyber-attack earlier in the year. Thanks to the team's execution, we ended fiscal year 2024 in a position of operational strength. We fully restored supply and distribution and recovered most of the market share that we lost. We closed out with flat organic sales for the full year, despite the significant disruption caused by the cyber-attack, which drove an 18% organic sales decline in the first quarter. Importantly, we continue to deliver on our commitment to rebuild margin to fuel growth, delivering our seventh consecutive quarter of margin expansion. We're on track to return to our pre-pandemic gross margins in fiscal year 2025. We also achieved another year of double-digits adjusted EPS growth. As we look ahead to fiscal year 2025, consumers will remain under pressure, which will continue to temporarily increase competitive activity and impact category growth. That said, we have a portfolio of strong brands in essential categories that have shown resilience during challenging times. We have and will continue to invest strongly behind our brands to maintain value superiority. While we have more work to do, we are confident that we have the right plans at investment level to win with consumers and deliver strong financial performance in fiscal year 2025, supported by a return to volume-driven sales growth, pre-pandemic gross margin and free cash flow in line with our long term goals. With that, Kevin and I will take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question today will come from Filippo Falorni with Citi."
},
{
"speaker": "Filippo Falorni",
"content": "Linda, maybe I wanted to start with just the visibility on the top-line outlook. Obviously, you called out the dynamic in the first and second half. But given the consumer environment and the weakness that you're seeing and the promotional intensity in some of your categories, why are you expecting more of an underlying, particularly in the back half of the year from a volume and pricing standpoint? Do you expect still negative pricing to drive the volume growth? Any more color on the top-line outlook, understanding the dynamic in the first half?"
},
{
"speaker": "Linda Rendle",
"content": "Sure, Filippo. Here's maybe helpful to kind of take a step back and frame what we have in front of us. I'll start just with the consumer environment to your point. The consumer environment is playing out as we expected. We certainly thought in the back half of fiscal year '24 that we would see, given the consumer is under pressure just more generally, we see that play out in our categories as we lap pricing, and as we saw competition in retailers react to trying to ensure that they get their shopper, et cetera. And so, that's played out exactly as we expected. We've seen category growth go from about mid-single-digits to low-single-digits, the softest month being in June. But what we see is generally what we've seen and what we've expected to see during this time. Consumers are continuing to be very focused on value. That means that, they are trading up to larger sizes, trading down. But our categories have been pretty resilient given that. Our brands, given their superiority and the fact that we've been rebuilding distribution and have fully rebuilt distribution coming out of the cyber-attack, our category is exactly where we expect them to be. I think moving forward, as we look at the year and to your point on front half versus back half, we continue to assume that the consumer will be under additional pressure, and that our categories will largely continue as we've seen them now, low-single-digits. And what we're really focused on is ensuring that, we're executing our spending plans. We have strong investment in ANFP, strong investment in innovation to support category growth as well as support share growth, which we expect this year and really focused on delivering superior value. And we know that, anyone can win in an environment where it's a little tougher, in the essential categories we compete in if we are laser-focused on delivering great value to consumers. That's exactly what we're focused on right now, to one, fully rebuild the momentum that we're still rebuild the momentum that we're still rebuilding in a couple of our categories coming out of cyber, and two to continue the momentum we're seeing in many of the other businesses that are restored."
},
{
"speaker": "Filippo Falorni",
"content": "And maybe one for you Kevin, on the gross margin clearly, outdelivery this quarter. What surprised you to the upside in the quarter? And as we think about next year, there was a lot of volatility in the manufacturing and logistic in the commodity front, maybe some level of expectation on those items for next year?"
},
{
"speaker": "Kevin Jacobsen",
"content": "I'd say this year, as you know, in Q4 came in a bit stronger than we anticipated. The biggest driver of the over delivery for us is what we call business unit mix. Our household segment came in below our expectations and we over delivered our expectations on health and wellness segment. And if you look at our profitability, it's meaningfully different between the two segments. And so that mix generates some nice savings for us. And then the other areas, I'd say, is just generally a bit more favorable across the other lines of the supply chain. We had anticipated commodity deflation is a little bit stronger than we anticipated. Cost savings was another very good quarter for the company a bit more than we thought. We got some nice favorability across the supply chain, but the biggest driver was the BU mix that we did not anticipate. As I look forward to fiscal year 2025, kind of talking about the key drivers are, as Linda said, our expectations are going to add another 100 basis points and fully rebuild gross margin. I'd look at a few drivers. Supporting margin expansion, we're going to have another very good year of cost savings. We target 175 basis points each year of EBIT margin expansion. In the last two years, we've done over 200 basis points. I think this year, we'll do another year over 200 basis points with the bulk of that being in the supply chain. And then, we're also seeing some nice benefit from the portfolio work we've done. As you guys saw, we sold Argentina last quarter. We've announced that we're in the process of selling our VMS business. That's going to structurally improve our gross margins as we get through that. So that will certainly contribute to that 100 basis points. I think modestly offsetting that, I do expect a bit of increased trade spending as we get back to this normalized environment, particularly in the front half of the year, where our trade spending last year was below normal because of the cyber event. You'll see a little bit of year-over-year hit in the front half on trade. And then, we're assuming just a modest level of cost inflation, about $75 million across the supply chain, which will partially offset the margin accretion activity I mentioned. But, all in, we feel very confident in our ability to fully rebuild gross margins. And then going forward, as we've talked quite a bit, as our goal is to get back in that cadence of 25 bps to 50 bps of EBIT margin expansion each year. And we think we're set up to do that as we get into '26 and beyond."
},
{
"speaker": "Operator",
"content": "Our next question will come from Peter Grom with UBS."
},
{
"speaker": "Peter Grom",
"content": "Maybe just a couple of follow-ups on the top-line. Maybe just first, I would love to kind of get some perspective on the exit rates or kind of what you're seeing quarter-to-date in household relative to the organic growth you delivered in the quarter. I think the prepared remarks mentioned some of the distribution recovery occurring later in the quarter. So just curious if you're already starting to see that improvement as the recovery happens."
},
{
"speaker": "Linda Rendle",
"content": "Sure, Peter. I'll start us with that. And I think that's a helpful place for us to go a bit more into household and what happened there. That was the bulk of the miss that we had in Q4, but feel like a number of these businesses, to your point, we saw good trends heading out. First I'll cover, which you all know that our grilling business, the largest quarter we have is Q4. It's about 50% of our business and it's a heavily weather dependent business. Unfortunately, for both Memorial Day and July 4, weather was terrible in the U.S., very rainy for Memorial Day and extremely hot for 4th of July and that meant the category was down anywhere from high single-digits to double-digits. And as a result, our Kingsford business came in short of expectations. I don't look at that as any type of structural issue in Kingsford. We had good merchandising plans and where consumers did pull, we saw good take through. I think that is simply just the effects of weather, and obviously a portion of why we didn't deliver. And then two other businesses, which I'll break down in a little -- each is a little bit different. They share some same characteristics. But we've spoken a lot in the past about Glad and Litter. And those were the other two that contributed to the Q4 mess. And in the case of Glad, distribution recovery happens later in the quarter than we had expected, but we have fully recovered distribution. So feel very good on the exit rate from a distribution perspective. And as well, we talked a lot about the fact that when we were out of stock, we had a harder time getting our large sizes back, which is one of our biggest growth levers and critical consumers. They're looking for large sizes. They're going to buy a large size than another competitor. So we didn't know exactly what that purchase cycle would look like and that happened again later in the quarter when we saw people come back to our large size business. That being said, we think that was largely a Q4 dynamic. We have strong plans in place for fiscal year '25 across spending and innovation. And then just some data points to kind of show the extra rate coming out. Obviously, distribution, as I said, was fully recovered by the end of the quarter. That happened a little bit later than we expected. Shares trending in the right direction. We were down nine-tenth of a share point in April, but up to just down two-tenths of a share point in June. So a very big change as we got that distribution in place. We're back to growing share at our largest customer. And then on that very important large size business, that was actually one of Amazon Prime Day's number one sellers. And so feel like Glad is in a great position to deliver the growth that we expect it for in 2025. And then finally, for household, I'll cover Litter. And Litter is a little bit of a mixed story. Certainly saw improvement as we went through the quarter. We got distribution back to what we expected it to be, et cetera. But we are not fully capitalizing on the growth in that category at this point. And we have the operational things in place to do that. We've fully recovered supply. We have our customer service levels back to where they need to be. But, we recognize that this is a category that's going to take a bit more time due to its nature. Just a few things to keep in mind. One, you have some consumers who -- it's difficult to switch because their cat's used to a Litter. And that's a little bit more of a headache to switch litters back and forth when we were out and now back in stock. So we're working through that. We're beginning to regain those consumers back, but it's taking some time. This is a business that's heavily on subscription, which I've spoken about before. And while we've made progress getting people back to their subscriptions for fresh step, we still have more work to do. Then we've seen increased competitive activity as people become more value focused, et cetera. And so I think that dynamic in the category combined with just what's going on in the broader context of the categories, where everybody is really attuned to delivering for consumers given how stressed they are, that's a business that's going to take a little bit longer to recover. I feel fully confident in our ability to do it. We have strong innovation on that business. We have strong spending. But that's one that we're working week in and week out to get those consumers back and it's just going to take a little longer than we had originally expected. If I can to ladder all that up, I feel good. We had one business that was weather related, Glad on the right track, Litter improving, have more work to do. And I think that's what we're going to be working on that for the next couple of quarters. But we're really happy with the progress. We have superior value brands. We're investing them in strongly. And there's growth for us to go get. Litter is one where we haven't fully participated in that growth and we are laser-focused on ensuring that happens in '25 and beyond."
},
{
"speaker": "Operator",
"content": "The next question will come from Andrea Teixeira with JPMorgan."
},
{
"speaker": "Andrea Teixeira",
"content": "Linda, if you can elaborate more on the elaborate more on the category health? You spoke a bit about how consumers continue to seek value. Wondering, if you can go through the key categories and give us a state of the union. And also in related to that, the RGM capabilities, I know you've in the past have done a lot of that. I wonder if you are, as you set up this 3% to 5% organic sales growth for fiscal '25, if you're deploying some ways of RGM that could help you achieve that."
},
{
"speaker": "Linda Rendle",
"content": "Sure, Andrea. On the category health piece, here's what I would say. The consumer is stressed in general, but our categories have been resilient and they're where we expected them to be. They're a bit softer, which is exactly what we've experienced in times when the consumer is more stressed. But given that we're in essential categories, they're pretty resilient. Obviously, our categories don't typically grow in the mid-single-digits range, but they did behind pricing. We knew some of that would roll off. But then we have this just additional pressure as consumers are more value focused. We've seen low single-digits. We've seen that bounce around, and we're watching it pretty carefully, but we see no signs right now where we're panicked. We see categories that continue to be resilient, consumers looking for value. Pricing is holding in the marketplace, which is great after taking those multiple rounds of pricing. You're seeing little changes here and there on how retailers are using promotion in the categories. But I would say, our categories are generally healthy and holding up, but just a bit softer as we would normally expect in a time like this. If I look, are there any special dynamics by category, there's still growth to be had. Cal Litter is a great example of one that I just called out that's been still growth-accretive from a category perspective for us. As consumers adopted more cats during COVID, they thankfully still have those cats, and they're investing in the well-being of their pets. I would say, every one category has the similar dynamics around value, et cetera. But we see categories with higher growth opportunities and somewhat a bit lower. But I would say again, they're pretty resilient. I think, if you look at private label, it's probably another important thing to cover. Private label was up about three-tenths of a share point in Q4, but that's coming off of what was some trading during our out-of-stock period. And we're seeing people come back to our brands. We're seeing the middle get squeezed again, which is usually what happens during periods like this. People change with the premium brand or in private label. We do not see consumers meaningfully move to private label in any way. Shares are pretty stable. I'd call out the promotional environment probably, Andrea, is the last thing to touch on. We had anticipated the promotional level would return to pre-COVID levels. We certainly anticipate that for fiscal year '25. Competition is pretty rational in that. We're seeing some pockets of more competition in categories like Glad and Litter and we would expect that, but generally pretty rational. We still think that assumption holds for '25 that will return to pre-COVID levels. It was slightly higher in Q4, actually partially driven by us, but competition as well, and as retailers try new promotional strategies. So, in general, for us, we think the categories are in a good place for us to do what we do best, which is focus on superior value, invest in our brands, ensure that we execute against the strong innovation plans that we have and we have those across all of our major brands again, and feel good about the position they put us in. what we would anticipate is, this slight slowdown will be temporary. We typically see this last 12 to 18 months and our categories would rebound to more of a mid-low single-digits growth number, and we'll just watch for that and be ready to ensure that our brands can take advantage of it. And then you asked on, RGM, Andreas. So I'll just touch on that too because it's so important for how we deliver value now but also in '26 and beyond. That's a relatively new capability for us. We've done some work by businesses. Glad is a great example where you've done some price pack architecture over the years. But we've built out a full capability in the company to take advantage of that and we see that being a top-line contributor and margin contributor for both '25 and beyond. A lot of the activity we'll do right now is really always on pricing, some initial price pack architecture work and we see even more of that in '26 and beyond. But that will be a huge growth driver for us, in the long range plan period."
},
{
"speaker": "Operator",
"content": "And we'll move next to Chris Carey with Wells Fargo."
},
{
"speaker": "Chris Carey",
"content": "I wanted to come back to sales again. Actually, in a strange way, the fiscal Q1 organic sales guidance is actually a bit lower than what I would have expected a multi-year basis if you assume you get back to growth. Are you embedding a progressive recovery, I guess, in your sales curve as you get through the year? In another way, is this just you're not exactly sure where things are going to land such as the volatility? Or is there greater recapture of some of the initiatives that you're looking for into the back half of the year, which is why you have that strong back half organic sales guidance applied? And I have a follow-up."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes. Hey, Chris, on Q1 sales and as you referred to our guidance of we think it's going to be 20%, 25% growth. And keep in mind, we're lapping an 18% decline in organic sales growth from the prior period. We think that growth is driven by both recovering from cyber as well as the strength of our demand plans. Now as I mentioned, that will be partially offset by increased trade spending. In this normalized environment, we're now lapping a period in front half of last year, when we were at a depressed level of merchandising support because of the out of stocks. And so you'll see good strong top-line growth modestly offset by increased trade spending in the front half of the year, which will depress it a bit. And then, as you get to the back half of the year, we average about a normalized level of spending in the back half of '24. I wouldn't expect much of a price mix impact year-over-year in the back half, but a little bit more pronounced in the front half."
},
{
"speaker": "Chris Carey",
"content": "And just, regarding that back half volume expectation, shaking out around mid-single-digits, do you see it the same way and just confidence around that number in this environment? And then, if I could sneak in, the deceleration that you're expecting in the Q1 gross margin relative to Q4 is quite atypical. I know you're talking about negative mix or positive mix in your fiscal Q4, but I understand charcoal also should have been a detriment. Why such a steep quarter-over-quarter decline? Is it all mix or is manufacturing coming off? Any context there would be helpful."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, sure. On the gross margin lines, you talked about sequentially going from Q4 to Q1. As we said, we think we're going to have a good solid quarter in Q1 up 400 basis points to 500 basis points, but that will be lower than what we landed Q4. Part of it is what I mentioned. The reason we over delivered Q4 is because of this BU mix. We just sold less household products relative to the rest of our portfolio. We don't expect that to be the case in Q1. We expect those businesses to continue to recover and take a larger portion of our sales in Q1, so you won't get that that temporary benefit. And then in addition to that, I talked about the trade spending. You'll have a bit more of a trade spending drag in Q1. And then lastly, some of it is just based on our cost savings timing. We have hundreds of cost savings projects that have natural timelines and so those play out over the course of the year. I'm not particularly too concerned about how it plays out in any given quarter as long as we deliver good strong cost savings for the year, which we expect to do, but that'll have some impact on quarters as well."
},
{
"speaker": "Chris Carey",
"content": "Just regarding the back half confidence, if that mid-single number is where you're kind of thinking and that's it for me."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes. On the 3% to 5% organic sales growth, yes, our expectation will have good strong growth in the back half as well for both volume and sales. When you think about our sales of 3% to 5%, we expect this to primarily come from growing volume and growing share and we expect it to happen both in the front and back half of the year."
},
{
"speaker": "Operator",
"content": "Our next question comes from Bonnie Herzog with Goldman Sachs."
},
{
"speaker": "Bonnie Herzog",
"content": "I had a quick follow-up on Litter. Linda, you mentioned more work to do and mentioned strong innovation you have. So could you maybe touch on some of that for us? And then whether there is more innovation planned to be rolled out in FY'25? Also, could you give us a sense of the magnitude of increased spend levels you'll need to win these consumers back? I guess, maybe just a big picture on trade spend and promos, how big of a risk you see for spend levels to go beyond what you're factoring into guidance? I guess I'm asking, given the retail and consumer environment."
},
{
"speaker": "Linda Rendle",
"content": "Sure. On Litter just a bit more. First on the innovation side that you touched on, we do have strong plans. First I would say that we're going to double down on some of the very successful platforms that we've had that are very value focused, like Outstretch, which we've talked about before, which is a more concentrated Litter and has performed really well in the market, as particularly consumers are looking for more value having to change that Litter box less, is a very high value for them. We'll double down on those and we have new innovations coming, which I can't give any details yet, but plan for the back half of our fiscal year '25 in the Litter category. We're also looking at claims, and ensuring that we have the right messaging from an advertising perspective. When it comes to investment particularly on Litter, and then I'll speak more broadly to your point on promotion and spend levels in aggregate. In Litter, we contemplated that in our outlook. That is embedded in the assumption that we have 11% to 11.5% of advertising and sales promotion as percent of sales. And then as Kevin just highlighted, the fact that we have increased trade promotion dollars in the system. And so Litter is accounted for that. And then that is the truth for the enterprise as well. We've accounted for the fact that, we're going to keep the spend level about what it was for advertising and sales promotion as a percent of sales versus last year. We think that's a prudent assumption and allows us to continue that momentum with consumers and talking about the value we offer and new innovation. And then same on the trade promotion piece. We have assumed that in our outlook. We've assumed the environment will be about what it was pre-COVID. The risk of that going higher, as what we've seen today, it's been pretty rational and we're seeing retailers be pretty rational. They're definitely ramping up promotion as we expected, but we're not seeing anything that sends us a signal that we haven't made a good assumption. It will be something Bonnie we watch throughout the year though. That certainly is a variable in the plan and could impact it. But for now, I think what people are looking at is using promotion in the right way to ensure that, we're communicating value, that we're introducing innovation, and using that in a very positive way. And we'll be watching it closely and we will react, if we see something from competition. But again, we see a pretty rational environment, pockets of things in Glad, Litter that we're dealing with but we've contemplated all about in the outlook."
},
{
"speaker": "Bonnie Herzog",
"content": "And maybe just a quick second question on your EBIT margin. It's still below historical levels. In the context of everything you just mentioned, how should we think about further recovery and essentially ultimately seeing when they could reach historical levels? And I guess, I'm asking the context of, again, everything you just mentioned, Linda, as well as gross margins becoming less of a tailwind moving forward and then certainly A&P investments and the increase and the expectations there?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes. Bonnie, on EBIT margin, I'd say I feel like we're making very good progress. And then I'll talk adjusted EBIT margin that factors out some of these one-time charges. But if you look at our history, back in fiscal year '22, when we had the significant inflation, our adjusted EBIT margin is about 12%. Last year, we built that back up to about 15%. And if you look at our plans this year, it gets us back to about 17% to 17.5%. We're getting pretty close to fully rebuilding EBIT margin, historical levels about 18%. Our expectation is, by the end of this year we're very close to that level. And then going forward, it's the same things we talked about is continued to drive our margin transformation efforts, continue to drive the top line. We think that's how we get there. And then the very good work we've done on the streamlined operating model, we completed that program. We're on track to deliver $100 million and as we've talked, our intent to start moving our admin spending closer to 13% of sales over time and that will certainly be a contributing element as well. I feel very good about the progress we've made over the last several years, including what we intend to do this year, but I think that work continues beyond. But I have every confidence we'll fully rebuild EBIT margin as well."
},
{
"speaker": "Operator",
"content": "Your next question will come from Dara Mohsenian with Morgan Stanley."
},
{
"speaker": "Dara Mohsenian",
"content": "I just wanted to follow-up on the 3% to 5% org sales outlook for fiscal '25. Can you just give us some clarity on the volume versus pricing mix that's embedded in guidance? It sounded like in prepared remarks you do assume some pricing, which surprised me but maybe that's international. Just the balance there and specifically what's driving the pricing would be helpful."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, as it relates to our 3% to 5% goal, that will come from volume growing slightly above 3% to 5%. And then our expectation for price mix is modestly negative, and that's primarily driven by this increased trade spending I talked about in the front half of the year to get back to a more normalized level of merchandising support. We don't have any meaningful pricing in the plan for fiscal year '25. We'll do a little bit internationally, but that won't have a ceding impact on the top line. It will be primarily coming from volume with a very modest offset in price mix."
},
{
"speaker": "Dara Mohsenian",
"content": "And then just, Linda, with the divestiture of Argentina and sale of VMS here, could you just address the 3% to 5% long-term organic sales growth outlook. Does that still hold? Presumably, it still does, but just give us some insight into how you think about the building blocks there, particularly given the recent divestitures?"
},
{
"speaker": "Linda Rendle",
"content": "Yes. It does. It's one of the steps that we take to ensure our financial algorithm is in a good spot. We're committed to continuing to evolve the portfolio in Argentina and VMS are great examples to ensure that we have businesses that are less volatile in the case of Argentina and businesses that we feel can deliver the consistent and profitable growth that we need to, and that really comes down to our decision on VMS. Both of those support a more stable, consistent sales growth. Both of them support margin expansion, as Kevin covered and a more profitable business overall. Obviously, that will have an impact to reported sales this year. But if you look at organic, it's pretty strong. And then as we move forward, what I think it really allows us to do is, focus on the places where we have growth opportunities. It allows us to focus in places like Litter, where I said we have more work to do, in other parts of the business, like international that has grown above our sales average. PPD, which we feel confident now is returning to a stronger grower in the portfolio. So that really in the future as we look to '25 and beyond, not only does that create a new base to grow from that is stronger, but it also allows us to focus on the opportunities in front of us."
},
{
"speaker": "Operator",
"content": "Our next question will come from Kaumil Gajrawala with Jefferies."
},
{
"speaker": "Kaumil Gajrawala",
"content": "On advertising, I saw in this quarter it was at about 14% of sales. Is that just a little bit of maybe a step-up in spend as you got one into the end of the year, just setting you up for next year? Is there something else going on?"
},
{
"speaker": "Linda Rendle",
"content": "Yes. Kaumil, obviously, fiscal year '24 was pretty dynamic, and we set out to have a higher level of spending to support what we thought would be a more value conscious consumer. And then after the cyber-attack in August, we tried to pull back as much spending as we could as we had out of stocks in the market and we backloaded a lot of that plan as we came back into full distribution, as we were able to merchandise again, as we fully rebuilt supply and that 14% represents getting all of those things back in the market and wanting a strong start from a consumer momentum perspective. As you saw for '25, we're returning back to that level of 11%, 11.5%, which is consistent with what we did in aggregate last year. But I think from a Q4 perspective, it just supported all of those fundamentals being live and back in the market and a strong start to the momentum that we intend to continue to build in '25."
},
{
"speaker": "Kaumil Gajrawala",
"content": "And then on promotional activity, but in the context of thinking about gross margins and promo activity, is the assumption that the levels that we're at right now in terms of train spend and promo is where we're sort of leveling off? Or is there an assumption, that it's going to continue to climb over the course of the next calendar year and that 100 bps of gross margin expansion incorporates the likelihood of promos increasing still?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Kaumil, the way I'd say it is, if you look at the back half of our fiscal year '24, we merchandise about 25% of our sales and that's very consistent sort of normal merchandising activity. But as I mentioned, in the front half of '24, it was depressed because of the cyber event. As you fast forward to fiscal year '25, you should see a year-over-year increase in trade spending in the front half of the year because we've got to lap that depressed level. But in the back half of fiscal year '25, we're about at the level we think is appropriate and I wouldn't expect a year-over-year increase. You'll see a little bit of a drag on sales and margin in the front half of fiscal year '25 as we get back to that normalized level and I would not expect to see much of that in the back half of fiscal year '25."
},
{
"speaker": "Operator",
"content": "Our next question will come from Kevin Grundy with BNP Paribas."
},
{
"speaker": "Kevin Grundy",
"content": "Question on advertising and marketing as well. A little bit of a different angle, though. Was there any consideration to maybe leaning in a bit and reinvesting more of this gross margin improvement? You're calling for a 100 basis points of GM improvement. Advertising and marketing up. But I guess I'm asking this one in the context of number one, the market share probably not where you'd hope it would be. And if we're looking at the Nielsen data sort of as a proxy, it seems like there's a lot of share loss beyond household. We're seeing share gains in Hidden Valley and Wipes. Beyond that, at least in the Nielsen data, there's quite a bit of share loss. I'd add to that, we're seeing advertising and marketing trade promo go up across the board. So sort of given the gross margin improvement, share probably not where you want it to be is it prudent just to kind of push back, respectfully push back a little bit to maintain advertising and marketing. Wouldn't this seem like the right time to get the market shares back to where you want them by leaning in even more in this environment, where it's going up across the board from the competitors and your market share is not quite where you want it to be. It'd be great to get your thoughts on that."
},
{
"speaker": "Linda Rendle",
"content": "Yes, Kevin. As you can imagine for '25, we look at a number of scenarios on what the right level of spend was on advertising on promotion. And our general managers, we pushed them to say, are there incremental spending opportunities that are good, decent short-term payout but would contribute long-term even more. And what they came back with was that 11% to 11.5% range that we had. We think that strikes the right balance. Here's maybe just a little bit of thinking about what you're seeing in share and what we expect and why we're comfortable with the 11% to 11.5%. If you look at share for the extra rate of what we had in June, less than three quarters of recovering from a pretty major cyber events where our distribution, et cetera our distribution was down a third. We lost five full share points. We ended June down three-tenths of a point in share in aggregate. I don't love being down in share, but I think that speaks to the power of the plans, our execution and our brands. To be clear, we intend to grow share in fiscal year '25. But what we're seeing is, just as we restored distribution, which happened mostly in May and June, we haven't even had a full purchase cycle with the consumer yet, which is about 90 days on average. What we're seeing is household penetration begin to rebound. It's not exactly where we want it to be right now, but generally things are all moving in the right direction. And that spend of 11.5% and the increased promotional spend we think is prudent based off of that. I'll be clear though, if the year starts to play out differently and we are not seeing what we expect from our businesses share improve, we feel absolutely comfortable coming back and saying, we need to spend more. And I know I think that would be met positively. But what we're trying to balance right now is top-line growth, ensuring that we have the fuel by expanding margins. We think we have that balance right, right now. And as I've said time and time again, we are not afraid to spend just like we did 14% in Q4 if we feel it's the right thing to do for the business for the long-term."
},
{
"speaker": "Operator",
"content": "And we'll move next to Robert Moskow with TD Cowen."
},
{
"speaker": "Robert Moskow",
"content": "Hi, thanks for the question. I guess we can wait for the 10-K, but can you give us a kind of a snapshot on how cash flow ended for the year? It was down for the first three quarters, but wanted to know if there's any kind of recovery in fourth. And then, how should we look at fiscal '25? Is it kind of a -- can we take the net income and kind of just add D&A and subtract CapEx? Or are there any kind of cash expenses that will really hit it or working capital changes that we should be aware of?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure, Robert. Happy to answer that on free cash flow. Just to remind folks, we target free cash flow as percent of sales 11% to 13%. If you look at free cash flow, it mirrors very similar to what we're doing on the P&L in terms of rebuilding gross margins profitability. If I go back to fiscal year '22, we had about 8% free cash flow. So inflation, depressing margin, depressing profit, we were well below our targeted 11% to 13%. If you look at the last two years, we've averaged about 10%. There are some timing issues on tax payments, but if you take that noise out for fiscal year in '23 and '24 about 10%. This year, fiscal year '25, as we continue to rebuild margin and profitability, we're targeting about 12% free cash flow as percent of sales, so very much back in line with our targeted growth rate. And as a result of that, I think you folks have seen we continue to support the dividend, but we're also starting to pull cash-up on the balance sheet. So we have restarted our share repurchase program. We started this year that we've had suspended for about the last three years and that's really a function of really rebuilding the balance sheet, rebuilding cash flow and now we're able to start deploying that cash back to shareholders."
},
{
"speaker": "Robert Moskow",
"content": "Where does that stand in your priorities for how to return cash to shareholders? Would there be a step-up in fiscal '25 or does it depend on other factors?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes. In terms of priorities, it's our lowest priority. So job one for us is to invest in the base business and we'll continue to make sure every opportunity we have to invest in the business that generates value for shareholders, we'll continue to do that. We have a very robust plan of investment this year, but in spite of that we support the dividend. Additionally, we have our debt to EBITDA. You folks may know we target 2x to 2.5x. This year, we're looking to be at the very low end of that range, so we're in a very good place from a leverage ratio. And then our last priority, if we have excess cash on the balance sheet, we're going to return that to shareholders and that's the position we find ourselves in this year. We started that process. I'd say for now we're targeting $250 million to $300 million to return. That's primarily catching up on dilution, as we've been out of the market for the last several years. But we'll evaluate that as we get through the year and see how things shake out, but we think this is a good place to start in terms of our outlook."
},
{
"speaker": "Operator",
"content": "And your next question comes from Javier Escalante with Evercore ISI. Just one moment, please. Then it looks like his line has disconnected. We'll move to our next caller, Olivia Tong with Raymond James."
},
{
"speaker": "Olivia Tong",
"content": "I was hoping you could talk a little bit about the margin improvement from this year, not just this quarter, because relative to your goals going into the year at this time last year, sales came in below but earnings actually was a fair bit above despite, arguably, consumer challenges building over the course of the neck the last 12 months. Putting cyber aside, would love to hear a little bit about the key drivers of the earnings improvement from this year."
},
{
"speaker": "Kevin Jacobsen",
"content": "In regard to I think you mentioned gross margin primarily. If you look at gross margin, what drove the roughly 360 basis points of improvement? For us, it was another very good year of cost savings, and I really credit our team in spite of the cyber disruption, folks stayed very focused on delivering the productivity improvements that we're counting on. And so we delivered 180 basis points of gross margin expansion through cost savings. That was a very good year for us. We also had pricing primarily in international markets, and that was really Argentina prior to the divestiture, but that certainly contributed to gross margin expansion as well. And then lastly, I'd just say, we've moved into a commodity environment that's fairly benign. If you look at commodities, we've been dealing with tremendous amount of inflation the previous two years. This year is essentially flat, we had no real commodity drag and you had all the benefits of cost savings and the pricing actions we took flowing through to the bottom line. Those are really the primary drivers."
},
{
"speaker": "Olivia Tong",
"content": "I was more sort of thinking about what came in as a surprise to you. It sounds like it's primarily the cost savings. But then the other thing that I wanted to know about is, one of the things that we're hearing during this earning season is about improving household penetration, especially given the backdrop. Can you discuss some of the things that you're doing to improve your household penetration, whether through promotion and trade spend or some of the digital investments that you're making to try and set out where there are potentially more pockets of consumers that you may be underserving?"
},
{
"speaker": "Linda Rendle",
"content": "Sure. Maybe I'll just close the point on margin, Olivia that you made. Kevin certainly outlined exactly what happened. I think what I would just note is, our continued confidence in the overall margin transformation program we put in place, that's leading to this type of sustained increase in cost savings. We're pulling levers that we pulled before in new ways and we have completely different capabilities that we've built, as well and we're enforcing that by investing in our digital transformation, so better access to data and insights and allowing us to move quicker. I think that's really what we've been pleased to see as it's played out. We have increased confidence and obviously giving us confidence to return to pre-pandemic gross margins, which if you look at the last few years, that's a significant feat given what we had experienced from a commodity increase perspective and overall inflation. That's what I would call out as we continue to get more and more confident about that and it gives us confidence in fiscal year '25 to return to those margins. And I think to Kevin's earlier point that gives us the flexibility to invest if we need to. We feel like we have the right investment levels now, but given the fact that we've made such strong progress there, if we need to invest more, we are ready to do that. And then your point on household penetration, as the industry took pricing, one of the trade-offs we always know that happen at a time when you take pricing is you trade-off household penetration and usually that's temporary. And that happens for a number of reasons. Consumers, you have elasticity and elasticity plays out in a number of ways. Consumers leave the category, consumers decide to behave differently within the category, they make substitute, they have longer purchase cycles, et cetera. And then as you see pricing roll through, you see consumers naturally come back, because they find their alternatives didn't work or they go through all of their pantry. We'd expect to see that happen naturally. But then the work that we're doing is really focused on ensuring that, we are focused on superior value, that we offer them a value that when they go and they're choosing their household essentials that they return to the category and they return to Clorox Brands. And we're seeing that, over the last couple of quarters with some improvements in household penetration. We would expect to see that continue and support the volume driven growth that we'll have in fiscal year '25. But there's a combination of things that we think about in this. Superiority is a combination of pricing, the brand and the product experience. We are ensuring that we have the right price points, which we feel good about. And as I've said before, we continue to look through our net revenue management work to ensure that price points and price gaps are where they need to be. They largely are, but we will absolutely take on if we see a place where our price gaps aren't where they need to be and we'll do that work to ensure that we have that. And we'll use things like price pack architecture to deliver even additional value to those consumers, who may have exited and need a different pack size or buying in a different channel. And then, if you think about product, that's where really innovation and focusing on claims matters. We had a strong innovation program this year. But what I would just emphasize is the last few years, we've had a number as the world has, but I think in particular if you think about Clorox, a number of operational disruptions outside of our control. And we've been trying to balance both margin, earnings, top-line and I think we've done a good job at that. But the organization now is really focused on returning maniacally to growth, given our confidence in margin rebuilding, given our confidence in the brands. And so we are really focused on where is our product need or boost from claims perspective. We are -- pretty innovating. How can we make our innovation even bigger and how can we bring to life those platforms that we intend to launch. And I'll give you maybe just an example of one that doesn't feel like a big deal, but is actually having really an impact in the marketplace, and that's Clorox Scentiva. We launched that a number of years ago. It was very successful. And I talked about in CAGNY that we were going to relaunch Scentiva. And we did that with better claims, better scent profiles and we've actually had the largest quarter in Q4 on Scentiva that we've ever had. A good example where the team is getting laser-focused on value and we're bringing in consumers who maybe can't afford anymore to buy a cleaner and an air freshener and they're getting a great value by having an all in one product with Clorox Scentiva. Good examples of where by category we're being pretty maniacal about that. And then finally, investment. As I've said, I feel like we have the right level of investment on [ANSP] and promo to do exactly that making sure we're capturing consumers at back to school, during times when their family gets ill, reminding them what we can do to keep them safe as well as talking about the trust of the brands and the promises that we deliver. All of that adds up to growing household penetration over time. That's what the team is focused on is, how do we return them to the levels that we were at before and grow them from there, and that it will be part of how we grow share in fiscal year '25."
},
{
"speaker": "Operator",
"content": "And we'll move to our next question that comes from Lauren Lieberman with Barclays."
},
{
"speaker": "Lauren Lieberman",
"content": "Linda, I mean your last answer gave a lot of color on this, but the implied market share gain, I think is very significant. I hear you on the kind of trend line and where you've gotten back to and more or less flattish. But talking about volume growth north of three to five in a category backdrop that you've described as challenged, resilient but challenged consumer just feels like a really big push. I guess number one, would be why start out with such a high bar? Because again like mid-single-digits volume is a big number and it just yes -- I'll leave it there as my first question."
},
{
"speaker": "Linda Rendle",
"content": "Sure, Lauren. I think first, one thing to keep in mind as we go through the quarters is we have the lap of cyber. And so we lost five points of share if you look at the height of the cyber tech. And we are regaining a lot of that volume in Q1 and gaining a lot of that share. If you think about exactly what you said, Lauren, the exit rate close to flattish in June. But you have to even if you just forecast getting back to flattish for an entire year, that is a significant amount of volume growth. Then growing share modestly on top of that gets you to that number. I think that's part of what's going on as you have a dynamic of lapping being out of stock, significant volume growth there, significant share loss and refilling that and then growing share modestly, what we would assume in the back half. And some categories will grow faster than others. But we assume the vast majority of our major categories we will see share improvement in and we feel like we have the plans to do that."
},
{
"speaker": "Lauren Lieberman",
"content": "And then if I can just follow-up on some gross margin components. Kevin, you've been super clear that mix is a big contributor this quarter. I just want to clarify, was that in that logistics and manufacturing line? And if you could give any guardrails for like roughly how big it was just when we think about next year's comparison? And then also commodities for fiscal 2025 kind of flattish or is that expected to be a benefit?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Lauren. On gross margin drivers, you're right. It shows up in the manufacturing line. So when you have mix between business units, and if you saw in our rec we provided. We're favorable about 200 basis points in Q4 and a good portion of that was driven by that favorable BU mix, which I wouldn't expect to continue as move into fiscal year 2025. In regard to commodities, if you look at our outlook for fiscal year 2025, our expectation is about $75 million of total supply chain inflation and we think about half of that will come through commodities and then the other half will come through the other aspects of the supply chain. And so, for us, roughly $35 million, $40 million of commodity inflation this year is a very modest amount of commodity inflation. That's what we're expecting the outlook."
},
{
"speaker": "Operator",
"content": "And we'll go next to Anna Lizzul with Bank of America Global Research."
},
{
"speaker": "Unidentified Analyst",
"content": "Hi. This is [John Kiefour] on the line for Anna. Just a very quick question on the digital transformation you guys outlined in the prepared remarks. You mentioned Canada seems to be relatively finished. Just wondering how far you guys expect to get through the remainder of the program by the end of this year? Have you seen that like realistically, can you give us any kind of size about how much of the benefits have flowed through? And I guess what you guys are expecting in terms of the cadence from that benefit to flow through overall?"
},
{
"speaker": "Linda Rendle",
"content": "Yes. The digital transformation, we're really pleased with our first wave of our ERP and global finance, rollout that happened on July 1st went very well and gave us strong confidence that, we have set up that wave to learn when we do the new U.S. coming up next year. And so, we have been maniacal about documenting everything that we've learned to set us up for the biggest transition that we have coming on that ERP portion. And as what you saw, we've talked about the fact that, that was delayed due to the cyber event. But we're still on track to finish the program, in fiscal year '26. And we'll make again strong progress this year on the ERP. Next year, the U.S. will come online, and we have additional capabilities coming online as well. We were able to reshuffle some things so that we end the program about the same time. We have seen some value, as you think about the overall digital transformation we have in place as we put our data lake in place, you saw that through things like our marketing efficiencies that we've already had early results on but the bulk of the value that we get and this is a very strong return on investment project comes in '26 and beyond as we complete the implementation of the ERP."
},
{
"speaker": "Operator",
"content": "And our next question comes from Steve Powers with Deutsche Bank."
},
{
"speaker": "Steve Powers",
"content": "I know we're running longs, but a couple of questions if I could on that 3% to 5% top-line goal for next year. I guess maybe this gets a little bit at what Lauren was asking about, but is there a way to think about how that compares to the assumed rate of consumption growth in fiscal 2025? I'd expect maybe a couple of points at least of net distribution gains contributing to shipments. So maybe assume consumption running below 3% to 5%, but just wanted to clarify and hopefully quantify that gap. And then as you're talking about it, if we think about it across the segments and just talk about segment variability relative to that goal, are each of the segments expected to run essentially within that range? Or do you see room for some -- any to run notably ahead or below? It seems to me like household and international candidates to run modestly ahead for different reasons, but I just want to play that back for your reaction."
},
{
"speaker": "Linda Rendle",
"content": "3% to 5%, this is a complicated set of factors to talk through, given each quarter is a little bit different. But Steve, I think to your point, some of that 3% to 5% is rebuilding, against when we were out of stock in Q1 and Q2. And remember, like you said, we didn't fully restore distribution and merchandising until Q4. You're going to have all of those impacts of that lap, in place. And our categories, we're expecting the low end of low single-digits right now. But we have categories that aren't tracked. And I would just help you keep that in mind too. We have international, we have our professional business that are not in those numbers and we would expect higher exposure to growth in those categories. We've seen that continue to play out and we have get more and more confidence in that, as they've delivered over the last couple of quarters. And then of course, we talked about for share. We won't expect many of our categories to be in the 3% to 5% range. We would expect them to be in low single-digits and then we'll perform slightly better than that. But you do have that lap effect that is certainly playing a role. And then on the segments, what I'd call out is our segments all do have different nuances on performing, call it international is a good example of one that has been a strong growth for us and we'd expect that to continue. And now that we've actually mostly eliminated most of the volatility that we had on FX due to the sale of Argentina, that will be more consistent as well. Our health and wellness segment has continued to perform well. We continue to see share growth opportunities there. Our professional business is back on track, so feeling good there. And then to the point that you made on household, we have maybe an easier comp as you look through the year, given it took longer to fill distribution and we didn't meet expectations on that business in Q4. I think you'll see some variability, but, not outside of the range of the normal variability you would see in our segments."
},
{
"speaker": "Steve Powers",
"content": "And then if I could, Kevin, you may not want to go here, but I'm going to try anyway. Just you mentioned the structural benefits from the portfolio reshaping, the exit of Argentina VMS, those benefits of margins. I'm wondering if you could give us some kind of quantification or order of magnitude as to how material that is, as you think about the margins that margin improvement is embedded in the '25 guidance?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Steve, I appreciate the framing of your question. As Linda and I both said, exiting both those businesses, if you think about what we're trying to accomplish in our Ignite strategy, our financial goal is more consistent profitable growth. Those businesses were both dilutive, dilutive to the top line growth rate, dilutive to growth margin and profitability. And so we're exiting both of those businesses. You will see structural improvement. From a top-line perspective, it's probably less than half a point, but it'll structurally improve the growth rates of this company from the top line. And then, from a margin as well, you probably get in that 50 bps to 70 bps structural improvement gross margins once we get both these businesses exited. To me, it is a very nice adjustment to our portfolio to make sure that, we're doing exactly what we committed to more consistency and more profitable growth. And we think exiting both those businesses, while not easy decisions certainly support that endeavor."
},
{
"speaker": "Steve Powers",
"content": "You appreciate the framing. I appreciate the answer."
},
{
"speaker": "Operator",
"content": "Our next question comes from Javier Escalante with Evercore ISI."
},
{
"speaker": "Javier Escalante",
"content": "I have no clue what happened, so let's see whether it works this time around. I would like to tackle the household business slightly different. When you step back, it's rare when you see negative pricing and negative volume at the same time? And I know that you spoke a lot about promotional activity, but to what extent the volumes are telling you is that you took too much pricing? And I have a follow-up."
},
{
"speaker": "Linda Rendle",
"content": "I'm glad you're back online, Javier. So in household, here's how I would look at it. Certainly, as I said, it didn't meet our expectations. Very clear on why for both for all grilling, Glad and Litter. And it's exactly what I highlighted for grilling. We didn't see any extraordinary merchandising in that category. It was exactly what we expected it to be, but volumes were down due to weather. For Glad, what's going on that you have there is, we were out of the large size market for quite a while. So you have some dynamics on pricing and mix that are happening within that business, until you fully restore supply. I'd say the same thing for Litter. But Litter was a much heavier promotional environment than we would even see as normal as we had expected it to be and we certainly contributed to that as we were looking to get subscriptions back, etcetera. What we see though again is a more rational environment as we move forward back to pre-COVID levels from a pricing perspective. If I look at our value, for Glad, again, we ended the quarter down two-tenths of a point. That would say that our pricing is holding up well in the marketplace. And as we return large sizes, that's the value consumers are looking for. If they might have switched due to price promotion before now that we have the items they want in the market, I would continue to believe that they'll choose us, and evidence of that is the fact that we did so well on Prime Day and we're back to growing share in Glad Trash and our largest customer. And then for Litter, I think again that one's going to take a little bit longer. That is a category we see a decent level of price promotion in. We've accounted for that in our outlook. We would expect to continue to be competitive. But I don't feel like we're in a place where our price gaps are out of whack. It's simply that people are looking to drive against a value-oriented consumer. They want to win share in a more value-oriented marketplace. And again, I think for grilling as we go forward, merchandising plays an important role. Our price gaps look generally in line. Our shares held up. We were down three-tenths of a share point in June. Feel good about where we were despite a bad grilling category season, and feel like if we need to make any adjustments to pricing, like I highlighted earlier, I'm not sure, Javier, when you joined back in the call. But if we need to make any adjustments on an item basis, we absolutely have that plan right now and we won't be afraid to do it as we go through the course of the year. But largely, in aggregate, our pricing is working and holding in the market."
},
{
"speaker": "Javier Escalante",
"content": "And then the second question has to do with A&P spending or marketing spending. And one particular business that looks very weak in [Circana data] that includes Ulta as well and Amazon and Burt's Bees. So the brand has been weak for a long period of time. It goes through channels that are not compatible or not the same of the balance of the portfolio. And you compete with companies that spend multiples of 14% in marketing, like over 30%. The question is, as you review the portfolio, do you think that you are competitive in Burt's Bees or you will consider adjustments?"
},
{
"speaker": "Linda Rendle",
"content": "Burt's has been an acquisition for us over the years that we've been really pleased about. It's been in a faster growing category and Burt's has contributed stronger sales growth, if you just look in the aggregate, year after year given the opportunities in the natural personal care segment and the attractiveness of those categories. And we don't compete really with some of these large multibillion dollar beauty brands. And we compete in a segment where consumers are looking for products that come from nature, that offer that promise. I mean, although that set is quite competitive, they're not competing with some of the bigger brands that you might think of. And we're really a food drug mass type of business and we were built for that. Our pricing, our architecture is built for that, et cetera. I feel very confident in Burt's future. I'd say, right now, if you look at what Burt's has gone through, unfortunately, last year, we had a massive supply issue when we had a supplier have a fire that put lip tube availability significantly at risk. And then, of course, Burt's had the compounding effect that all of our businesses had of the cyber-attack. What you're seeing is some variability in distribution, et cetera. But if I look at the long-term health and opportunities in front of Burt, I see that as being an opportunities for it to continue to be growth accretive to the company. We're laser focused on making sure that as we have restored supply, we're getting that distribution back. We're also rationalizing distribution in some of the categories. I don't think it makes sense for us to compete in and I think that's just good portfolio management. But Burt's categories are attractive. We have a very strong brand that consumers love and I feel very confident about it moving forward."
},
{
"speaker": "Operator",
"content": "This concludes the question-and-answer session. Ms. Rendle, I would now like to turn the program back to you."
},
{
"speaker": "Linda Rendle",
"content": "Thanks. To close out today's call, I'd like to revisit our long-term strategy and reflect on our transformation journey. Ignite was created to accelerate profitable growth, to create long-term shareholder value. As part of that goal, we set on a course to fundamentally strengthen our value creation model, including how we generate the fuel necessary to drive growth. We're innovating with clear intention. We're focused on delivering superior value through brands consumers love. We're creating a consumer obsessed, faster and leaner organization by reimagining how we work, enabling our team with data and technology, streamlining our operating model, evolving our portfolio to reduce volatility and driving more profitable long term growth. Our strategy has guided us well over the past five years, but we've had to adjust our execution based on several factors outside of our control. We've gone through periods where we saw massive demand increases during COVID-19, normalization of demand, unprecedented inflation, multiple rounds of pricing, a cyber-attack, and the global macroeconomic and geopolitical uncertainty and volatility that persist today. These shocks have caused our performance to be more volatile. At the same time, they've also led to the acceleration of our transformation agenda. We've been purposeful and balanced on our actions, leaning on our strategy to execute through every challenge, staying committed to rebuilding our margin and earnings, while maintaining top-line growth. This is positioning us to fully restore margin in fiscal year 2025 and deliver strong free cash flow in line with our long-term goals, while investing strongly in our brands. I'm confident we're taking all the right steps, some of which add value now and others will bear fruit as we advance the choices further. We have consistently said that this would not be linear given the environment and challenges, but we continue to make strong progress and remain confident that we're on the right track. Through it all, we stayed true to our goal to transform Clorox into a stronger company poised to deliver more consistent profitable growth and enhance long-term shareholder value. Thank you for your time and questions. We look forward to updating you on our continued progress against our transformation agenda next quarter. Take care."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for attending."
}
] |
clx | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to the Clorox Company Third Quarter Fiscal Year 2024 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our prepared remarks, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin your conference."
},
{
"speaker": "Lisah Burhan",
"content": "Thanks Paul. Good afternoon and thank you for joining us. On the call today with me are Linda Rendle, our Chair CEO, and Kevin Jacobsen, our CFO. I hope everyone has had a chance to review our earnings release and prepared remarks, both of these are available on our website. In just a moment, Linda will share a few opening comments and then we'll take your questions. During this call, we may make forward-looking statements, including about our fiscal 2024 outlook. These statements are based on management's current expectations, but may differ from actual results or outcomes. In addition, we may refer to non-GAAP financial measures. Please refer to the forward-looking statements section, which identifies various factors that could affect such forward-looking statements, which has been filed with the SEC. In addition, please refer to the non-GAAP financial information section of our earnings release and the supplemental financial schedules in the investor relations section of our website for reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures. Now I'll turn it over to Linda."
},
{
"speaker": "Linda Rendle",
"content": "Thank you for joining us today. During the third quarter, we continued to progress our recovery from the August cyber-attack while advancing our Ignite strategy to build a stronger, more resilient company. For the most part, our progress in the third quarter was in-line with our expectations. Sales came in lower, as a few businesses experienced slower supply recovery than we planned. Gross margin came in higher, benefiting from our margin transformation program and a [modernized environment] (ph). Despite lower sales and strong investments in our brands, we finished the quarter ahead of our expectations on adjusted earnings per share. Before we turn to questions, I think stepping back and putting these results in context is important. Given the magnitude of disruption from the cyber-attack, we knew our plans to restore the fundamentals of our business would be complex, and a recovery path would not be linear. We have made tremendous progress and are laser-focused on finishing the job. We tracked well ahead of our expectations in the second quarter and knew we had more work to do as we entered the back half of the year to return our business to the strong trajectory it was on at the start of fiscal year 2024. This included fully rebuilding inventories, restoring normalized service levels, and rebuilding commercial plans for each of our businesses, which we accomplished by the end of the third quarter. These actions unlock our ability to fully restore lost distribution due to the cyber-attack and return to normalized merchandising levels as planned in the fourth quarter. Through Q3, we have regained nearly 90% of the market share we lost and expect to make further progress in Q4. With service levels now normalized and strong investment levels behind our brands, we're confident we can rebuild household penetration and return to volume growth over time. Despite the significant disruption and lost sales we've experienced and based on our team's strong work, we are now positioned to exceed our original gross margin target and meet or exceed our adjusted EPS guidance we provided at the beginning of the year before the cyber-attack. Importantly, our recovery progress to date puts us in a good position to exit fiscal 2024 with strong fundamentals. In addition, we continue to execute well against our IGNITE strategic priorities throughout our recovery. We made substantial progress rebuilding gross margins, continuing to target returning to pre-pandemic levels over time. We launched innovation invested in our brands and capabilities, progressed our streamlined operating model and digital transformation, and completed the divestiture of our Argentina business, which supports our goal of evolving our portfolio to deliver more consistent and profitable growth. In closing, we're taking the right steps to navigate the near-term and continuing to advance our IGNITE strategy. I'm confident we have the right investments and plans to deliver against our strategic and financial objectives and enhance long-term shareholder value. With that, Kevin and I will take your questions."
},
{
"speaker": "Operator",
"content": "Thank you, Ms. Linda. [Operator Instructions] And our first question comes from Peter Grom of UBS. Your line is open."
},
{
"speaker": "Peter Grom",
"content": "Thank you, operator, and good afternoon, everyone. Hope you're doing well. I was hoping to get some more color on kind of the implied 4Q organic sales growth and how this informs you on kind of the path forward here. I know this was always the case, but it seems like you're expecting to kind of close some of these distribution gaps of 4Q, more or less implying that you're going to overship versus consumption. But when you kind of look at the implied 4Q guide and to kind of where you need to be to land at the low end -- of low single digits for the year, doesn't really imply a ton of growth considering this dynamic. So maybe first, am I thinking about that right? And if so, how does this exit rate inform your view on the growth looking out to next year just in the context of the long-term algorithm of 3% to 5%? Thanks."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Peter. Why don't I get us started and I'll just talk about some of the dynamics that we expect in the fourth quarter. And then I'll hand it to Kevin, and he can talk about the outlook. And of course, you'll appreciate we're not setting guidance for fiscal year ‘25 at this point, but Kevin can certainly give you how we're thinking about the exit. So as it comes to Q4, there are a number of dynamics and things that are important that we plan to do and have the right plans to address. And the first is what you mentioned. We intend to fully restore the temporary distribution we lost as a result of the cyber-attack. And we are well on track to do that. At this point, we know the decisions on the shelf resets from all of our major retailers. We built the inventory in order to supply those distribution losses and are on track to restore that distribution. So certainly, that will help both reported and organic sales as we head into the fourth quarter. The second dynamic is now that we have fully restored our ability to supply and are back to normalized service levels, we are going to return to our merchandising plans, which, if you recall from our earlier conversations, we expect to be higher than they were during the pandemic, basically returning to pre-pandemic levels. And that is on track as well for the fourth quarter, and both of those will support growth. The thing I would mention, And as you can see, the implied range is rather large. And that's because it's still quite variable and volatile what we're dealing with. We're dealing with a complex recovery. shelf resets are all at different times for our retailers. How fast those resets happen. And then, of course, where we are on the purchase cycle with consumers will matter, and that's informing the depth and breadth of that range. But I'll hand that over to Kevin and he can help you think about just how that plays out in the outlook."
},
{
"speaker": "Kevin Jacobsen",
"content": "Hey, Peter. You know, as it relates to the outlook and I think specifically your question, organic sales growth in Q4. What I expect to see occurring this quarter is improving volume trends. If you look at our volume performance, we're down about 7% the front half of the year down 4% in Q3. I expect that to continue to improve as we move forward. I also expect we'll see some increased trade spending. We continue to work back towards a more normalized promotional environment. Q3 was still below sort of that normal level, so I think you would expect to see some increased trade spending. And then as a result of the divestiture of Argentina business, it's gotten a lot simpler. I don't expect any FX headwinds. I don't expect any meaningful pricing now. Most of our pricing was in international -- that would all go away. So you should see improving volume trends, a little bit of uptick in trade spending, and that gets you down to probably flat to down a little bit in terms of organic sales growth in Q4. And that would keep us on track to be up about 1% for the year."
},
{
"speaker": "Peter Grom",
"content": "Awesome. Thanks so much for that. And Kevin, maybe just one follow-up or more of a piece of clarification. In the prepared remarks, you mentioned kind of building on the 43% gross margin exiting the year. Is that a broad-based comment, or are you talking specifically on building relative to the 4Q exit rate?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, I think there's a few things. You saw where we landed, Peter, in Q3, a little over 42%. We think we'll be closer to 43% when we exit. You know, as Linda said, we're not prepared to provide our outlook for next year. But I would tell you, we fully expect to continue to expand margins in fiscal year ‘25. So we'll exit this year. You know, over the full year, we're probably up around 42%. And I expect a bill on that next year."
},
{
"speaker": "Peter Grom",
"content": "Thanks so much. I'll pass it on."
},
{
"speaker": "Kevin Jacobsen",
"content": "Thanks, Peter."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrea Teixeira of JP Morgan. Your line is open."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you, everyone, and good afternoon there. Linda, you mentioned in the prepared remarks few areas of the portfolio that experienced slower supply recovered than planned, that impacted the third quarter. And I understand the 10% that you mentioned that still is below the service levels. But relative to your 2% organic growth, how much was out-channel consumption given also comments in that same report that you experienced consumption losses? So can you elaborate more on which areas you were still below in share and what gives you confidence that the consumers you lost during that period within your consumption patterns would come back. And then Kevin, a clarification on what you just said about building margins into 2025 -- the fiscal 2025. How do you see rising prices in other commodities? Are you embedding these two inflationary commodities and how would you expect to offset that? Is that mostly on the savings? They IGNITE, how we should be thinking as we move forward."
},
{
"speaker": "Linda Rendle",
"content": "Sure. All right, I'll get started with that first question. And I think the question was twofold. So I'll start first maybe addressing the areas on supply that we called out that impacted sales for the quarter. And then I'll talk a bit more about the consumer and the confidence that we have about where we are and that we have the right plans in place as we roll into Q4 to continue to accomplish what we intend to do around the consumer and restore our business fundamentals. So in supply recovery, we talked about the last call and actually the call before that we had a couple of businesses that were more challenged given the depth of their portfolio. And that was Glad, and we called out Litter as well. And those continued to be a challenge a bit longer in the quarter than we had originally anticipated at the time of forecast. The good news is that with a few other minor things in businesses, we were able to fully fix all of those by the end of the quarter, and we exited Q3 getting back to normalized service levels to our customers. And so feel good that as we head into Q4, we have the right inventory and we have the right production plans and plans with our retailers to be able to get back all of those distribution points that we lost temporarily and, again, restore merchandising. So again, that was a temporary thing in nature, impacted Q3, but we don't anticipate that it will impact Q4. If you look at the consumer, a few things going on. First, our distribution points are still down versus pre-cyber, which we had anticipated. And we knew that the majority of shelf resets would happen in Q4. That is still going as planned and we expect to fully regain that distribution that we anticipated having at the beginning of the year when we set our original outlook. So on track there. And then I would say we're starting to see the share turnarounds. We've recovered nearly 90% of our share loss. And actually, if you even look at the last few weeks, you've continued to see that trend improve. And in addition, we're rebuilding households. So our households in Q3 are still down versus pre-cyber, which we expected, but improving and moving in the right direction. And if you think about it, we really only had from when we fully restored inventories, and again, haven't fully restored distribution, that's basically one purchase cycle for the consumer in our categories. Purchase cycle is about 90 days. So we've had one chance to influence as that consumer comes back to the shelf, and we're not fully restored yet. What we're laser focused on in Q4, and this is why we have the investment levels that we do, where we've increased our spending on advertising and sales promotion, as well as reduced revenue, ensuring that we have the right spending that in this next purchase cycle, that we can recapture that consumer. We intend to do as much of that as we can in Q4, and we're hoping to get the majority of it done. We're very confident in distribution, very confident in the merchandising, and now we're just watching as the consumer comes back to a fully-stocked shelf. What is their behavior, and do we need to make any tweaks as we head into the beginning of fiscal year ‘25, but feel very good about where we are in restoring the fundamentals and very good that we're beginning to see the consumer come back that we lost during that time."
},
{
"speaker": "Kevin Jacobsen",
"content": "Andrea, your question on ‘25 and gross margin, you know, as I'm sure you can appreciate, we're still in the process of building our plans right now for ‘25. But where we're sitting at today, I fully expect we're going to be growing top line, expanding margins, growing earnings. And so as you think about how we grow margin, I think to your specific question, certainly top-line growth helps build margin. Additionally, divestiture of our Argentina business, that was [margin-diluted] (ph) to the company. So, divesting that business certainly helps our margin. And then our margin transformation efforts. We think collectively that more than offsets what we believe will be a level of cost inflation but continue to moderate. So, we do not believe right now we're going to be in a deflationary environment next year. There will be some cost inflation, but it continues to moderate. And the actions I just mentioned we think are more than enough to offset that and allow us to continue to build margin next year. But the exact amount we're still working through."
},
{
"speaker": "Andrea Teixeira",
"content": "Yeah, thank you. That's super helpful. In Argentina, what is the impact of removing Argentina as a tailwind?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, we don't break that out, Andrea, specifically. But I can tell you it was significantly below the company average in terms of gross margins. You can probably do some math. It was 2% of sales and well below the company average in terms of gross margin."
},
{
"speaker": "Andrea Teixeira",
"content": "Okay, very good. Thank you very much, I will pass it on."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Chris Carey of Wells Fargo. Your line is open."
},
{
"speaker": "Christopher Carey",
"content": "Hi, everyone."
},
{
"speaker": "Linda Rendle",
"content": "Hi, Chris."
},
{
"speaker": "Christopher Carey",
"content": "I wanted to ask about sales delivery in the quarter excluding international. So in the prepared remarks, you spoke about increased competitive activity as you were trying to get back on shelf. Price mix was negative in your key division in the quarter. And I'm trying to marry that with, I think you had sounded quite good recently on the logistical dynamic of getting back on shelf in the quarter. And so I guess I'm trying to put maybe altogether the why behind sales coming in a bit below your expectations and whether competitors are perhaps a bit firmer on shelf and share gains than you had expected, and you need to increase competitive spending, whether that's in price mix? And obviously, you called out some trade promo in your gross margins this quarter, to get back on shelf and whether you think to your comment to the prior question, you may need to actually accelerate that spending over the next several quarters if this shelf-uplift is not exactly how you expect. So you can tell, I'm trying to wrestle between not just that sales came in below the expectation, but the why and some of the actions that you seem to be taking to try and rectify the situation."
},
{
"speaker": "Linda Rendle",
"content": "Yes, Chris, we -- from all the data that we see, the progress we've made with the consumer and what we anticipate will happen here in Q4, we do not feel like we have a dynamic that the sales miss was due to a consumer issue that we have or not bouncing back to that degree with the household penetration we lost. This was simply we had two very complex businesses, we thought we would make more progress on supply than we did. It went longer, it went through the remainder of the quarter when we thought we would get it done mid-quarter. That impacted our ability really to supply for merchandising mostly. Distribution, we always knew would come back in the fourth quarter because that's when retailers reset their shelves. So the good news is because we were able to fully restore supply by the end of the quarter, we're still on track to recover that distribution. But this really was heightened competition as we weren't able to supply merchandising events and still not in a place where we were fully able to supply on those couple of businesses. But we're through that, we got through that at the end of Q3. We have the ability now to fully supply in Q4. That investment level, we feel is the right investment level. And I'll just be clear, we have not constrained our businesses. We have said they should spend what they need to -- to get these households back. That is contemplated in the outlook that we provided and we believe we have the right spending on both advertising and [self-promotion] (ph) and merchandising. And if we have to make adjustments as we go through the quarter, we will. But right now, we feel like we have the right plans, we are seeing those households come back. Again, we went through one purchase cycle. We're going through another one here in Q4, but all indicators are that we will restore our business. And we feel like the fundamentals will be fully recovered by the end of Q4 and set us up well as we head into fiscal year '25."
},
{
"speaker": "Christopher Carey",
"content": "Okay. One quick follow-up would just be Manufacturing and Logistics was a 210 basis point negative impact to gross margin in the quarter. That's a pretty notable step-up. And I don't think we're seeing logistics inflation at that level. Kevin, can you maybe just contextualize what happened there in the quarter? And whether that specifically is durable going forward or whether this is just an anomaly? Thanks."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure, Chris. The increase you referred to that is primarily driven by inflation in Argentina, you might recall before we divested that business, we were projecting about 300% inflation, and they had a significant devaluation in December. So that was playing through and it's the biggest driver. To your question, as you go forward now that we divest the business, I would not expect to see Logistics and Manufacturing be that level of a drag. Logistics is turning on us, it's fairly benign in terms of year-over-year cost once you strip out Argentina. So, this is one of the additional benefits of not having that business in our portfolio any longer, given the disruptions it had broadly across the P&L."
},
{
"speaker": "Christopher Carey",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our next question comes from Dara Mohsenian of Morgan Stanley. Your line is open."
},
{
"speaker": "Dara Mohsenian",
"content": "Hi guys. I get you don't want to be too explicit for fiscal '25 at this point, but I just had a follow-up question on top-line growth as we move into next year just relative to a normal base this year. Kevin, can you just talk about or Linda, any puts and takes as you look out to fiscal '25 as we think about top line growth? And maybe also just quantify what level of sales did you lose in fiscal '24? Do you expect to lose in fiscal '24 from the systems issue relative to a typical year?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Hi, Dara, what I'd say it's a little too early for us to talk too specifically about the '25. As I said, we're still developing our plan. Maybe the one item, I would just make sure remind folks is, with the divestiture of Argentina business, that's about 2 points of sales. We'll see a portion of that in Q4, but you'll probably still have about 1.5 point headwind next year as a result of that sale. But for the other items, we're going to wait until August to have that conversation because we're still working through our plans. It'd just be too early to talk any detail."
},
{
"speaker": "Dara Mohsenian",
"content": "Okay. And then on gross margins, you talked about a CAGNY to focus on holistic margin management and RGM. Can you give us a little more color on how important that might be over the next couple of years? And as you think about recovering gross margin pressure over time as you indicated in the prepared remarks, is that a big piece of the recovery? And as we think about the recovery, is this a multi-year effort? Should we think about a lot of progress coming out in fiscal 2025? How do you think about that conceptually from a timing standpoint?"
},
{
"speaker": "Linda Rendle",
"content": "Sure, Dara. Without obviously, again providing any guidance for 2025 or beyond on specifics. I think I can say with really strong confidence, one based on the track records, if you look, we've delivered our sixth consecutive quarter of gross margin expansion behind this toolkit that we have. And what we talked about at CAGNY is important. Pricing and cost savings have been the majority of the tools that we've had, and we put them to good use over the last couple of years as we've dealt with inflation. But we knew that we wanted to take a broader look and the fact that we are implementing a digital transformation, and we have more visibility end-to-end, gave us a great opportunity to look and see where else can we go beyond traditional cost savings. Revenue growth management is certainly one of those tools, price pack architecture within that. And the teams all have plans in place to use those tools to continue to make progress against our commitment that we stand behind to return gross margins to pre-pandemic levels and then grow from there. And we feel very confident in our ability to do that. Kevin and I have talked before, it's really dependent on two things. One how fast we implement this toolbox and feel good about that. But second will be what the cost environment looks like. And as what we continue to look forward, we continue to see inflation in people's reporting. Again, we are not providing any specifics around our business at this point. But the pace of recovery and when we returned to pre-pandemic levels will be those two factors, but we feel very good about what's in our control and that we have the right toolbox to be able to accomplish what we set out to do."
},
{
"speaker": "Dara Mohsenian",
"content": "Okay, thanks guys."
},
{
"speaker": "Linda Rendle",
"content": "Thanks Dara."
},
{
"speaker": "Operator",
"content": "Our next question comes from Anna Lizzul of Bank of America. Your line is open."
},
{
"speaker": "Anna Lizzul",
"content": "Hi, good afternoon. Thank you for the question. You mentioned in your prepared remarks a consumer who remains under pressure. I was wondering if you're seeing this across all income tiers? Or is this comment primarily related to the lower income consumer as some other companies have indicated so far in Q1? And then you mentioned your levels of merchandising and promotion are increasing along with the higher advertising spend in the second half here. So, just wondering how much of this is driven by the need to rebuild share loss from the cyber-attack versus just trying to win over a financially weaker consumer. Thank you."
},
{
"speaker": "Linda Rendle",
"content": "Sure. We're seeing pressure across all consumer groups. And we are seeing behaviors broadly outside of our categories changing for nearly everyone, as they evaluate what's going on. And as they think about what's happening in the future whether that come down to the interest rate environment, et cetera, cost of housing, a cost of a basket of groceries when they go to the store. So we are seeing that behavior quite broadly, and we called it value-seeking. People are buying larger sizes, they are buying smaller sizes and they are thinking about the trips they take, et cetera. I would say, in particular, we always have our eyes focused on the lower income consumer as they are more pressured. And I -- and to-date, we have stood very well with them. And we tend to do it during times -- tough economic times for low-income consumers because we deliver products at a great value that work really well, and they can't afford to make a mistake in our categories. And so we typically fared-well, and we continue to see that we are doing well with low income consumers. And we haven't seen a material trade to private label that isn't due to the cyber-attack. And of course we are watching that closely as we get our distribution and our merchandising back, but we largely believe private label growth is due to the fact that we weren't on the shelf. And we are seeing Q3 their share was lower than it was in Q2. We are seeing all the right indicators our households are coming back that might have tried private label during that time when we were off the shelf. So we're watching all income tiers always focused on low income, but that was a very general comment to say that all consumers are under more pressure and are certainly evaluating their behaviors and how they are spending their wallet. And then when it comes to our spending plans, we had always anticipated that we would return to pre-pandemic merchandising levels before we even saw a more stressed consumer. Because we just thought that was the right level of spending to ensure we were introducing people to new innovation making sure that we are capturing new behaviors in times where consumers are open to that. For example, when they send their kids back to school or when they send the kids to college. And so we'd always anticipated that, and that -- this promo though does also support our return to share growth and our return from a distribution perspective. So we like that it works doubly hard for us. But I wouldn't say, we are doing this because of our recovery from cyber. We just always anticipated that this merchandising level of return. And then from an advertising and sales promotion level, we did increase that this year because we saw a pressured consumer and wanted to make sure that we were communicating our superior value, et cetera. But these are all within the range of normal spending for us in a given year. We typically spend around 10% in advertising and sales promotion. It will be closer to 11% this year, and we are returning to a level of reduced revenue spending that we've had in the past. So, we don't see any need to go further or deeper than that. We feel like we have the right level. But this really is about more normal course of business than it is that we're seeing consumer behaviors that we need to react to."
},
{
"speaker": "Anna Lizzul",
"content": "Okay, that’s very helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Javier Escalante of Evercore ISI. Your line is open."
},
{
"speaker": "Javier Escalante",
"content": "Good afternoon everyone and thank you for the question. I actually have two. One is if you could -- on the commentary when it comes to market share and household penetration, it feels as if you are referring always back to the cyber-attack. But if I understand the trajectory correctly, there was also market share losses relative to say pre-pandemic because of the supply chain issues that you mentioned. So if you can comment on that -- whether the intent is to restore market share to pre-pandemic levels in these highly contested categories like pet litters and trash bags? And then I have a follow-up."
},
{
"speaker": "Linda Rendle",
"content": "Sure, Javier. I mean it has certainly been a complex last few years and lots of puts and takes. And so what I would comment on is we intend to grow market share. That is our mid- to long-term goal, and that is the bar we hold for ourselves to say if we are winning with the consumer or not. Clearly, given the cyber-attack, we have not grown market share this year, but we're seeing the trend move in the right place. So for perspective, we lost about 5 points of share, nearly one-third of our market share during the low point from a cyber perspective. And we are back down -- we ended the quarter down about [0.75] (ph). We've made progress since there if you look at the weekly data. But what we first need to do is restore market share and then grow from there, and we believe we have the right plans to do that. If you look at many of our businesses, they are variable versus the market share they had in the past. But in aggregate, we mostly returned and some businesses were higher, for example, on our cleaning business. We made significant progress on market share, even though we had COVID and then, of course, multiple rounds of pricing. And our brands have held up really well. So my evaluation would be heading into the cyber that we were in the right place from a market share. We had plans to grow market share. Cyber has unfortunately caused another place where we took a step back, and we have to rebuild, but I'm confident in our ability to return and then we're working on plans in fiscal year '25 and beyond to deliver that market share growth we aspire to."
},
{
"speaker": "Javier Escalante",
"content": "Thank you. And then the follow-up, and it's a little bit in the line of Chris' question. It seems -- rarely you are seeing consumer businesses, and it could be accounting that you have negative pricing and negative volumes at the same time in the quarter. So what gives you confidence that you didn't take too much pricing and the value players are gaining share in trash bags and pet litter and I believe most recently in Glad that you don't need to reset prices into 2025."
},
{
"speaker": "Linda Rendle",
"content": "Yes. I would say, first of all there is a price mix in a trade component of Q3, and certainly, Kevin can walk through that in more detail. But if I just take step back and say, what were the dynamics in Q3 that give us confidence and what were the dynamics that negatively impacted us? It's pretty clear. We weren't able to fully supply on a couple of those businesses that you mentioned, Glad and Litter in particular. And that means we weren't fully available for the consumer, which we don't like. But the good news is, as I've said, we recovered that ability to supply by the end of Q3, and we feel good heading into Q4. And also, there were more competitive dynamics, given that fact that we couldn't fully supply. We saw more merchandising from competitors, et cetera. As it specifically relates to private label, if you look -- there was a stressed consumer prior to the cyber event, and we didn't have any material loss to private label and share during that time, nor have we, in any recessionary time lost any material share to private label. We offer brands with great value. We offer innovation, the consumer trust us, they love our products. They love our brands, and we spend behind those brands to ensure that they understand the superior value we deliver. And we see that beginning to take hold and work in Q3, as we restore distribution and inventories. We saw private label share come down versus Q2 and heading in the right direction back to what we would expect it to be in a more normalized environment. We expect to continue to make progress as we restore distribution in Q4. So I think it would be pretty understandable to say -- when you are not fully on the shelf and you don't have all your distribution, a consumer is going to choose what's on the shelf, and they did. And -- but we feel confident in our brands, confident in our spending plans that we'll restore that back. And history would tell us when we were out of stock in COVID that happens. When we've had product issues where we're out of shelf on time sell, we came back. We restored our share in distribution. We have a long history of doing this, and I remain confident in our ability to do it in Q4 and beyond."
},
{
"speaker": "Javier Escalante",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Filippo Falorni of Citigroup. Your line is open."
},
{
"speaker": "Filippo Falorni",
"content": "Hi, good afternoon guys. I first wanted to ask on the recovery from a shelf space standpoint. In prior earnings call, you sounded very confident that you're going to recover the full of the TDP that you still haven't recovered the distribution points. Is that still the expectation and in the quarter, and in the year, I mean? And was the weakness in the quarter? Like does that change a bit the full year expectation versus what you had expected, particularly for Glad and for the Cat Litter business? Thank you."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Filippo. We fully expect to recover in Q4, the distribution against our plan that we had fiscal year '24 that we lost. We view that as temporary. And we have seen the shelf decisions from retailers. They are now in the process of converting their sets. As we speak in some of our categories and some will happen throughout the quarter. So we have strong confidence that we will restore that distribution. And that really was not the Q3 story because we always knew most of that distribution would come back in Q4. That's really more of a supply and service level issue story in Q3. And again, we have fully recovered from that, and we are heading into Q4 in a great place. We're able to fully supply that distribution that we will recover. I'd also just note, I did a recent roadshow with all of our top retailers. And they want our business pack on shelf-two. We are the brand that leads their categories. They're very invested and growing with us. Our conversations we're focused on growing, moving forward, our innovation plans, what we want to do to unlock our joint digital plans now that we're well underway on our digital transformation, now that we know 100 million consumers, how can we personalize better to them. The conversations were very growth-oriented, future focused and they're looking forward to having our full distribution back as well so that we can grow their categories."
},
{
"speaker": "Filippo Falorni",
"content": "Got it. That's helpful. And then maybe, Linda, just a longer-term question. I remember when you updated your long-term outlook to 3% to 5% from 2% to 4%, a component of that higher outlook was the international business. Obviously, you made the decision to divest Argentina. So maybe you can review what's left in the international business and how that contributes to your long-term target?"
},
{
"speaker": "Linda Rendle",
"content": "Sure. You are absolutely right that we talked about international being a portion of that growth. And if you look at the performance of our International over the last couple of years, it certainly has played a role where it's growing faster. But we also talked about having a more consistent less volatile business. And Argentina was a high source of volatility and variability. And certainly, you saw the FX impact play out, and you heard Kevin talk about what we expect moving forward. So that was definitely on our minds to reduce the volatility and variability that we had and then be able to grow from a very solid base. And you might recall from a few years ago, we had purchased the majority ownership of a JV partnership we have in the Middle East, was a good example of looking at markets that we could grow faster in that were more stable and predictable and that has played out very well. We continue to have a really healthy consumer there. Innovation is working well in that marketplace. And so what I’d say is, it's very consistent with what we've said before. We have continued business in Latin America that we feel good about, and we'll continue to grow business in Asia, Europe, the Middle East. And we continue to have growth pockets on businesses like Litter, et cetera, our cleaning business, which is the majority of our business is international and we continue to expect international to be a strong contributor, but it will be much more profitable and stable versus what it was before."
},
{
"speaker": "Filippo Falorni",
"content": "Great. Thank you."
},
{
"speaker": "Linda Rendle",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Lauren Lieberman of Barclays. Your line is open."
},
{
"speaker": "Lauren Lieberman",
"content": "Great. Thanks. Just a couple of things. So first was just in the release you specifically called out that part of the increase in the gross margin outlook was a more favorable outlook for raw material cost or for input. So just curious on a little bit of color there. And then secondly was thinking about Argentina, I know we are not going to do business planning guidance for '25. But just thinking about when you lap Argentina, like Argentina FX is such a huge impact, for example, on gross margins even this quarter, last quarter. Do we like reverse that? Or is it just the impact disappear because the business is gone. I'm just kind of thinking ahead. Again, not about the totality of gross margin, but just how to think about the absence of Argentina moving forward and the margin impact on the business."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Lauren, happy to take those. As it relates to gross margins – I’m going to start there and kind of what we're seeing from a cost perspective. We are seeing costs continue to moderate, I think as you saw in Q3, is a fairly small impact, particularly if you look at commodities, we are seeing some commodities become deflationary. You see that a bit in soybean oil, which is something we use in our food business. You're seeing it in other categories, substrates, some chemicals. We are seeing still some cost increases, particularly on petroleum-based products, solvents, diesel. Resins up just a little bit. That's more supply-demand driven more than input costs. And so I'd say, it is definitely going in the right direction. It is a fairly modest hit for us in Q3, and that's certainly been an ongoing improvement. I would say, on the other piece of inflation, which is more wage driven, it's generally playing out as we expected. That tends to show up in manufacturing and warehousing. We're still seeing ongoing inflation there. But on the commodity front, it is certainly easing and as we step out of Argentina, which is a source of inflation, I expect it will be fairly benign by the time we get to Q4 on the commodity side, and then we'll continue to deal with the wage inflation. And then [how] (ph) thing about Argentina next year, I think you said exactly right, is -- as we move forward, a number of the areas you talked about, you will not have that impact going forward. So let me give you an example. You highlighted FX this quarter, to your point it was about 180 basis point hit to margin. That was almost entirely Argentina. As I look forward, even starting in Q4, we should have almost no FX hit to gross margin. So you get that benefit. But keep in mind, that will be offset by other areas, things like pricing, but pricing you see in Q3 was primary Argentina, that will also go away. So you'll strip all that out. Ultimately, the net impact of all that is Argentina was a margin-dilutive business for us. So by stepping out of that, all the different lines, when you look at it in totality, our margins will go up as a result of exiting Argentina. But you'll strip out each one of those elements that Argentina drove."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay. And that impact from Argentina from the exit and just going back to it's actually a pretty small business. It is a small net impact when you put all these pieces back together on the year-over-year margin like in this quarter next year for example?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, that's right. I mean you look at the business, it is 2% of sales, and you can probably do the math pretty quickly. It is a very dilutive business to us that when we owned it and represents 2% of our sales. So you can probably do the math, you see there is some modest benefit to our gross margin going forward now is out of the portfolio."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay. Great. And then one thing I just want to clarify. I think I figured out the call in on, but there were two conflicting statements in the release in the prepared remarks about supply chain constraints being a problem in the quarter, but having resumed normal service levels. So I didn't know if it was a timing difference, like normal service levels as you exit the quarter, but constrained by supply chain during the quarter. I just wanted to make sure it's clear on how those two statements fit together."
},
{
"speaker": "Linda Rendle",
"content": "That's right, Lauren. So we were not able to fully service our retailers throughout Q3 until the end. So at the end of Q3, we restored normal service levels and we entered Q4 with them back to being normalized and that marries with the supply chain comment that we had some constraints, which impacted those service levels throughout the quarter."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay, all right. Thanks so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Olivia Tong of Raymond James. Your line is open."
},
{
"speaker": "Olivia Tong",
"content": "Great, thanks. I wanted to ask you two questions around margins. First, on gross margin. Obviously, the EPS outlook for this year is now higher than where you were pre cyber-attack and much of that is due to the gross margin expansion of about 100 basis points ahead of where you thought you were going to be at the beginning of the year. So in the past, you've talked about 200 basis points of gross margin improvement annually, as you recover from the post-COVID decline this year, now [$2.75] (ph). Last year, obviously, a lot more than that, despite all the ups and downs with the cyber-attack. So, can you just talk about ex-Argentina, ex the cyber, all these things, the ability to keep outperforming on gross margin, what you learned from this year last year, what capabilities continue versus some of the one-offs that are helping and hurting this year? Or just sort of the ongoing recovery on gross margin relative to the post-COVID timing? Thanks."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure, I'll be happy to take that one. As you think about gross margin, and you almost have to separate what we've been doing for the last several years in terms of where I think it's going longer-term. We're still working to recover from the record level of inflation that we've had to absorb. And as I think you know quite well, Olivia, we lost about 800 basis points in gross margin due to this inflationary cycle. And Linda and I both talked quite a bit, we remain committed fully recovering that. To your point, with the work we did last year, the work we're doing this year, we'll get about 650 basis points – we will recover. We've got more work to do and feel quite confident we'll get there. The process to get there, we were leaning into pricing. We took four rounds of pricing, which is very consistent with what you saw broadly in our industry to recover from this inflation. As we move forward though, now and get back into what I described as we believe a more normalized cost environment, typically, our cost savings efforts is more than enough to cover normal levels of inflation and allows a little bit extra that we can either invest back in the business, take to the bottom-line to further expand EBIT margin. And that's where that long-term goal of 25 basis points to 50 basis points was generated, which is normal level of cost inflation, which for us tends to be about $75 million a year. Our cost savings more than cover that and we use the extra to modestly improve margins each year. That's where we're going. We're not there yet. We're still working on recovering from the inflationary cycle, not was through pricing, but it's certainly moving in the right direction. So we will get back to fully recovering these gross margins over time. And then I expect assuming that the commodity environment gets to a more normalized level, that's how you should expect to see us continue to grow margins over the long term as our margin transformation efforts more than offsetting regular levels of inflation."
},
{
"speaker": "Olivia Tong",
"content": "Got it. And then just a point of clarification on your call for higher advertising in the second half --. Are you talking about higher as a percentage of sales sequentially or that the year-over-year change in second half is higher than it was in the first half? And how much of that is due to the clear pullback in spend in first half when you had -- you're out of stocks versus just desire to have greater programs, greater opportunity to support some of the innovation? Thanks."
},
{
"speaker": "Linda Rendle",
"content": "Sure. Olivia, if we wind the clock back to the beginning of the fiscal year, we actually had intended to spend more money in advertising and sales promotion in our original guidance, we said about 11%. And -- we still intend to do that. But you're absolutely right that given the cyber attack, the shape of that over the course of the year has changed. So we spent less in the front half of the year, we are spending more in the back half, still with the intention of spending. What we're seeing now is over 11% of sales. I want to be clear on the dynamics there, though. It is about -- we're spending about the same money we had intended. But given what we've talked about from a sales outlook perspective and Argentina it would put us above 11%. But we're still spending about the same amount of money as we intended to when we first gave that guidance. But again, this was more about supporting our brands as consumers are more challenged. We felt good about our innovation plans and we wanted to spend behind them. And again, just the shape of the year has changed given the cyber event."
},
{
"speaker": "Olivia Tong",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "This concludes the question-and-answer session. Ms. Rendle, I would now like to turn the program back to you."
},
{
"speaker": "Linda Rendle",
"content": "Thanks so much, everyone. We look forward to updating you on our continued progress on our next call. Until then, stay well."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for attending."
}
] |
clx | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to The Clorox Company Second Quarter Fiscal Year 2024 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our prepared remarks, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin your conference."
},
{
"speaker": "Lisah Burhan",
"content": "Thank you, Jen. Good afternoon, and thank you for joining us. On the call with me today are Linda Rendle, our Chair and CEO, and Kevin Jacobsen, our CFO. I hope everyone has had a chance to review our earnings release and prepared remarks, both of which are available on our website. In just a moment, Linda will share a few opening comments and then we'll take your questions. During this call, we may make forward-looking statements including about our fiscal 2024 outlook. These statements are based on management's current expectations, but may differ from actual results or outcomes. In addition, we may refer to certain non-GAAP financial measures. Please refer to the forward-looking statements section which identifies various factors that could affect such forward-looking statements, which has been filed with the SEC. In addition, please refer to the non-GAAP financial information section of our earnings release and the supplemental financial schedules in the Investor Relations section of our website for reconciliation of non-GAAP financial measures to the most directly-comparable GAAP measures. Now, I'll turn it over to Linda."
},
{
"speaker": "Linda Rendle",
"content": "Hello, everyone, and thank you for joining us today. We delivered financial results above our expectations in the second quarter, thanks to very strong progress on our recovery from the August cyberattack, continued advancement of our strategies to drive top-line growth and rebuild margin, as well as the swift and effective management of currency headwinds in Argentina. We are rebuilding retailer inventories ahead of schedule, enabling us to return to merchandising and restore distribution. As a result, we made great strides rebuilding market shares. Importantly, throughout our out-of-stock period and recovery, we've maintained our strong brand superiority results as measured by our consumer value metric. This speaks to the power of our advantaged portfolio, the superior value of our brands and their role in consumers' daily lives. While there is still more work to do, we're on the right path to return our business to the trajectory it was on before the cyberattack. Looking ahead, we expect the operating environment to remain challenging, as consumers remain under pressure and their value-seeking behaviors continue. Nevertheless, we remain committed to growing the top line and rebuilding margins and expect volume to play a stronger role in our top line performance as we lap pricing. We're well-positioned to make further progress in rebuilding distribution and market shares, as well as drive volume and household penetration growth over time through strong demand creation plans. Given the progress we've made in the second quarter, we are also updating our full year 2024 outlook. We have a strong diverse portfolio of trusted brands, we play in essential categories and we're making the right investments guided by our IGNITE strategy to create long-term value for stakeholders. I'm confident that we're taking the appropriate actions to build a stronger, more resilient Company that is positioned to win in the marketplace, and deliver consistent, profitable growth over time. With that, Kevin and I will take your questions."
},
{
"speaker": "Operator",
"content": "Thank you, Ms. Rendle. [Operator Instructions] And our first question today will come from Andrea Teixeira with JPMorgan Chase."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you. Good afternoon there . Linda and Kevin, I just wanted to go back, obviously, an amazing performance you caught up with I think with the second quarter fiscal you caught up with kind of according to my math a minus 2%, pretty much first half against first half of the prior year. And then what are you implying given the Argentine peso depreciation is underlying beta as you put in prepared remarks and your commented it just now but then you have a greater FX headwind. But when you go and flow through everything and according to the new guidance the plus 200 basis points improvement in gross margin. It implies that your gross margin in the back end declines vis-a-vis what you had in the back end of last year. And so I was just trying to reconcile, because your numbers kind of imply profitability going down, the way I understand the transactional FX. But it seems a bit high. If you can kind of walk us through why would that happen given the beats the magnitude of the beats?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, Andrea. And maybe let me take a stab at answering some of those questions, and let me know if we missed anything. But as it relates, maybe I'll just start with Argentina might be a good place to start. Because you've heard from many of our peers that's an incredibly difficult environment right now. I think if you just step back and think about our business in Argentina, we've been in there for a very long time, we have very capable leaders managing very strong brands. While there are some negative impact in Argentina flowing through our outlook we provided today, both on the top line in terms of higher FX as well as higher inflation and FX exposure and margin. What you should know is, based on the actions we've taken in Argentina, including incremental pricing, we think we fully cover the negative impacts of Argentina within this outlook with the one exception of the remeasurement loss and I'm happy to talk about that, but setting that remeasurement loss aside, we think we fully contain the Argentina impact in this P&L. As it relates to the back half, you were asking about gross margin, and as you saw, we delivered about 41.5% gross margin in the front half. And if you look at the back half, based on the outlook, it suggests will be fairly similar 41.5% as well. And so we're looking at sequentially fairly consistent trends. If I think about what's changing from the front half to the back half, there's a few items I'd point out. In terms of increased headwinds, we continue to expect higher trade spending in the back half of the year, as we get to a more normalized environment. We also now have lapped all our US pricing. We lapped the last round of pricing in December. So you'll see less benefit from pricing in the US. And then we're expecting more inflation and more FX headwinds coming out of Argentina. We are offsetting that with incremental pricing, we're executing in Argentina, so you'll see international price mix benefits in the back half of the year to a greater degree than the front half of the year, as well as we're projecting improving volumes trend. And so collectively that's offsetting those headwinds, and we're getting to a margin fairly consistent front half versus back half and that puts us in a position to improve margins by 200 basis points on a full year basis. Now, I think maybe the last question you talked about versus prior year, I think you have to be a little careful looking at the comps. If you look at our gross margins in the back half of last year, I think they're up almost 600 basis points. And so we're relatively flat, but on a very strong performance in the prior year. Well, let me stop there. Andrea, let me know if that answered your question."
},
{
"speaker": "Andrea Teixeira",
"content": "Yeah, that did Kevin. Thank you. And I think one of the kind of like a fine point on that commentary. When you say, in the prepared remarks, I think Linda had mentioned you're confident to regain shelf space and you're looking obviously regained service levels. It sounds to and even in our meeting recently in New York, you kind of alluded to initially that guidance and I think we all in this call appreciated there was a lot of moving pieces and you're conservative. It seems like you're embedding some potential risk at that point of not being able to recover the service levels, now you did recover. So I'm more in the side of like thinking of the strength of what you achieved in six months. I'm thinking more, why not expecting that momentum to continue now, that you potentially could recover some of the shelf space losses that you had, especially now coming up on the spring reset."
},
{
"speaker": "Linda Rendle",
"content": "Sure, I'll take that and maybe I'll just start with your first important point, which was our expectations in Q2, and what drove the significant over delivery. If you recall, you got it exactly right. At the point where we provided an outlook for Q2, we were at a point where we had just turned back to automated order processing and we knew there'd be a transition time going from manual to automated and that would take us a bit of time to ramp up. We're also heading into key holiday time for retailers, which is a challenging time to ensure that we get the ability to have appointments and ensure that we could deliver what we needed to, in order to deliver what we ended up doing for the quarter, which was every single day shipping significantly above an average day that we would normally ship. And we I think were appropriately cautious given all of those potential headwinds on what we could accomplish. And again, the goal was to restore inventories by the end, the majority by the end of Q2, knowing some of that would flow into Q3 and Q4. So what happened in Q2, we were able to get all of that ramp up and we really leaned into our operating model. We designated a General Manager, who is in-charge of solely getting inventories rebuilt and retailers. And she had a multi-functional team around her to do that. And we were able to quickly ramp up from manual to automated and ship nearly every single day significantly above an average shipping day pre-cyber event, and our retailers were extraordinary. So we were able to get in, we were able to get appointments and the result of that, if you look at distribution, we were down over 30% of our TDP. If you look at average weekly TDPs down over 30% at the height of our out-of-stocks. We've gotten back to mid-single-digits, some business is slightly better than that, some slightly worse, and I can cover that. Market shares at the height of this, we were down over five points. If you look at the four, five weeks ending December, we were down a point. Look at the latest four, five weeks ending January 21st down 0.7, so all that flowed in the right direction, which gives us confidence. But that speaks to with the work we have remaining and we talked about this last quarter. We spoke about the fact that a lot of this was under our control and we were going to maximize that I felt good about what we did in Q2. But we're also dealing with the fact that in order to fully restore distribution, we need to have retailer resets, and those happen mainly in the spring and they vary through the back half of our year. And we intend to finish the job, then. And in addition to that we have to fully restore merchandising. So as we get our business up to the service levels we expect, and to be clear, our service levels are still depressed. They are significantly better. But we need to fully restore those. We'll return to merchandising in the back half and full as well. And with that, we feel good about our plans, we feel like we have the right investment levels. Our brands have maintained their superior value as I said in my opening comments, so feel good about it. But I just want to be clear, we didn't -- the job not done in Q2, tremendous progress, but we have more work to do in the back half."
},
{
"speaker": "Andrea Teixeira",
"content": "Thank you. I'll pass it on."
},
{
"speaker": "Operator",
"content": "And our next question will come from Peter Grom with UBS."
},
{
"speaker": "Peter Grom",
"content": "Thanks, operator, and good afternoon, everyone. So I wanted to ask on the organic revenue growth trajectory. Can you maybe just help us understand how you are thinking about volume versus price in the back half of the year. Linda, you mentioned you expect volume to be a stronger contributor to your performance, does that assume a return to growth or just kind of less of a drag versus what we've seen prior to the disruption. And then just on the pricing as well, particularly as you now lapped the US pricing but are taking incremental pricing related to Argentina. Thanks."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure. Hi, Peter. As it relates to organic sales growth and transitioning from the front half to the back half, you have to think about what the changes are, as it relates to volume, we expect to see improving volume trends in the back half of the year. That's a combination of both continue to recover from a cyber-event as well as now that we've lapped pricing, we'd expect to see improving volume. If you look at the front half, our volume was down high single-digits and so we would certainly expect to see those improving volume trends as we go forward. And then in addition to price mix we've now as I said lapped our US pricing in December, the last of the four rounds we took. And so US will be contributing much less, in fact very little impact to favorable price mix. But we have now leaned into Argentina in November and December we took double-digit price increases both months. And so you will still continue to see positive price mix in the back half of the year in-spite of increased trade spending. So I'd say overall improving volume trends from the front half of the year. Price-mix being a little lower than the front half because we've lapped US pricing, but still fairly strong for us, and that's how we get to an expectation that we'll be growing for the full year low-single digits, and that means the back half would be a bit stronger than where we land in the front half in terms of organic sales growth."
},
{
"speaker": "Peter Grom",
"content": "Got it. And that's really helpful . And then I guess just, Kevin on the 42% exit rate, I think, I may be reading too much into this, but are you simply just trying to provide some color on the second half phasing, or are you trying to signal how we should be thinking about the gross margin recapture opportunity looking out to fiscal '25."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, it's more about phasing in the back half. Just want to make sure we're highlighting folks for that all that pricing in Argentina to take effect, it will probably be the fourth quarter or it's fully in market. So I'd I expect my fourth quarter gross margin to be a bit stronger than third quarter. But having said that, as you know, Peter, Linda and I remain committed to rebuilding gross margins back to the level we had before the, what I described as you know the super cycle of inflation. Good progress last year. We intend to make more progress this year, but the work is not done. And I fully expect going into '25, we'll continue to expand margins. But importantly we'll do that while we continue to invest to grow the top line and continue to advance our strategic initiatives. So we continue to focus on all three. But as it relates to margin I expect to make solid progress this year and I expect that to continue as we go into '25."
},
{
"speaker": "Peter Grom",
"content": "Thanks so much. I'll pass it on."
},
{
"speaker": "Kevin Jacobsen",
"content": "Thanks, Peter."
},
{
"speaker": "Operator",
"content": "And we'll move next to Anna Lizzul with Bank of America."
},
{
"speaker": "Anna Lizzul",
"content": "Hi. Good afternoon. Thanks very much for the question. I wanted to ask on the outlook in the prepared remarks, you mentioned expecting a modest slowdown in category growth rates in the back half of the fiscal year. Are there any particular categories where you expect an outsized impact versus categories that you think are more resilient."
},
{
"speaker": "Linda Rendle",
"content": "Sure. This assumption on a modest slowdown in categories is one consistent with what we provided as an original outlook to fiscal year '24, as we saw the consumer come under more pressure, and we originally had the assumption of a mild recession which we are no longer assuming, but still assuming that consumer is going to be under more pressure given all the factors in the macro-economy. And so that's consistent with that. And if you look at our categories, given they're all mostly household essential categories, we would expect no large difference in those categories. We might see little nuances here and there, but on average, we expect all of them to be slightly slower. And that's consistent with what we've seen in the past in times like this. But I wouldn't call out anything in particular that would be a wide variance to that assumption."
},
{
"speaker": "Anna Lizzul",
"content": "Thanks for that. And just a follow-up on the organic sales question earlier on the Lifestyle segment in fiscal Q2, we saw a negative price mix. Can you just tell us what is driving that and should we expect to see negative price mix in the back half of the year on this? Thanks."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure. As it relates to Lifestyle that was in our Burt's Bees business, we do quite a bit of holiday gift packing and merchandising in the second quarter on that business, and so you have increased promotional activity. And so that was specific to the second quarter. And you may see that occasionally based on merchandising plans as we go forward."
},
{
"speaker": "Anna Lizzul",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "And our next question will come from Dara Mohsenian with Morgan Stanley."
},
{
"speaker": "Dara Mohsenian",
"content": "Hey guys. Just maybe looking beyond fiscal '24, I think the tailing question today is probably the earnings outlook as we look out to fiscal '25. I know obviously you won't comment on that directly, but maybe just looking at a couple line items. First, Linda from a top line standpoint, obviously, a lot of moving parts. Are you pretty comfortable now that longer term retailer relationships have not been impacted from a systems issue? Do you have a line of sight to eventually regaining full distribution to Andrea's question understanding the job's not done, but do you think you have that line of sight? And also maybe just an update on the competitive environment near term, are there any pricing or promotional concerns that have cropped up from competitors recently, given some of the volatility that might linger as we look out over the next year or two? And how you think about that?"
},
{
"speaker": "Linda Rendle",
"content": "Sure, thanks for the questions, Dara. So, obviously, as you said, we won't provide any perspective on fiscal year '25, but the thing is that you've outlined are important as we think about closing out this year. And then, of course, the future of our continued commitment to grow top line while rebuilding margins. And what we see from a top line perspective is very strong brands. And I think I'd highlight again what I called out around brand superiority. Even in the out-of-stock issue that we experienced and cyber, we maintained our brand superiority ratings, which is significantly higher than it was pre-pandemic. So our brands continue to remain strong and we feel great about the investments we have in the back half, both increasing our advertising and sales promotion levels and we're going to spend about 11% this year. We continue to expect that. And we do expect trade promotion to increase as Kevin highlighted earlier. And innovation plans. We've also spoken about the fact that during the cyber incident we walled those resources off and so our innovation plans remain on track and we expect innovation across every major brand at Clorox. And we'll continue to invest in those plans. So I feel great about the brand's health going into this. From a category perspective, as we said, we expect to see some moderation in category growth. We tend to fare well in times when the consumers stretched because we offer value superiority. And in fact we're seeing in many cases, people still trading into premium segments of our business, we're seeing that in wipes, we're seeing that in premium litter, we're seeing that in our food business and across many others. So feel really good about where we stand with the consumer, even as they are more challenged and we're not seeing excessive trading to private-label. We did see some during our out-of-stock period, but we're seeing that rebound as we get back on shelf. And then retailers. I'll just take another moment to thank them and I can't thank them enough. They've been tremendous partners. And I say with confidence our relationships are stronger coming out of this. Unfortunate incident than they were heading in and they were strong heading in super grateful for their partnership and what they've done and we're back focused on category growth and focused on finishing the job on distribution. And I have full confidence given the plans that we have that we will restore distribution. It will just be how fast we can do it and on what timing. And again, some of those things are out of our control. But we have the right plans, we have the right relationships and strong brands to get it done."
},
{
"speaker": "Dara Mohsenian",
"content": "Okay. And can you just comment on the promotional environment. And if I can slip in one more Kevin, on the margin front. You talked about leaving the year at 42%, but still well below peak levels of 45% to 46%, if you go back historically. You mentioned in response to Peter's question that there'll be progress in fiscal '25, just help us understand potentially the slope of that gross margin recovery over time, the key drivers and how you think about long-term potential relative to that peak historical level. Thanks."
},
{
"speaker": "Linda Rendle",
"content": "Sure. On the merchandising and competitive front, we continue to see merchandising levels below what we saw pre-pandemic. And we expect in the back half for those to continue to ramp up. But what I'd say is, some of that was depressed given the fact that we were out-of-stock and not had as much merchandising. But we're not seeing anything in any material way, where we're seeing deep discount price merchandising, where we're seeing a fundamental change. But we would expect that, that level to rise, consistent with a more pressured consumer. And I would say there are little pockets here and there in categories, we're seeing some competition in litter, where there's a bit more aggressive merchandising and price promoting going on, but nothing outside of what we have assumed in our outlook from our categories and competition. And again, we continue to expect merchandising to increase both ours and competition in the back half, but we don't expect that to go to levels beyond what we thought pre-pandemic. And we'll see how that plays out."
},
{
"speaker": "Kevin Jacobsen",
"content": "And then, Dara, on gross margin. Yeah, as I said, getting to about 42 as our exit in Q4, I expect we'll make more progress in fiscal year '25, and I'm sure you can appreciate. I'll refrain from being too specific. We haven't finished our planning yet for '25, but here's what I expect, we will continue to drive cost savings. And as you know, we target 175 basis points of EBIT margin expansion each year. Last couple of years, we've been doing north of 200. So we'll continue to drive cost savings. If you assume we're going to move into a more normalized cost environment, potentially even some cost deflation, you can see how that 200 basis points can quickly start advancing our gross margins. It's not being absorbed by cost inflation. So that will be what we expect going forward. We'll have to see where the cost environment is when we get there. Pricing will play a smaller role as we've now lapped US pricing, we're still doing some pricing international, but that will play a smaller role. As we mentioned, we continue to expect improving volume trends, which will certainly contribute to margin expansion as well. So as I said, we're going to make progress. It's hard to call when we think we'll get back to that initial margin, we talked about 44%. It's hard to call exactly when we'll get there because it's not fully in our control. Some of that's going to be driven on how the cost environment plays out. If we see deflation, it could move more quickly, and if it's still continues to inflate, it may take a little bit longer. And then, I think once we get back into a more normalized environment, typically, our cost savings is more than enough to offset a normal level of cost inflation and we can take a little bit to the bottom line. And that's how you get that 25 bps to 50 bps of EBIT margin expansion each year ongoing. So I think, job one is to get back to that 44%, we remain committed doing that. I think over time you get back to a more modest improvement year after year in a more normalized cost environment."
},
{
"speaker": "Dara Mohsenian",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question will come from Filippo Falorni with Citi."
},
{
"speaker": "Filippo Falorni",
"content": "Hey, good afternoon guys. So, Linda, I wanted to go back to your comment of, there is still some jobs to be done in terms of recovering shelf space. Maybe moving in a few categories if I look at the track channel data, there's three big categories where your total distribution points are still below pre-cyber-attack levels particularly trash bags, bleach and cat litter. Maybe you could give us a color like what are your plans are to get the shelf space back."
},
{
"speaker": "Linda Rendle",
"content": "Sure, Filippo. Just in aggregate, so that we're completely clear, we are still -- have fewer distribution points than we did pre-cyber. But we are close to restoring at an aggregate enterprise level. So as I mentioned earlier, we were down well over 30% in average weekly distribution points at the low point of our out-of-stocks and now we're mid-single digits on average. But you're right to call out that in particular, trash and cat litter, we're actually more on track to what we originally expected in Q2 and we were able to in the rest of the categories accelerate the distribution point recovery. But trash and cat litter were more on the schedule that we had expected them to be in Q2 and there's really two things driving it. The first on cat litter is the ongoing catch up that we're playing as the category has grown so fast to catch up from a supply perspective to demand. We continue to expect to make progress on that this year, but that's part of the reason why cat litter is slightly behind. And then trash. That's a complex category and we prioritized a certain set of items to ensure that those were on-shelf fast. And with that, we have to bring back the full distribution, particularly, I'll call it, large sizes, is one that we have not fully restored yet. We have plans to do that in these upcoming resets. Those are important items in the category and retailers realize that. And we feel we have the right plans in place to get them back, but those are two categories that will look more like we had thought at the beginning of Q2. But just like the rest of the categories. We believe we have the right plans. We will make progress in Q3 and Q4. And we're not seeing anything abnormal from a consumer perspective that gives us any concern of our ability to do that."
},
{
"speaker": "Filippo Falorni",
"content": "Great. That's super helpful. And then Kevin, two quick follow-ups on the gross margin. First on the commodity line, it was neutral this quarter. You talked about maybe a more favorable environment. Are you expecting some deflation in the second half, meaning a benefit? And then on the manufacturing and logistics, maybe you can walk us through the drivers on that line as well."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure, Filippo. As it relates to maybe I'll start with all three and just talk about inflation. As you know, we came into the year expecting about $200 million worth of cost inflation. Some of that in commodities, but more of that in manufacturing and logistics, primarily driven by wage inflation. What I would tell you is we're seeing a little bit of improvement in commodities, it's a little bit better than we anticipated. And keep in mind, we forecast, not based on spot rates, but based on forward curves. And so I'd say we're still generally in that $200 million range, but a little bit better news we're seeing on commodities. Now having said that, that's before we factor in, Argentina and sort of the new reality in Argentina. But if I exclude that for a moment, I'd say generally playing out as we expected about $200 million of inflation, mostly in manufacturing and logistics. You don't see it as much when you look at our web attachments in the front half of the year. We had a number of charges last year that we're lapping. We should add more favorability in manufacturing, logistics, but that was offset by inflation in the front half and you get to a pretty neutral outcome is what you're seeing for the front half. And now when you add in Argentina, we're forecasting now almost 300% inflation in that economy. So we are seeing more cost inflation broadly across the supply chain, including commodities. And so I expect to have unfavorable commodity inflation in the back half of the year, a little bit of the US, but more so being driven from Argentina. But what's important to note, and I mentioned this earlier in Argentina, if you step back from all the noise and where it shows up in the P&L, we believe we have a plan to fully cover the negative impact to our P&L through the increased pricing we're taking."
},
{
"speaker": "Filippo Falorni",
"content": "Got it. Super helpful guys . I'll pass it on."
},
{
"speaker": "Kevin Jacobsen",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And we'll move next to Chris Carey with Wells Fargo."
},
{
"speaker": "Christopher Carey",
"content": "Hi, everybody. So just a couple of question then kind of a broader question. Number one, are you or did you experience any negative impact from a delayed cold flu season that we should anticipate some benefit going into the March quarter. And then to just follow-up there on Argentina, we've seen some companies cap the level of pricing so as not to, I guess, take all of the inflationary pricing that we just need different methodology. Is it fair to assume that you would strive to offset all the inflation in Argentina as it gets worse, just so we know how to kind of try to track this going forward. And I have a follow-up."
},
{
"speaker": "Linda Rendle",
"content": "Sure. Yeah, Chris, I'll start with the cold and flu. And just so we're all level set. Cold and flu is actually this year very similar to previous cold and flu seasons that we saw before. So definitely different than last year. So started later than last year, but more like an average cold and flu season which we typically see in January and February, so I would say normalized is the assumption that we have. So too early to say what the impacts will be we'll obviously talk that when we talk Q3. But we're looking at an average cold and flu season. And to your point, that means as we lap it the lap looks different because we experienced cold and flu earlier last year. And we'll be experiencing a more normalized, so mostly a Q3 impact for cold and flu that's been contemplated in our outlook. And we have like we normally do normalized assumptions around cold and flu and we'll see how that plays out. But to-date it looks like a very normal cold and flu season. From an Argentina perspective that would certainly be our perspective and as Kevin highlighted we intend right now with the plans that we have and what we're seeing in Argentina to fully offset the impacts through pricing. We'll see what happens as we move forward. That would continue to be our posture. And the reasons and proof points, we believe we can do it our market shares continue to be very strong. Our brands are very strong, we'll watch that closely but based on what we're seeing today, we expect to fully offset the currency headwinds with pricing."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, Chris. The one item I'd add as it relates to Argentina is on remeasurement. It's worth noting that things you're modeling. In Argentina, you have to remeasure the monetary assets every quarter, and the more devaluation you have the larger charge you take to your P&L. In Q2 we took a $0.10 charge to the P&L. We have in our outlook, the assumption we're going to take about a $0.20 charge in total, we took $0.04 in Q1. So most of the charge we're taking, which is roughly $30 million, we've taken in the front half. But we do expect there'll be some more remeasurement impacts to the P&L in the back half of the year, but it's fairly modest given what we've already taken to-date."
},
{
"speaker": "Christopher Carey",
"content": "Okay. And then just one additional clarification on some prior questioning. So just to be clear, so you're mostly caught up on inventory levels, but not entirely caught up. And so we're still seeing negative trends on a year-over-year basis from a sales standpoint in the Nielsen data, for example. You should continue to outpace your consumption data for maybe at least another quarter. Is that a fair analysis? And then you would expect some acceleration in consumption going into your fiscal Q4, just any way you could frame that for us would be helpful. Thanks."
},
{
"speaker": "Linda Rendle",
"content": "What I would say is you've got it right and that you are hearing us correctly that we've restored the vast majority of inventory. We still have work to do to close all the way back to the distribution points that we were at pre-cyber. And so, as I said, we're still down about low-single digits, up from down over 30 points. And then, market share is the same thing I highlighted, we have work left to do, as we do two things, restore those distribution points and return to merchandising and fall on those two things will have an impact and output on share. I'd also say the underlying thing behind this all is, too, we have to do that work on the fundamentals, and we will. We also have to ensure consumers bought other items during this time when we're out-of-stock. And so we're also doing the disciplined work by brand to ensure that we get them back to The Clorox brands they know and love through our marketing efforts, through the efforts that we're talking with shoppers at the point of decide, and all that's going on track, but that's the work that we also have to do, not only just restoring distribution and merchandising, but also ensuring that we're getting that next purchase from people who may have tried something different during our out-of- stock period."
},
{
"speaker": "Christopher Carey",
"content": "Okay. Thanks so much."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Chris."
},
{
"speaker": "Operator",
"content": "And our next question will come from Kaumil Gajrawala with Jefferies."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Hey everybody. It's a good segue from Chris' question on winning back some of the consumers that you lost. I guess you're holding advertising flat as a percentage of sales, but your outlook for revenues are higher. So from a dollar perspective I suppose that's an increase. Is there an increase or is it about where internally you had expected to spend over the course of the year?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Hey, Kaumil, we're expecting increased spending. So as you know, we typically spend about 10% of sales, this year we're targeting 11%, and in fact in the back half it will be closer to 20%, so we're leaning in investing to continue to drive value superiority at an elevated rate. So year-over-year, it will be higher based on the elevated rate of spending we intend to spend."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Got it. That's useful. Thanks. And then maybe a little more information on something you alluded to a few times on consumer pressure. Is it something you're already seeing or something you're planning for the back half and maybe if you could sort of marry that comments with some of what you guys have talked about as it relates to promo activity."
},
{
"speaker": "Linda Rendle",
"content": "The consumer has been fairly resilient and we've continued to say that, we saw that in the front half of the year. It is a little difficult in our categories to get a completely clean read just to be fair given that we were out-of-stock and so there's a lot of dynamics going on. But as we come back in stock we're seeing largely what we expected from the consumer in their front half which is a lot of resiliency. We continue to see value seeking behaviour. So we're seeing trading up to larger sizes, we're seeing trading into opening price points. Not seeing what we would expect anything different on trading into private label than we would have expected. Again, certainly more people tried private label when we were out-of-stock but we're seeing that reverse as we get back on-shelf. We continue to see a squeeze of other brands. So the leading brands and private-label tend to be the two that are doing well in categories that have multiple brands. So all of those behaviours continued in the front-half. What we expect in the back half is the consumer to continue to be under more pressure. That being said, our categories are fairly resilient, because we're household essential. So we're expecting a moderation, but this is not a reversal of the trends we've seen and we're seeing the shift from price mix being the driver of growth to volume, and that is certainly playing out. If you look at sequential volume improvement trends over the course of time, and if you kind of backup the effects of being out-of-stock from cyber, you're seeing consistently volume improving. At the end of December volumes were down very low-single digits for example, from a consumption perspective, if you look at the MULO universe. And we would expect to see that continue in the back half. So what we just see is consumer under more pressure, value seeking behaviours continue, a slight moderation in our categories, we've assumed all of that in our outlook. We'll continue to moderate. But to-date, the consumer has been resilient. And we think those things will play in through the other assumptions we have, like more merchandising in the back half. And you know competitors focused on ensuring that they are offering a great value to consumers as their wallets are stretched. But it's very, very consistent with what we had expected at the beginning of this year. We don't see any change in behaviour from consumer outside of those assumptions we had six months ago."
},
{
"speaker": "Kaumil Gajrawala",
"content": "Okay, great. Thank you. Well done."
},
{
"speaker": "Linda Rendle",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "And we'll move next to Steve Powers with Deutsche Bank."
},
{
"speaker": "Stephen Powers",
"content": "Hey, thanks and congrats from me, really to you and to the whole Company on pretty remarkable recovery these past several months. One quick follow-up and then a question. The follow-up, just on the categories that Filippo had mentioned, you talked about, there's still some work to do to fully catch up and recover. Is the expectation that as you exit fiscal '24 that you have fully recovered there or is there more work that you expect we should expect carries over into the back half of calendar '24 and fiscal '25?"
},
{
"speaker": "Linda Rendle",
"content": "Hi, Steve, thank you for your nice comments. We really appreciate them. On those categories and I would say just in general, we intend to make as much progress as we possibly can in Q3 and Q4. Will there be some lingering effects that could be outside of our control, if there's a retailer reset or change, perhaps. But we are focused on getting as much of that back in Q3 and Q4 as we can. What I wouldn't say is, I wouldn't commit to any number at this point right now, except, we expect to make continued progress over the course of the next six months. I think for trash and litter, litter has been a challenge for a while, given that we've caught up to supply, so that is the one that we're laser-focused on, and has more to do with bringing new plant up to speed than it has to do with recovering from a cyber-incident itself. So, that will be one that we'll be watching closely and try to make as much progress on. But we are going to make as much progress as possible and we expect significantly more in Q3 and Q4."
},
{
"speaker": "Stephen Powers",
"content": "Okay, very good. And the question I had, if we step back from the last quarter, since August, when we go back to before the summer, we were talking about a lot of things, one of those topics was sort of the ongoing digital transformation of the Company, the operating model change that you guys have been working on sort of long-term strategic arc of business transformation. Has anything over this period since August set you back on that trajectory or have you been able to keep pace so that the progress that was anticipated at the start of the summer is still sort of broadly on track."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Steve. And just as a preview, we'll spend a lot more time at CAGNY and have a chance to talk about our overall transformation and in particular, the operating model and digital transformation. So I look forward to talking you all about that then. But right now, what I can say is, we are absolutely deeply committed to the strategic priorities, including those two areas of transformation for the Company. They are critically important for our success, they're about investing in the long-term health of our business and being ready to take on the challenges of the future, and so the commitment is absolutely there. What I'd say is, on the operating model, we were able to proceed even through the cyber-event, and executing that we remain on track to that plan. And as you can imagine from a technology side during a cyber-event, we've had some delays on our ERP. We'll talk to you more about the timeline of that when we finalize it. But we're still committed to the transformation and all of the elements of that. But of course, our team was focused on getting safe and secure and ensuring that we moved from manual to automated processes, as the number one priority and we are now returning to that digital transformation and we'll have more of an update in the coming months."
},
{
"speaker": "Stephen Powers",
"content": "Okay, excellent. I'll see in a couple of weeks."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Steve."
},
{
"speaker": "Operator",
"content": "And we'll move next to Javier Escalante with Evercore ISI."
},
{
"speaker": "Javier Escalante",
"content": "Hi. Good evening, everyone. I have -- I'm going to kick a deadish horse here, but I do have a problem with adding up into the second half forecast, particularly for the gross margin. So if you can help us with two items specifically, one is ForEx. How big Argentina can possibly be? Two, if you can help us understand and you mentioned that impact first on sales and gross margin as to basically be flat in the second half. So that's point number one. The other has to do with the job to be done and the two categories that you're investing or you are still about to invest trash bags and cat. They are very competitive, do you have competitors that have a value stand? So to what extent it's not an issue of distribution, but an issue of retailers changing the assortment or value and then you needed to basically buy up space features and things like that that is going to create a negative offset to gross margin. Thank you."
},
{
"speaker": "Kevin Jacobsen",
"content": "Hey, Javier, let me start with your question on FX and how it's impacting sales and gross margin. And when we entered this year, we were anticipating about two points of FX headwinds on the top line, mostly coming out of Argentina. The Argentina economy has declined more than we had anticipated. And as you may have seen in our prepared remarks, we're now anticipating about five points of FX headwinds on the top line that is solely a function of revising our expectations for Argentina. We now have in our outlook an expectation that the currency will devalue about 75%, and that's going to be back half loaded. If you look at the front half we had about three points of FX headwinds, and that puts you into the mid to high single-digit FX headwinds in the back half and again a function of Argentina. And then that also plays through in gross margins. We expect a greater negative hit to gross margins, as it relates to the FX impacts. So if you look at last year, FX was about less than 100 basis point hit, this year will be well north of that closer to 150 basis points or so. And again, it will be more pronounced in the back half of the year. Important to note that, maybe just to finish that up and I'll let Linda addressed the other question was, as I mentioned earlier, in-spite of those negative impacts based on the actions we have already taken and will take primarily as it relates to pricing, we believe, we can offset both the top line FX impact as well as the FX impact to gross margin. And as a result, you can see we're raising our sales expectation, expect to grow margins in-spite of a pretty difficult environment, we're dealing with there."
},
{
"speaker": "Linda Rendle",
"content": "Javier on the piece that you mentioned on those two particular categories trash and litter that we spoke about. It's exactly what we said it is from a supply perspective, those are two businesses that are a bit more challenged. We feel very confident in the health of our brands there. And as I spoke about from a superiority perspective, consumers just find value not as the lowest price, but of course, what is the overall best offering from them, which price is an element of. We feel great about the superior value of both of those brands when they offer. We continue to see our innovation do very well in both of those categories and we highlighted both of those in CAGNY some of the innovations we have, Glad with Clorox and other launches that we have in Glad that are similar and of course our outstretched cat litter which has done very well and it's held up even through out-of-stocks. We continue to see people trade in to premium cat litters. So we feel confident about our plans. Again, we have the right investment levels. And we're focused on providing exactly what you said, which is the right value to consumers and retailers see that, and we play an important role in their category growth. And I have confidence that we will retain or regain distribution, get back to the proper level of merchandising in these categories. And that will get our ourselves back to where they need to be just in these two categories, it's a little bit extended versus some of our other categories. But I have every confidence in these two that we'll get back, just like we are on the other ones."
},
{
"speaker": "Javier Escalante",
"content": "Thank you very much."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Javier."
},
{
"speaker": "Operator",
"content": "And we'll hear next from Callum Elliott with Bernstein Research."
},
{
"speaker": "Callum Elliott",
"content": "Great. Thanks for the question. I just wanted to build on Steve's question and hopefully not to pre-empt your CAGNY presentation too much. But alongside the digital transformation, you guys had other long-term initiatives before the hack that we're also targeting the top line. I think it feels like quite a long time ago now that you raised the long-term top line target to 3% to 5% driven by this push into international and professional. But hoping you can update or update us on those strategic initiatives and where we stand, now that we're hopefully starting to put the hack in the rear-view mirror. Thank you."
},
{
"speaker": "Linda Rendle",
"content": "Thank you. And we certainly want to get back to where we ended fiscal year '23. We were very proud of the performance and what we had done. And of course we remain deeply committed to what we talked about which is expanding top line over the long-term 3% to 5% and expanding EBIT margins 25 to 50 basis points and we want to get back to that. Exactly as you said and our transformation as a critical component of that and ensuring that we have the right capabilities and processes, and that people at Clorox are more consumer obsessed and we're working faster in a leaner fashion to get there and we'll talk about that. As we spoke about actually at CAGNY, I think, it's two years ago now, what we expected from a growth perspective continues to remain, we continue to see opportunities in international, we continue to expect to see returning to growth in our professional business as that more normalizes. But we spoke about all the other things that we had seen trend-wise. We saw more cat adoptions and so natural category tailwinds for litter. We saw people having increased interest in disinfecting which still remains and we still see that or seeing as we look at the data today. People still have a heightened need to have their spaces cleaned and disinfected. People generally are taking care of their health and wellness more so, things like Brita have natural tailwinds. And water consumption. Our Vitamins, Minerals and Supplements business is the same thing, continues to have natural tailwinds. So we'll speak about all of that at CAGNY, but we remain committed to that 3% to 5% top line over the long-term and to do that in a more profitable and consistent way. And we have all the right levers and are pulling all at the right transformation buckets in order to do that, and I feel we're on the right path to get back to where we were coming out of fiscal year '23."
},
{
"speaker": "Callum Elliott",
"content": "Thanks, Linda."
},
{
"speaker": "Linda Rendle",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And we'll move next to Lauren Lieberman with Barclays Capital."
},
{
"speaker": "Lauren Lieberman",
"content": "Great, thanks, everybody. So I was just looking back and I remember that last quarter when you were talking about the outlook and the recovery plan and expectations. That you said you expected customer inventory levels to be rebuilt by the end of fiscal 2Q. But tying to that was the conversation of mid-single-digit sales growth, right? So now retail inventories are in fact rebuilt, the main thing does it leave? But it was with sales growth that was way higher than mid-single-digit. So can you just tie those two things together for me because, I think the just the visibility in the forecasting I think is an open question. And if you go back even pre-cyber the pattern of exceeding your own outlook was incredible. But you do have to also ask the question of like what happens if it goes the other way, if this is a question of visibility."
},
{
"speaker": "Linda Rendle",
"content": "Hi, Lauren. Let me try to paint a picture for what happened in Q2. So we're all on exactly the same page. You are right to say that we expect it to build the vast majority of inventories by the end of Q2. What happened is, we did that faster so what you get less of a consumption loss impact in the quarter. So instead of doing that, call it, the last two weeks of December we did that earlier and earlier by categories. So you have less out-of-stocks which significantly increased our top line, and that's really the difference that you see in the quarter. And of course that had positive impacts in terms of the merchandising, we can do and all of the fundamentals from a retailer perspective that we want to return to and gave us great confidence in the back half. Not only do we take our outlook up because we over-delivered in Q2, but we see a stronger back half as a result of that. So that's really the difference is we have less lost consumption because inventories returned faster in the quarter than we had expected."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay. That's fantastic. And then just also on Burt's, I feel like when we all saw you in December, at the time you were talking about the challenge of Burt's and restoring that business just because of the natural complexity of SKUs and the line-up in that business and that holiday merchandising might actually be -- that might be a spot where you'd fall short. When I look at the trends in Lifestyle, right, clearly, Burt's had a great quarter. So there too kind of same story or I'm -- just I'm a little confused on that one, because it felt like that was a business, that was going to be tough to be able to get that merchandising in and holiday is pretty -- it's a important seasonal time for that brand is my understanding."
},
{
"speaker": "Linda Rendle",
"content": "Yeah, Lauren. You remember correctly from December, we highlighted one of the places that we were focused on actually two places. We talked about cold and flu, if you recall and our push to get as much of that distribution restored to ensure that we could protect cold and flu, which we feel we did. And then second exactly right is Burt's Bees and the importance of the holiday period. We were able to do most of that. I would say for holiday, we didn't get all of it out, but we got the vast majority of holiday out which was good. And that certainly did support a stronger performance on Burt's than we had anticipated. But that was a big challenge, but I would say, unfortunately we didn't get it all out, and that certainly has an impact, but the good news, it was more positive than we even expected back in December for it to be."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay, perfect. And then the final thing, sorry in this vein, but I'm just trying to put the pieces back together, if you will. Logistics that was one area, Kevin, where you had talked also last quarter about that logistics cost would be elevated this quarter because as you mentioned, Linda you're shipping well above normal every day, right and that you're going to end up using a lot more carriers and freight and so on, beyond what you'd normally be contracted for, and that there'll be elevated cost with that. Again, like, I know there's many pieces of that gross margin build, but logistics is one that really jumped out for us, it's being pretty different. So I'm just not -- that's another area of question of kind of what played out differently there, was a retailer fine. I think you mentioned that in the prepared remarks, but that seemed like a pretty significant difference versus something that should have carried elevated cost within the quarter itself."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yeah, Lauren, you remembered exactly correct, when you think about the gross margin for the second quarter came in higher than we expected, both the combination of stronger top line. But exactly what you just highlighted, we did not incur the up charges we anticipated. If you remember, when we were talking last quarter, we said our priority, job one is to get product back on shelf as quick as we can. And we were fully prepared to incur additional logistics manufacturing up charge to get that done. And that will take the form of running the plants more over time, less than full truckloads out of route shipments. We said that was all available and we expect to do some of that to get product there quickly. A credit to our team and as Linda mentioned, and a credit to our retail partners here, as we move more quickly getting productive retailers, we did that in a very efficient manner. We did not have to incur the up charges, we were mostly using our carriers, we're mostly being able to do that in full trucks. And because we got that done even faster than we expected, it didn't bleed onto the full quarter. And so it's really about us executing more effectively than we anticipated going into the quarter. But we went in expecting we would have to spend more and we prepared to do that as we are prioritizing getting product on shelf, it just resulted in the fact we didn't have to."
},
{
"speaker": "Linda Rendle",
"content": "Yeah. I'll just maybe make another comment on our operating model. Lauren and there were some good questions on our transformation and are we continuing it. And I think one of the things really proud of is one we learned a lot in COVID that we applied to the situation. Unfortunately, we were hoping we'd never have to play it again, but we were ready to go. The second thing is, this is an output of our operating model, getting laser-focused on what matters, putting a business leader in-charge who sees end-to-end who is able to make the calls and trade-offs, and she and her team were able to do just that, to be able to restore inventories and do all those things. Kevin spoke about, not requiring a lot of overtime. Our decision to take, our inventories up in Q1 was an important one, and we knew that we would work those down, but we made that choice early to ensure that we could do as much as we could in Q2. But I would just plug our operating model. That's a real output of what we've been driving and that changed to be bought more business unit focus, more focused on the consumer and customer and fast."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay. All right. Great. Thanks. I really appreciate it."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Lauren."
},
{
"speaker": "Operator",
"content": "And our next question comes from Olivia Tong with Raymond James."
},
{
"speaker": "Olivia Tong",
"content": "Great. Thanks. And great work on the improvements. In terms of the macro backdrop you talked about how -- for second half you're now no longer expecting the recession that you had before, but could you just talk about what your expectation target for the current environment to stay the way the second half to be similar to what we saw in the first half or that there is still a step-down just not as much as you had before."
},
{
"speaker": "Linda Rendle",
"content": "Hey, Olivia. On the macroeconomic and consumer front that's exactly right, we are no longer expecting a mild recession. Of course when we released our outlook six months ago, we said that's an assumption. And if it changes, then we'll adjust. But really what we meant by mild recession and the impact it would have for us is a more stretched consumer, and we continue to see this in environment that leads us to believe that consumers will be more stressed. And if you start to look at categories around us that certainly has been playing out, we feel the impact will be moderate to our categories, given the fact that we play in household essentials. But we are seeing consumers more use of credit. We're seeing them shift their behaviors and showing things that they value and don't value discretionary goods have been down for a while. And we see the cumulative impact of that, as they've gotten down to a place now where their savings were down to pre-pandemic levels, they no longer have that extra disposable cash even though employment remains high. We think that all adds up to a more pressured consumer. And we think the impact of that will be a moderate impact on our categories, as consumers are more conscious about how they spend their dollars. That's really the assumption. Again, the consumer has been resilient to-date, we continue to see that, but we are seeing them in our categories, they are value-seeking . And as I mentioned earlier, they are trading up to larger sizes, they're using opening price points, they are stretching their dollar they might be trading into an item they feel like is more multipurpose. And at the same time we're seeing them given the superior value of our products, they are trading at a premium, because they are not willing to trade-off efficacy, they are not willing to trade-off convenience. So we're seeing all of those things play out. But we just think the consumer will continue to be under more pressure, not in the form of we believe a mild recession anymore, but just all of the other macroeconomic factors that are out there."
},
{
"speaker": "Olivia Tong",
"content": "Got it. That's very helpful. And then relative to your expectations going into the year, obviously, putting aside the cyberattack. Do you think you'll end the year in line with the your -- start of your target on promotion and merchandising levels? Because I'm trying to understand obviously, there's a lot of puts and takes of where your expectations they're now versus in August before the cyberattack happened. But you had said in the past that perhaps we'd have to do a little bit more promotion, little bit more merchandising just to make sure that given what's happened. Just wondering, today what you're thinking in terms of the level of promotion merchandising relative to where you started the year."
},
{
"speaker": "Linda Rendle",
"content": "Yeah, on that assumption, certainly we saw a dip in Q2 given the out-of-stock situation. And we had to prioritize, ensuring that we got supply up before we could merchandise. But now that we're returning distribution and market shares, we would expect promotion to pick up and we expect for the back half the same assumption that we had at the beginning of the year, which is higher than it had been, and returning closer to pre-pandemic levels. We don't think that merchandising will exceed pre-pandemic levels, but begin to return to that level. As people are focused on a more stressed consumer and continuing to offer the right value. And of course, doing things like releasing innovation, ensuring we introduce consumers to new items and great innovation. So that's what our expectation continues to be, we'll see merchandising increase than what it was last year, getting closer to pre-pandemic levels and we expect that to happen over the course of Q3 and Q4."
},
{
"speaker": "Olivia Tong",
"content": "Got it. Thank you so much."
},
{
"speaker": "Linda Rendle",
"content": "Thanks, Olivia."
},
{
"speaker": "Operator",
"content": "This concludes the question-and-answer session. Ms. Rendle I'd now like to turn the program back to you."
},
{
"speaker": "Linda Rendle",
"content": "Thank you, everyone. As we covered today we've made strong progress on our priorities in the second quarter. While there is still more work to do to fully recover in the market from the cyber incident, we're focused on executing with excellence and delivering on our strategies to drive top line growth and rebuild margins. Guided by our IGNITE strategy, we're confident we have the right plans in place to deliver long-term shareholder value creation. And as I mentioned earlier in the call, we look forward to sharing more with you in our upcoming presentation at the CAGNY Conference in February. Until then please stay well everyone."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for attending."
}
] |
clx | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen, and welcome to The Clorox Company First Quarter Fiscal Year 2024 Earnings Release Conference Call. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference call, Ms. Lisah Burhan, Vice President of Investor Relations for The Clorox Company. Ms. Burhan, you may begin your conference."
},
{
"speaker": "Lisah Burhan",
"content": "Thank you, Jen. Good afternoon, and thank you for joining us. On the call today with me are Linda Rendle, our CEO; and Kevin Jacobsen, our CFO. I hope everyone has had a chance to review our earnings release and prepared remarks, both of which are available on our website. In just a moment, Linda will share a few opening comments, and then we'll take your questions."
},
{
"speaker": "",
"content": "During this call, we may make forward-looking statements, including about our fiscal 2024 outlook. These statements are based on management's current expectations but may differ from actual results or outcomes. In addition, we may refer to certain non-GAAP financial measures. Please refer to the forward-looking statements section, which identifies various factors that could affect such forward-looking statements, which have been filed with the SEC. In addition, please refer to the non-GAAP financial information section of our earnings release and the supplemental financial schedules in the Investor Relations section of our website for a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures."
},
{
"speaker": "",
"content": "Now I'll turn it over to Linda."
},
{
"speaker": "Linda Rendle",
"content": "Hello, everyone, and thank you for joining us. We entered fiscal year 2024 with momentum, supported by strong progress on our priorities over the past several quarters to maintain top line growth while rebuilding margins. Prior to the August cyber-attack, our performance was on track with our expectations with solid consumption and market share trends, including improving volume consumption as we lapped year ago pricing actions. This is a testament to the strength and superior value of our brands and the role they play in our consumers' daily lives."
},
{
"speaker": "",
"content": "In addition, we continue to realize benefits from our margin-enhancing initiatives, including pricing, cost savings and supply chain optimization. However, the cyber-attack caused wide-scale operational disruptions, which adversely impacted our first quarter financial performance. While we're not yet back to normal, we are now on a solid path to operational recovery, but this will take some time. We're laser-focused on our immediate priorities of rebuilding retailer inventories as quickly as possible, preserving merchandising activity and improving our distribution to return to the trajectory we were on prior to the cyber-attack."
},
{
"speaker": "",
"content": "We've proven that we can execute and rebuild inventories, earn back our shelf space and distribution and regain and ultimately drive share growth over time, just as we did coming out of the pandemic, when we restored supply following extraordinary demand for our products. We're confident in our ability to do so again, given the strength and superior value of our brands, the relevance of our IGNITE strategy and the relentless focus of our teams on executing with excellence to win in the marketplace."
},
{
"speaker": "",
"content": "As we navigate the near term, we remain committed to our long-term strategies for growing the top line and rebuilding margins, which includes investing in innovation and brand building, driving our hallmark cost savings program and advancing our digital transformation and streamlined operating model. Looking ahead, the disruption of the last few months does not change The Clorox story. As we execute on our recovery efforts, we're confident that our portfolio of leading brands in essential categories and our IGNITE strategy will enable us to regain market share and deliver consistent profitable growth over time."
},
{
"speaker": "",
"content": "With that, Kevin and I will take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from Peter Grom with UBS."
},
{
"speaker": "Peter Grom",
"content": "So Kevin, I was hoping to just get some color on the phasing implied in the guidance in the context of the 1Q performance in some of the 2Q commentary. Maybe just to start with gross margin up nicely in 1Q. Can you maybe walk us through the drivers that actually would push gross margin to be flat for the year? And then I know from a sales perspective, it's still a wide range, but it does seem to imply a decline in the back half of the year. Is that just some conservatism? Or are there key reasons behind that?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Let me start with gross margin phasing and talk about what we're seeing in Q1 and sort of how we see that playing out as we go forward. The 1 thing to keep in mind is -- and these assumptions really have not changed since we talked last quarter in August, which is, as it relates to pricing, as you may know, we took 4 rounds of pricing. We've now lapped 3 rounds of pricing. So you're going to start to see the benefit of pricing continue to moderate as we move throughout the fiscal year, and we'll lap the fourth round by the end of this quarter."
},
{
"speaker": "",
"content": "And so as we get into the back half of the year, we'll no longer have the benefit of pricing. Now we're still taking pricing internationally. So there'll be some benefit, but not to the degree you're seeing. And as an example, if you look at our most recent quarter, pricing benefit to margin is worth about 470 basis points. So a nice contributor and you'll see that moderate as we go through the year."
},
{
"speaker": "",
"content": "And then the other item I would highlight is, we're going to see our belief is increased merchandising levels. And again, this is not a change in our assumptions. We continue to operate below pre-pandemic levels. Typically, we merchandise about 25%, 27% of our business. And last year, we ended up about 20%. And so we continue to expect that to increase as we go forward. And so our assumption is in the back half of the year that we'll see increased levels of merchandising support that will put a low pressure on margin."
},
{
"speaker": "",
"content": "And then lastly, we continue to believe that we're going to see a consumer that's under more pressure in the back half of the year. And for all the reasons you folks know is we talk about a return to paying student loan, payments, increasing interest rates and the pressure that will put on consumers. And typically, that puts a little bit of pressure on our categories. Now based on the nature of our categories being everyday essential categories, it's not a significant impact. But usually, you could see consumption down 1 or 2 points as a result of that. And that's an assumption we've continued to assume since the beginning of the year, and that will pressure margins a little bit as well."
},
{
"speaker": "",
"content": "Now on the sales, talk a little bit about the back half. Obviously, you folks saw we were down 20% in Q1. And if we deliver our expectation for Q2, which is sales to grow mid-single digits, that would project in the back half of the year on a reported basis, sales being flat to down high single digits. And that's a fairly wide range. I think it's a function of both the macroeconomic uncertainty about how this plays out with the consumer. But then the additional variability we have is we're working to rebuild some of the distribution and share we've lost, we fully expect to rebuild that, but we recognize there will be some variability in the exact pace of that recovery and it's not totally in our control. And so that will have some impact on our sales performance as well."
},
{
"speaker": "",
"content": "But I think, Peter, what's most important is, Linda and I are quite confident we will rebuild back that distribution share we lost as a result of cyber event. But trying to predict the exact pace of that recovery is a little difficult to do. And so we provide a range that we think reflects that variability."
},
{
"speaker": "Peter Grom",
"content": "And then maybe just a follow-up. I know this may be hard to answer as we're kind of only in the first quarter of this year. But do you have any perspective around whether you think the disruption could have some lasting impacts beyond this year? Maybe from a top line perspective, do you see any risk that there could be shelf-space losses or permanent share shifts, anything from a margin perspective. I guess what I'm really trying to understand is whether you think you can fully recapture the earnings loss from the incident as you think about fiscal '25."
},
{
"speaker": "Linda Rendle",
"content": "We're really confident there's no structural issues related to this incident. It's short term in nature. And as Kevin highlighted, we have full confidence we'll be able to restore distribution and share over time. And what Kevin highlighted is exactly right. It's about pace. And what we're focused on this year is making progress as quickly as we can, and that starts in Q2 with rebuilding inventories. And we already are shipping well ahead of consumption now as we finished out the end of this month and we intend to continue to do that for the rest of the quarter with the goal of getting back to inventory in retailers as fast as we possibly can. We think we'll get through the bulk of that in Q2. We'll have some left to do in the back half of the year."
},
{
"speaker": "",
"content": "And then, as Kevin said, rebuilding ensuring we have merchandising and distribution back to where it is. We are working as quickly as feasible to get as much of that done in '24 as we possibly can and that's what we're focused on. And we have a history of doing that. If you look back when, for example, Pine-Sol was out due to a product issue, we were able to get that distribution back quickly. If you look at post-COVID, the ramp-up on distribution was fast. And then we had a couple of quarters after that initial ramp-up where we continue to make progress. But what I can say is we intend to do as much of it as we possibly can in fiscal year '24. There's no structural issues related to this in our business. And we have strong confidence that given the superior value of our brands, our investments, and innovation that we will get it back. And again, as Kevin said, it's a matter of timing."
},
{
"speaker": "Operator",
"content": "And our next question comes from Filippo Falorni with Citi."
},
{
"speaker": "Filippo Falorni",
"content": "Linda, maybe just can you give us a little more color on the conversation with key retailers as you go and try to rebuild the shelf space. Is there a requirement of increasing merchandising? It seemed like part of your gross margin outlook as well. Just any color on how those conversations have been going so far."
},
{
"speaker": "Linda Rendle",
"content": "Yes. Thank you for the question and for the opportunity to once again thank my retailer partners for everything they have done during this time, they have been tremendous. And that is without exception, they have all gone above and beyond to ensure that we're getting as much product as possible to their shoppers. They partnered with us on manual operations, which is not easy for anyone to do. It wasn't easy for us and certainly not easy for retailers. They've been tremendous, and they continue to be tremendous."
},
{
"speaker": "",
"content": "And now our focus is shifting from manual operations to rebuilding that inventory and they have the same goal of building it as quickly as we do, and they are taking every measure on their side to ensure that we have the right appointments et cetera, to do that. And it's a busy season for them with holidays, et cetera, and they're still prioritizing that. And then, of course, our joint focus is on ensuring that we get merchandising for things like cold and flu. We have Burt's holiday merchandising. We're focused and they are focused on ensuring that we meet those deadlines and that we get those in front of consumers and shoppers at that time."
},
{
"speaker": "",
"content": "And then ultimately, what our goal is, and this is really important to retailers, too. Just like coming out of COVID, we had stronger relationships with our retailer partners than we did going in, and they were strong to start. We very much intend to make this a moment to be even stronger with our retailers through transparency, through partnering, through ensuring that we're doing everything feasible to get them what they need. So I feel great about where we are. And again, my thank you to them for everything that they're doing. And we are well on our path to restore where we need to be from an inventory perspective, and then we'll get the hard work back of ensuring we have innovation and great plans with their shoppers, so we can continue to get focused on growing categories once we get past this initial recovery."
},
{
"speaker": "Filippo Falorni",
"content": "Got it. That's helpful. And then, Kevin, maybe a follow-up on your gross margin question. Your commodity impact in the quarter and the gross margin bridge was 1 of the lowest in a very long time. So like can you give us a sense of whether your expectation on the commodity front for the balance of the year and maybe some help with the phasing."
},
{
"speaker": "Kevin Jacobsen",
"content": "Sure. Happy to, Filippo. We came into the year with an expectation we have about $200 million worth of supply chain inflation. Now that's broader than just commodities. That's inflation across the entire supply chain. And that is still an inflationary environment, but certainly moderating versus what we've seen over the last few years. As you look at that $200 million, about 1/3 of that we anticipate is commodity cost inflation, about 2/3 is in other areas of supply chain, primarily driven by wage inflation that shows up in a lot of different areas."
},
{
"speaker": "",
"content": "As it relates to commodities, we still expect to see commodity cost inflation this year. It has evolved a little bit. We've seen some areas coming in lower than originally anticipated. Chemicals being 1 of those areas, substrate as well. But then there are other items that we are seeing increases and primarily petroleum-based products. So some diesel solvents and even some of the ag products are a little higher, but mostly puts and takes. And so we still expect about $200 million worth of total supply chain inflation and that includes commodities."
},
{
"speaker": "",
"content": "And in terms of phasing, it's pretty consistent through the year. I would think a little bit of increase in the back half of the year, to your point, is fairly modest in Q1, about 20 basis points. And so you'll see a little bit of that back loaded. But again, it's fairly modest relative to what we've been dealing with for the last several years."
},
{
"speaker": "Operator",
"content": "And we'll hear next from Anna Lizzul with Bank of America."
},
{
"speaker": "Anna Lizzul",
"content": "I just wanted to ask on regaining distribution. How much of the distribution recovery will need to be driven by innovation and do you already have this innovation in the pipeline? Anything in particular you had in the plan for fiscal '24?"
},
{
"speaker": "Linda Rendle",
"content": "Thanks for the question. So the first priority, of course, will be restoring the distribution of the everyday items we have on the shelf that performed really well from a retailer perspective and consumer perspective. So we want to make sure that we get those back on and because we're very choiceful in how we work with retailers on the distribution and shelving that we have, the items that we have on the shelf deserve to be on there, and we're going to work to get those back on."
},
{
"speaker": "",
"content": "But your point on innovation is exactly right. How we continue to delight consumers and shoppers and drive growth in the category is on innovation. And we had a team of people that we walled off as we were dealing with the initial impacts of this cyber-attack to ensure that we were able to ship the innovation that we have in the back half. And we're happy to report that innovation in the back half will go with plans. And all of our major brands will continue to have innovation that ships at that time, and we're working with retailers to ensure we get that on shelf as quickly as possible and that we get that in front of their shoppers. So we feel very confident about the base distribution that we will rebuild back as well as the strong innovation plans we have on all major brands in the back half and getting that on shelf with retailers."
},
{
"speaker": "Anna Lizzul",
"content": "And I wanted to ask around advertising and sales promotional spend. You mentioned it will be about 11% of sales. Is this enough given the disruption and potential loss in market share versus a similar percentage of sales that peers are spending on advertising and promotion."
},
{
"speaker": "Linda Rendle",
"content": "Yes. As you know, we'll continue to spend about 11% of sales on advertising and sales promotion, which was up versus last year where we spent about 10%. And we continue to believe this is the right level of spending to support the brands as we get through this inventory recovery and growth phase as we head into the back half. And of course, we'll make any adjustments that we see necessary by brand, et cetera. And it's also supported, I would note, by continued very strong performance from an ROI perspective. So we're getting more and more for that spend. So not only are we spending at a higher rates but we're also getting more for every dollar that we invest. And we'll continue to monitor that closely. But between that and the increased promotional environment we expect to see, we think we have the right money in the market to ensure that retailers have the right plans and the consumers are seeing our brands from a marketing perspective."
},
{
"speaker": "Operator",
"content": "And we'll take our next question from Lauren Lieberman with Barclays."
},
{
"speaker": "Lauren Lieberman",
"content": "I just want to follow up on that -- the gross margin conversation you had an answer to the first question. Because 1 spot where I was a little bit confused is, Kevin, you talked about pricing and merchandising dynamics, most notably for the second half and discussed them as being the same as prior assumptions and most notably to me on the merchandising side. But I'm not -- I feel like there's a disconnect because the prior gross margin pre-cyber, which you know is like a different time and world. I don't think it would have supported the idea of gross margins kind of flattish or flat to down in the back half. So I feel like there's a piece maybe missing outside -- I think you mentioned logistics costs for 2Q. But it does really something else is pressure in gross margins in the second half. So I just wanted to follow up on that point first."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, I'd say there's a few items. So you're exactly right. We've always assumed increased merchandising support. That was true back in August and that continues to be the case. The 1 other area, though, that we should talk about is as we're working to rebuild distribution and we're working to rebuild share, we are expecting lower sales in the back half than we were anticipating back in August. So lower sales will have some lower volume deleveraging that will impact margin. And then the other assumptions are generally similar to what we thought back 3 months ago."
},
{
"speaker": "Lauren Lieberman",
"content": "And then pricing, I guess, just to follow on also because if we're assuming that higher merchandising in the second half, that means I'm guessing that price promotion should be a headwind to sales in the back half. Is that right?"
},
{
"speaker": "Kevin Jacobsen",
"content": "Well, I'd say merchandising levels overall will be as part of price mix, you'll see that show up."
},
{
"speaker": "Lauren Lieberman",
"content": "So yes, I was just struggling with the shipments, right? So that if shipments this quarter roughly right are down the high 20%, call 30% for rounding sake. Having your net sales only up in the mid- to high single digits in 2Q and saying you're shipping above consumption, it just feels like shipments sprinkle should be higher than that, right? I feel like the thing we're shipping above consumption is almost like a circular logic because Nielsen is informed by what's on the shelf, not necessarily consumer demand."
},
{
"speaker": "Kevin Jacobsen",
"content": "So I can certainly talk about Q2 and our expectation as you mentioned, we're projecting mid-single-digit organic sales growth in Q2. And you're exactly right. We expect, as a result of shipping above consumption, that's certainly going to help the top line relative to Q1. There's 2 items that will partially offset that. The first is we're going to continue to lap the benefit of pricing. And so you'll see that offering a smaller benefit in Q2 sequentially versus Q1. So if you saw in Q1, we had about 8 points of favorable price mix. The quarter before that, we had 16 points. So you'll continue to see that step down in Q2, and that will be a smaller benefit."
},
{
"speaker": "",
"content": "And then the other item is, we are still in a position, particularly in October, we were losing consumption. We were losing sales. While we are shipping above consumption, we have not rebuilt retailer inventory levels yet. We still have auto stocks occurring. And so we are still losing sales, particularly in the month of October, probably bleed a bit into November as well. And so that's still providing a drag on sales in Q1 as well. So when you look at all that together, we think we will have that mid-single-digit growth as a result."
},
{
"speaker": "Linda Rendle",
"content": "Lauren, I'll add just 1 thing, which is a nuance to your point on shipping above consumption. When we say consumption, we mean what average consumption would have been being fully in inventory. So we're shipping well beyond that level, and that's how we rebuild inventories over time. So it is a meaningful overshipment versus what we normally would."
},
{
"speaker": "Lauren Lieberman",
"content": "Perfect. That definitely helps a lot. And then just the other thing is that it feels like, as I'm trying to piece through the model that selling in admin dollars, and I'm looking at everything versus my like model as of August 3. That you're actually able to take a good amount of cost out of selling and admin. And I was curious, and I'm just looking at straight dollars, not percentage of sales. I'm just curious how much of that you say is related to the operating model changes that were already [ implied ]? Is it -- some of this is maybe more variable, or has there been some belt tightening that goes with this, given the unfortunate cyber situation."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Lauren, this is primarily the nice work we've done on the streamlined operating model work we're doing. As you know, we're targeting to eliminate about $100 million in cost. And I'd say, keep in mind, while we talk quite a bit about the admin savings, this is really about making us a more competitive company by accelerating decision-making and getting decision-making closer to people know their consumer best. But it does generate nice savings for us, and we are very much on track by the end of this year to complete that 2-year program to generate about $100 million in reduced admin savings. And so we started that last year, and you should see us continue to drive admin savings this year as well as we complete the program."
},
{
"speaker": "",
"content": "But even in absolute dollars, you're seeing the dollars start to go down year-over-year in spite of the increased costs we're incurring because of the cyber event."
},
{
"speaker": "Lauren Lieberman",
"content": "Okay, for sure. And why not raise advertising dollars? I would have thought you want to spend -- you'd want to spend more. I get the percent of sales math, but sales are down so much. So I would just would have thought like trying to stay in front of the consumer when, frankly, this year's earnings \"doesn't matter\" all that much because it's a rebuild. Why not flex the advertising higher in the second half once you're back in stock?"
},
{
"speaker": "Linda Rendle",
"content": "Lauren, we had all of those debates to see and prioritize having the right level of spending. And that's exactly the exercise that we undertook. And we think what we have in combination with innovation, with the merchandising spend is the right level, if there's any change to that based off of what we see in the marketplace, we absolutely will make adjustments prioritizing the health of our brands and ensuring that we're in front of our consumer but we feel good about that 11%. It still is slightly higher than it was last year, if you just look at absolute dollars as well. And of course, we're driving our team to try to get as much efficiency impact as they possibly can on that spend as well. But we think it's the right level. And again, as we always do, we will prioritize that. And if there's any adjustment needed based off of the path forward as we rebuild, we will make that, but feel very confident where we are right now."
},
{
"speaker": "Operator",
"content": "And our next question will come from Chris Carey with Wells Fargo."
},
{
"speaker": "Christopher Carey",
"content": "So a couple of quick questions. Number one, are there specific categories where you feel like it will be more challenging to rebuild your shelf than others, should we be thinking about this on a total portfolio basis? Or are there nuances between your various businesses?"
},
{
"speaker": "Linda Rendle",
"content": "Over the long term, Chris, no. We feel confident across all of our categories that we'll be able to rebuild distribution, return to merchandising and, of course, return to the shares that we were before and grow from there. In the short term, though, there are some nuances, and you'll see recovery faster in some businesses than others. And that has to do with the rate of turn from a consumer perspective. So some of our items turn incredibly quickly, and they're heavy and bulky. And so we saw inventories depleted faster in those categories, for example, and those will take a bit longer to restore. And then some of our other categories where the turns are slower. We've had better inventory positions up into this point and the rebuild will be faster. And then some of it has to do with the complexity."
},
{
"speaker": "",
"content": "So for example, Burt's Bees was more significantly impacted because those orders are highly complex. And in a manual environment that took more touches for us to get Burt's shipments out. And so that's 1 we're focused on rebuilding as quickly as we can given that was more impacted than some of our other businesses. And that's exactly the work we're doing right now and prioritizing that with retailers so that we have Burt's holiday merchandising, cold and flu, and we restore inventories in the most critical items that we have. And we're prioritizing that by retailer, by part of the country, by merchandising events. But over the long term, we have full confidence across all of our categories that we'll be able to restore inventory and distribution."
},
{
"speaker": "Christopher Carey",
"content": "One quick follow-up. I think there are some questions around trying to understand if there's any incremental costs associated with this maybe over the medium term, whether there's a step-up in merchandising in the back half or any other costs on top of that. I guess what I'm hearing is there are not, right? So you don't feel the need to invest more into digital infrastructure to protect against such things, you don't feel like you need to accelerate merchandising spending in the back half of the year to perhaps manage the retailers to give you more shelf space. Am I reading that correctly? It's more you lost the shelf now you're going to come back on, but there's no kind of incremental cost that are going to take time to fade away?"
},
{
"speaker": "Linda Rendle",
"content": "Sure, Chris. First, and clearly, we had incremental costs in Q1 associated with this as we dealt with the cyber-attack itself and the systems issues that we needed to overcome and build. So there was an incremental cost there. Second, on the marketplace piece, we felt like we put a plan in place that took into account what we thought was going to be a more challenging environment. And that plan works very well for us in this environment of rebuilding as well. So we think we have the right tools in place. We believe, again, we have the right level of advertising and sales promotion, promotional dollars invested in that -- on the recovery."
},
{
"speaker": "",
"content": "I would note 1 of the things that we're looking at because we remain deeply committed to our strategic priorities over the long term, including our digital transformation but we are so laser-focused on the inventory rebuild. We have work to do to see how we sequence that out over the future. And if there are any implications or shifts in timing in that, but we're not prepared to talk about that in detail today. Just know that continues to be of the highest importance to our strategy. We're deeply committed to it, and we'll be working out what that means in terms of timing and any implications over the coming quarters."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our next question will come from Andrea Teixeira with JPMorgan."
},
{
"speaker": "Andrea Teixeira",
"content": "So I wanted to go back, sorry, the shipment consumption but tackle it in a different way. So you think that like if you think about units, right, the categories that you compete in, would you say a positive in volumes like in the low single digits, if you -- if my math is correct. And if that's the case, what you're saying is that, yes, the mid- to high single digit given pricing is phasing off a bit and building off. You're saying it might take not 1 quarter, it might take 1 or 2 quarters and some unfortunate like losses that you had in market share or the volume that, that consumer went and couldn't find your product, it's not that they are going to buy 2 of them when they got into the store, right? Those lost sales are the lost sales. So is that the way we should be thinking?"
},
{
"speaker": "",
"content": "And then related to that, in a way, a second part of the question is that, is there any way you can quantify, like, if there is any -- how you -- as you get back to shelf, are you getting back that consumer that may have experimented because they couldn't find your product and regaining that consumer back? And what are the tactics that you're using to regain that consumer?"
},
{
"speaker": "Linda Rendle",
"content": "Sure. Let me -- I'll start with the first part of your question. So maybe if we step back and look at what happened over Q1 and what we anticipate is happening over Q2 and beyond. The big picture is that when this first happens and we move to manual operations, which meant there was a period of time we were shipping anything for a very short period of time. And then we began manual operations and we were shipping at a lower rate. We still had inventory in the system for a number of weeks that allow consumers to have no visibility to this whatsoever. They went to the shelf and they had, for the most part, a normal experience and they were buying Clorox products."
},
{
"speaker": "",
"content": "And then over time, depending on the item and category and depending on the inventory that a retailer had and how much we could get to a particular category or a retailer in the manual operations, consumers began to see out-of-stocks. And there's a number of behaviors that happen when they experience that. One can be they delay their purchase. They don't find their Clorox product and they delay. The second thing is they really need the item in that category, and so they purchase a competitive product. And that varies across, again, different categories and depending on where consumer inventories were."
},
{
"speaker": "",
"content": "What that led to, though, is if you look at kind of what we had in Q1, about half of that downside was more than half was the bleed down of customer inventories. And then the rest of that we look at is lost sales. And then as we're rebuilding that inventory back up, you still have lost sales in Q2 at the beginning because we are not fully back. And so that same dynamic happens with the consumer when they go to the shelf. And as we rebuild inventories, we would expect as people who have delayed that purchase cycle or, frankly, haven't even had a purchase cycle yet come back that they'll see our items and continue to buy."
},
{
"speaker": "",
"content": "And those that have switched to a competitive product, we have strong confidence given the superior value and the trust people have in our brands that once we bring those items back, they will return to that. And of course, we'll support that with all of the things that we know how to do really well. Merchandising that reminds them of the benefits of our products at key pulse periods. It is why we are absolutely laser-focused on things like getting cold and flu merchandising, which we begin to ship later this month and ensuring that we have that and people that are looking for Clorox disinfecting products at that time, we want to make sure that we're not disappointing them. We will do that through innovation and giving them new and increased benefits and of course, speaking to them in our strong marketing communications, where we talk about the benefits of our product and the value they offer to consumers."
},
{
"speaker": "",
"content": "And we have strong confidence based off of a number of things in the past, COVID being one, where there was unprecedented demand and we couldn't fully need it. And we were able to, as we restore supply, consumers came back to our items even though they didn't find us on shelf in previous shopping trips that they had. So we're going to employ all the regular tactics that we have under our tool back. We're laser-focused on doing that."
},
{
"speaker": "",
"content": "And then as you think about that consumer coming back, if you look at past history, just like I said with COVID or for example, when we were out of the market in Pine-Sol for a while, as we came back, those tactics worked very well to restore share, maybe Wipes, maybe the best example, we lost 20 share points during the time of the height of the pandemic due to inability to meet that extraordinary demand."
},
{
"speaker": "",
"content": "And once we got our distribution back, which we did, we were able to regain that and then even more. People trusted our brand, and it's what they wanted. And so we have full confidence we'll be able to do that given the strength of our portfolio, the superior value of our brands and our continued focus on investments."
},
{
"speaker": "",
"content": "What I would say is it's all about the pace. We can't completely control the pace of getting back in full distribution, but that's what we are absolutely laser-focused on. Our retailers have the same goal to get us fully back in and that's how we're really thinking about it. It is ensuring we get products back on the shelf, we get back to in market fundamentals and then, of course, doing everything we can to support consumers and what we think is going to be a tougher back half for them just as you look, as Kevin talked about from an economic perspective."
},
{
"speaker": "Operator",
"content": "Your next question will come from Olivia Tong with Raymond James."
},
{
"speaker": "Olivia Tong Cheang",
"content": "As you think about sort of rebuilding inventory and market share, how do you ensure that this doesn't impact your ability to stay on pace on innovation and then eventually, your ability to get back to the gross margin recovery path because there's obviously -- you're not quite back there yet. You're still working on that. How is it that you can stay on patient innovation with all the disruption that's happened in the business and potentially some need to rejigger the marketing, promotional dollars, et cetera, in the second half of the year?"
},
{
"speaker": "Linda Rendle",
"content": "Yes. Olivia, it comes back to what we've spoken about before and continues to be of critical importance to us. We are deeply committed to our strategy, and that includes continuing to drive our top line momentum while rebuilding margin and balancing the pace of those 2 things. And that continues to be the center of the focus as we make decisions recovering from the cyber-attack and all the choices that we'll have over the coming quarters to ensure that we're balancing that for consumers."
},
{
"speaker": "",
"content": "So when this first happened, of course, job #1 was to ensure that we had contained the incident, we believe we have. Job #2 was to ensure that we could return operationally, which we did. And of course, we transitioned back to automated and now laser-focused on restoring supply. But at the same time, we knew it was critically important that we could not let go of the long term. And so I mentioned just a little bit earlier that we had taken a group of resources that did not need to be focused on the immediate issue at hand and we ask them to do everything in their power to preserve innovation in the back half. And that was while systems were down. And so they put together a set of plans to do that. And the good news is, we do have the ability to continue with our innovation plans in the back half because we did that."
},
{
"speaker": "",
"content": "And what we believe is we just have to continue to balance those 2 things. We have to balance the short term and laser focus on restoring but we have to make sure that we have that innovation. And that's how we're approaching this internally. We are trying very hard to ensure that the resources focused on the short term are not distracted and the same with the resources on the long term. And if you recall, Olivia, we did this during COVID when the same issue occurred. Demand was so high. We had to ramp up supply. We were dealing with shortages on all of raw materials but we also did the same thing where we put resources aside for innovation to ensure that we preserve that long term."
},
{
"speaker": "",
"content": "So that's what we're going to continue to do as we make choices moving forward is we want to balance short and long term. We want to balance top line momentum with rebuilding margin, and we have every confidence that we can do both of those based off of the plans that we've outlined for fiscal year '24 and beyond."
},
{
"speaker": "Olivia Tong Cheang",
"content": "Got it. And then just secondly, given the cyber-attacks, and I imagine you took another look at your capabilities and IT infrastructure, obviously in the middle of a program right now. Have you revisited the plan? Do you think there are more needs to be done? And if so, could that potentially extend the project further out?"
},
{
"speaker": "Linda Rendle",
"content": "Yes. So 2 things. Prior to the cyber-attack, we had a number of particular cybersecurity measures in place, including endpoint detection and response tools across our enterprise. And as we experience this, we continue as we bring our systems online to enhance those and taking a series is to further strengthen our security controls. So that's 1 bucket."
},
{
"speaker": "",
"content": "Second, of course, is we are in the middle of our digital transformation, as you note, and we continue to be deeply committed to that digital transformation. We think we have taken into account the broad set of tools and capabilities that we need to put in place to be more effective and efficient as part of that digital transformation. And we think more strongly than ever that is an important to our business and a critical priority to do that. What we are doing now is going through that program and ensuring any learnings we have over the last couple of months we're integrating into it. And then we're taking that into account as we bring the ERP online in the future and as we bring the rest of the tools in place."
},
{
"speaker": "",
"content": "But what I would say at this point is, it's too early to say if there will be any tactical changes that we'll make and how we'll sequence and time that. But what I can reaffirm is our deep commitment to it, how critical we think it is to the company. And it is just more reaffirmed given what we've experienced over the last few months as we've restarted our systems."
},
{
"speaker": "Operator",
"content": "Your next question will come from Javier Escalante with Evercore ISI."
},
{
"speaker": "Javier Escalante Manzo",
"content": "I have a question, I guess, is a CFO question. And it has to do with the business planning, forecasting and reporting that you had. How often do you communicate with the segments reporting to you? Because this seems to be kind of like a very simple business, mostly U.S.-driven. And I was surprised by the fact that it took over a month to know that the incident was material."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Javier. What I would say is, I think you saw we communicated in 1 of our previous 8-K that we thought this was going to have a material impact on our results. And so we try to communicate that fairly quickly. But then the next step for us was to determine the actual financial impact and so that's what we communicated in our preannouncement because we thought it was important, given the last outlook we had was what has put out there in August prior to the event. We did not want to wait until our earnings call today to report results. So as soon as we had a fairly good handle on the financial impact we communicated that publicly. Yes, you have to keep in mind the reality is we're working in an environment that had limited systems capabilities. So it was more manual effort. So that takes a little bit longer. But importantly, we thought we want to get out there and provide that information as soon as we could."
},
{
"speaker": "",
"content": "But you have to really work through this, Javier, because what you're really trying to figure out is when you can restructure systems, when you can start rebuilding inventory. And depending on that time line, that will impact the financial performance. So you have to let this play out a bit as we're going through the evaluation of the cyber event itself, developing recovery plan and then determining the financial indications of that recovery plan. So that was all the work that went on. And then as a result of that, we came out with a pre-announcement about a month ago."
},
{
"speaker": "Linda Rendle",
"content": "Sorry, Javier, I was just going to build on Kevin's response to your question. The other thing I would just note is this is actually a fairly complex business. We compete in 13 categories in over 100 countries around the world. And we're aggregating all that information in a manual environment to understand the impacts. In addition to that, we are working with all of our retailers and supplier partners who then have to transition to a manual process with us and getting our arms around exactly the implications and timing. So I just wanted to note, it is actually a rather complex business and one where -- when we are in a manual environment, you could understand how difficult it would be to have full visibility to all parts of that. And as Kevin said, our commitment was to transparency and giving information as we had it, which you saw in those series of 8-Ks."
},
{
"speaker": "Javier Escalante Manzo",
"content": "I appreciate that. Now my question was, I used to work for 1 corporation, a large 1 global. And I remember that they used to close the books every month and we re-forecast every month. So basically, that was the question I was asking. So how frequent does the CFO office re-forecast the business plan on a regular basis, understanding that there was a cyber event, which is very unfortunate."
},
{
"speaker": "Kevin Jacobsen",
"content": "Yes, Javier. Let me separate a normal environment versus the cyber environment because I was asked much different. So we -- similar to -- it sounds like the experience we close our books every month, we sell our results every month and we forecast on a regular basis. That's a cadence of anywhere from 5 to 8 forecasts a year. So we have very frequent updates in a normal environment. But as Linda mentioned, in this last period because of the limitation of automated systems, [ in vary ] manual environment. So it has less visibility to our financial performance while our systems were down. And then as we brought those systems back up, we actually communicated as soon as we had a handle on what we thought the financial impact was."
},
{
"speaker": "Javier Escalante Manzo",
"content": "And right now you have full visibility over your P&L, all the legal entities, all that."
},
{
"speaker": "Kevin Jacobsen",
"content": "We do. We've started up our systems, we're back to an automated environment that includes our ERP system. So yes, we have full visibility as we move forward now."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. Ms. Rendle, I would now like to turn the program back to you."
},
{
"speaker": "Linda Rendle",
"content": "Thank you, everyone. We look forward to speaking with you again on our next call. And until then, please stay well."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for attending."
}
] |
cmcsa | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Comcast's 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. I will now turn the call over to Executive Vice President, Investor Relations, Ms. Marci Ryvicker. Please go ahead, Ms. Ryvicker."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you, operator, and welcome, everyone. Joining us on today's call are Brian Roberts, Mike Cavanagh, Jason Armstrong and Dave Watson. I will now refer you to Slide 2 of the presentation accompanying this call, which can also be found on our Investor Relations website and which contains our safe harbor disclaimer. This conference call may include forward-looking statements subject to certain risks and uncertainties. In addition, during this call, we will refer to certain non-GAAP financial measures. Please see our 8-K and trending schedule issued earlier this morning for the reconciliations of these non-GAAP financial measures to GAAP. With that, I'll turn the call over to Mike."
},
{
"speaker": "Michael Cavanagh",
"content": "Good morning, everybody, and thanks for joining us. We are very proud that the company produced record revenue of $124 billion and record adjusted EBITDA of $38 billion in 2024. In addition, we grew adjusted EPS by 9% and generated substantial free cash flow of $12.5 billion. This is despite the intense competition and strategic challenges that we faced across our businesses. And in our Residential Connectivity business, in particular, broadband revenue grew 3% for the year. And convergence revenue, which we define as domestic broadband and wireless revenue, grew nearly 5%, which is among the best performance across the converged players, despite our incumbent status in broadband and as we faced continued overbuilding, fixed wireless expansion and the challenges associated with the end of the ACP program. As you've already seen in our earnings release, net broadband subscriber additions were negative 139,000 in the fourth quarter, which is disappointing and worse than what we indicated in early December. Dave will discuss in more detail when we get to Q&A, but in short competitive conditions remain intense, dynamic and varied across our footprint and customer segments, and we see no signs of this changing in the near term. Dave is not sitting still in this environment, and he will discuss later in the call the actions that his team has underway. But let me be clear that all of us continue to strongly believe in the long-term opportunity for our Connectivity business despite the need to adjust to the ever evolving competitive environment. Zooming back out, in 2024, we made substantial progress in each of our six growth businesses. To run through each one briefly, first, residential domestic broadband revenue grew 3%, as I just mentioned. Second, in wireless, revenue grew at a mid-teens rate, and we added another 1.2 million lines, taking us to 7.8 million as of year-end and to 12% penetration of our broadband customer base. Third, we delivered strong results in Business Services, growing revenue and EBITDA at mid-single digit rates. And we continue to identify new growth opportunities like our recently announced plans to acquire Nitel, which will enhance our capabilities to serve multisite enterprise and mid-market businesses. Today, Comcast business is nearly $10 billion in revenue and a $60 billion addressable market in the U.S. Fourth, in streaming, we achieved a $1 billion improvement in Peacock EBITDA losses and delivered on the promise of streaming with the excellent execution of the Paris Olympics. Fifth is our Studio business, where we rank second in global box office, making it the third year in a row where we've been either #1 or #2. And our TV studios ended the broadcast season with more top 10 series than any other studio. And finally, in our Destinations & Experiences business, we finished the year strong across our parks globally after having experienced some temporary headwinds in the middle of the year. Our team stayed hard at work preparing for the opening of Epic Universe in May of this year. Now turning to 2025. Our plans call for us to make progress on all of these fronts again, but let me highlight two areas for deeper commentary. First is Dave's action plan behind the commitment to drive continued growth in broadband and convergence revenue. We will lean into wireless more than ever before. We are the challenger in a market that is 2.5x the size of broadband with a capital light strategy that does not require network trade-offs. Wireless is a meaningful differentiator as our converged offers provide great savings to the consumer. And so you will see us shift our strategy to package mobile with more of our higher-tier broadband products, both for new and many of our existing customers. In addition, we will be capitalizing on our broadband and WiFi network capabilities by automatically boosting the speeds of Xfinity Mobile customers by up to 1 gig whenever they connect to our 23 million WiFi hotspots, which is the largest and fastest WiFi network in North America. Next is our world-class broadband network, which consistently delivers peak performance even as Internet traffic increases at double-digit rates. This fall alone, we saw NFL streaming and large game downloads drive the biggest consumption in Internet history. These trends play to our strengths as we have the best path to deliver data in the most cost-efficient way over the long term. So a top priority is driving our broadband network upgrade that will ultimately deliver multi-gigabit symmetrical speeds across every market we serve and incorporate AI throughout our entire network. Project Genesis, as we call it, is making great progress. Today, over 50% of our network is fully virtualized, and we will reach about 70% by the end of this year. Now that we are more than halfway through, we will be introducing new pricing and packaging in the upgraded markets in the coming months that will bundle wireless and Internet with faster upload speeds and simplified all-in pricing with the goal of removing points of friction with our customers. Finally, we are creating new products designed to appeal to our key customer segments and provide more flexibility with attractive pricing. One example is our sports and news TV package announced just last week that combines the best linear networks along with Peacock at a price that is competitive against virtual MVPDs. We know sports fans want and need great broadband. And we will continue to look for packages like these to sell more Xfinity Internet and to lower churn for existing subscribers, which together increased customer lifetime value. Helping Dave across all of these priorities will be Steve Croney, who in the past month was promoted to Chief Operating Officer of Connectivity & Platforms. His areas of responsibility are Comcast residential and commercial businesses, including product strategy, sales and marketing, customer experience, field operations and data analytics. Steve will serve as a catalyst as we push even harder for progress across the range of initiatives I just laid out. Now moving to Content & Experiences. The big news of the fourth quarter was our decision to spin off a strong portfolio of cable television networks and digital assets to our shareholders in a tax-free transaction that we estimate will be completed at the end of the year. Earlier this month, we announced key appointments to the future senior leadership team for this new company with Mark Lazarus as CEO; and Anand Kini as CFO and Chief Operating Officer. As a well-capitalized independent company with a focused management team and strong portfolio of news, sports and genre-based entertainment, SpinCo will be well positioned to lead in the changing cable and digital media landscape. Importantly, the creation of SpinCo will be a positive catalyst for what I've been calling future NBCUniversal. First, let me define what that looks like. When we announced SpinCo in November, we also announced the restructuring of the remaining NBCU Media businesses, which will operate together and consist of the NBC broadcast network with NBC Sports, which is the home of the NFL, the Olympics, the Premier League, NASCAR, golf and later this year, the NBA; and Bravo, which is a leader in reality television and home of beloved franchises, including the Real Housewives and Below Deck. Together, NBC and Bravo reach 100 million U.S. households each month and help power Peacock. Then there's Peacock itself, which in four years has built a base of 36 million subscribers and integrates original programming, universal films and exclusive sports and news as well as NBC News, the leading news organization in the United States plus Telemundo, America's #1 Spanish language content powerhouse and our local stations. With our Media business now focused on streaming and broadcast alongside our growing Studios and Destinations & Experiences businesses, the future NBCU will continue to be one of the largest media companies in the world with nearly $40 billion in annual revenue. NBCU will be on a growth trajectory fueled by our world-class content, technology, IP, properties and talent, all working in concert with each other as an integrated media company. Our extraordinary parks business and industry-leading film and TV studios are already positioned for long-term success. Theme Parks will be supercharged by the opening of Epic Universe, the most technologically advanced theme park ever. And just last week, our film studio earned a total of 25 Oscar nominations, the most in the studio's history. This is on the heels of a hugely successful run for Wicked, which at over $700 million at the global box office has become the highest grossing film based on a Broadway musical. So to wrap up, I want to reiterate the confidence that our entire management team has in our business, allowing us to again raise our dividend by a healthy $0.08 per share. Through our dividend payments and share repurchases, we have now returned more than $55 billion to shareholders, since 2021 when we resumed our buyback program. And while we've demonstrated our commitment to returning capital to shareholders, we've been transparent that our first priority is to reinvest to set ourselves up for revenue growth, and we've done so consistently across six key growth drivers. We expect this formula to guide us in 2025 and the years ahead. Before I turn it over to Jason, I'd like to close by saying that our hearts go out to everyone impacted by the devastating wildfires. I am in awe of the first responders and others on the front lines and grateful to our news teams on the ground, covering this tragedy and sharing vital information as well as the operations teams and everyone in the community who have rallied to support people in this difficult time. Jason, over to you."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Mike, and thank you, everyone, for joining us. I want to start with a high-level overview of our consolidated results. Total revenue grew 2% for both the fourth quarter and the full-year with our six major growth drivers, including residential broadband, wireless, Business Services Connectivity, Theme Parks, streaming and premium content in our Studios increasing at a mid-single-digit rate and now comprising close to 60% of our total revenue. On a reported basis, we grew EBITDA 10% to $8.8 billion for the fourth quarter and 1% to $38.1 billion for the full-year. Excluding severance and other in both years, EBITDA grew 8% in the quarter and 1% for the full-year. Adjusted EPS increased 14% to $0.96 in the fourth quarter and 9% to $4.33 for the full-year. We generated $3.3 billion of free cash flow for the quarter and $12.5 billion for the full-year, returning over 100% of this to shareholders with $13.5 billion of capital returned for the full-year. Now I'd like to touch on broadband, where we lost 139,000 customers in the quarter, while we grew ARPU 3.1%. Importantly, our measuring stick is revenue growth. And on that score, for the full-year, we grew broadband revenue 3% and convergence revenue by 5%. And into 2025, we expect broadband revenue to continue on a growth trajectory with convergence revenue again growing at an even faster pace than broadband revenue. Our view over the near term is that fiber operators will continue to overbuild us, and fixed wireless operators will continue to sell into remaining excess capacity. Longer term, our view is that we will face fiber as the primary competition in most of our footprint. In effect, there will be two multi-gig symmetrical wires in the vast majority of homes that we serve. In addition, there will be opportunistic, capacity-constrained competitors carving out a permanent part of the market in the form of fixed wireless and likely satellite as well. That shouldn't be a surprise to anybody. That is and has for quite a while now been our view of the long-term structural and competitive characteristics of the broadband market. Along those lines, let me remind you that we've competed against fiber for over 20 years. And during this time, we have generally seen a repeated pattern where new fiber builds gain early market share wins and then settle into fairly equal market share amongst providers over the medium to longer term. Despite the increased competition, these markets maintain strong ARPU characteristics in line with non-fiber markets. Keep in mind that this past experience versus fiber was with prior-generation cable networks, where fiber was able to market a significant speed advantage. That's increasingly not the case now and will not be the case in the future where multi-gig symmetrical parity will exist among both of us and will further differentiate our offering with everything that we surround around broadband like whole home coverage, control, security, aggregation, best in-home WiFi and added value in wireless. Speaking of wireless, we have an incredible hand in conversions, underpinned by ubiquitous broadband network, product differentiation and a super competitive wireless product available to all of our customers. In fact, in convergence terms, while we are the incumbent in the $80 billion U.S. residential broadband market, we are the challenger in the far larger $200 billion U.S. wireless market. Wireless is an integral part of our broadband strategy. It reduces churn and is a key acquisition tool and a driver of our strong convergence revenue growth, which has been in the mid-single digits and at the high end of our telecom peers and competitors. And with 7.8 million total wireless lines, which is 12% penetration of our residential broadband customer base or around 6% of our total passings, we have a long runway ahead. Finally, on Business Services, the fourth quarter, the full-year 2024 and our outlook for 2025 all fit within the same framework. And that is within small and medium-sized business segment, we're operating in the same competitive environment as residential broadband. And similarly, despite the elevated competition, we are delivering nice revenue growth in this segment driven by higher adoption of our suite of advanced services that deepens the relationship with our large base of customers. Add in significant progress in revenue growth we're seeing across larger enterprise and government contracts and the overall category of Business Services has been growing at an industry-leading mid-single-digit range with a total revenue base approaching $10 billion and a margin at nearly 57% as of year-end. Putting this all together, in the quarter, Connectivity & Platforms revenue remained consistent with the prior year as 5% growth in our connectivity businesses was offset by revenue declines in video and other, while EBITDA grew 2% and margins expanded by another 80 basis points when excluding severance and other in both periods. Looking ahead, we intend to lean into wireless, which means additional investment there, but the overall framework for growth over the long-term remains the same: a mix shift driven by continued strong growth in our connectivity businesses, which creates opportunity for further margin expansion, the same dynamics that have driven our results for the past several years. And we still believe we can deliver that in 2025 despite certain higher areas of investment. In addition, we landed our CapEx intensity at just over 10% in 2024 and expect to continue in and around this range for 2025. This all creates continued favorable characteristics for strong and growing net cash flow generation coming out of Connectivity & Platforms. In the Content & Experiences segment, I would frame the business as follows. In parks, we're seeing some stabilization after a slowdown in the second and third quarters. Adjusted for Epic preopening costs of around $35 million, EBITDA in the fourth quarter was flat year-over-year with attendance trends improving across most of our parks, including Orlando, solidifying the foundation for our opening of Epic Universe in May. We couldn't be more excited for the launch of Epic. We've also been clear we will have significant costs leading up to this opening with over $100 million or the vast majority landing in the first quarter. In addition, we will have incremental domestic marketing spend as well as an impact from the tragic fires that raged around Hollywood. Our Studios continue to deliver as this was the third straight year in which we've been in the top 2 in global box office. And we are excited about the 2025 slate, which includes How to Train Your Dragon, Jurassic World Rebirth and Wicked: For Good, just to name a few. While we expect another strong theatrical and PVOD run, Studio EBITDA growth will be impacted in 2025 by higher marketing expenses tied to a larger film slate and lower carryover from prior years, given the writers' and actors' strikes in 2023. In Media, we are making a successful pivot to streaming as evidenced by Peacock's strong revenue growth of 46% for the full-year, driving a $1 billion improvement in Peacock's EBITDA loss. And we expect to make continued improvement in Peacock EBITDA losses in 2025. We couldn't be more excited for the year ahead as we welcome the NBA back to NBC and also on Peacock later this year. To put 2024 in perspective, we dealt with potentially the most competitive environment we faced in broadband, saw an unexpected but significant temporary slowdown in Theme Parks and made major investments in our key growth initiatives. Yet when you sum it all up, we grew adjusted EPS nearly double-digits and generated $12.5 billion in free cash flow, speaking to the overall breadth and resilience of our business. At the same time, we maintained a healthy balance sheet, ending the year with net leverage at 2.3x, while returning $13.5 billion to shareholders, including over $8.5 billion in share repurchases. Since we restarted our buyback program in 2021, we've reduced our share count by nearly 20% and see significant room to continue to deliver on this trajectory. With that, let me turn the call over to Brian."
},
{
"speaker": "Brian Roberts",
"content": "During all of that, I'm certainly proud that we had the best year in our 60-year history with record revenue, EBITDA and EPS along with significant free cash flow, all while returning so much capital to shareholders and never take any of that for granted. Our team is executing in industries that are going through rapid and exciting transformation. And it's our founding principle to lean into that change and constantly look for new growth as we have always done. I also like to step back and think about our assets from our 64 million homes passed with really fast gig speed Internet to our robust backbone with hundreds of thousands of miles of fiber, localized data centers complete with space, power and connectivity, together, this network gives us a competitive advantage in the markets we serve but also importantly positions us really well for new growth opportunities in a world hungry for connectivity that will be increasingly driven by AI and edge computing. So as we turn the page to the coming year, there's a lot to be excited about, starting with our most recent Comcast business acquisition of Nitel; the launch of Epic Universe, much awaited; and our new 11-year deal that will welcome the NBA back to NBC, just to name a few. We have a wonderful company, but nothing beats good execution. And as you heard, our team is already hard at work and energized for what lies ahead in 2025 and beyond. Marci, now over to you for Q&A."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Brian. Operator, let's open the call for Q&A, please."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Ben Swinburne from Morgan Stanley. Please go ahead."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thank you. Good morning. I want to come back to your comments on wireless. Obviously, you guys are excited about that opportunity and seem to be -- I think Mike used the word shifting strategies that -- should we be expecting net adds to accelerate? Is that what success looks like there? And any more comments you can give around the investments that Jason mentioned and kind of removing friction, thinking about things like handset subsidies, et cetera? And then I know you talked about it, but I don't know if Brian want to comment on just the vision for NBC's Media business sort of post the spin-off kind of wrapped in sports and broadcast. But like longer term, how do you think about the growth opportunities for what we used to think about as kind of the television business at NBC? Thanks so much."
},
{
"speaker": "Michael Cavanagh",
"content": "Hey, Ben, I'll start, and then maybe Dave can chime in on wireless, and Brian on Media. I'd like to start on that one, too. But -- so on wireless, yes, I think we're pleased that we've gotten to 12% penetration. I think we have a very good hand as you think about offering a converged offering to consumers with the best broadband product out there across 63 million homes, together with the ability to put a mobile phone in people's hands with a good value on the best network with the best devices. So we've been at it for a few years, and I think we like what we see. And our intention is to push harder. We've seen Charter try some things that we have watched and seen what they're doing, so I think pushing for more simplified bundles. One thing we talked about in the earlier comments is how as we've rolled out our network upgrades, it's going to both enable stronger products, a stronger converged product across mobile and broadband. Together with the friction points is putting some more simplicity in the offers themselves and the way we go to market with broadband and wireless together. And I think in addition to that, we're going to be looking at trying to attach and penetrate our existing base of customers, not just new customers but especially those in our highest value wireless cohorts. So all that will have some impact on -- as we invest behind success, but that's -- and that's what Jason was referring to. Dave, I don't know if you want to add anything to that?"
},
{
"speaker": "David Watson",
"content": "Yes, Mike. Hi Ben, the -- we had certainly some success with our prior approach leading up to this moment with wireless and buy one, get one. It's been a pretty -- we were pleased with that. But I felt it was the right moment to shift strategy to package mobile rate and included with into more of our higher-tier broadband products. This is a fundamental shift that will impact acquisition, base management, and retention to be included. So included mobile, and it's all towards the effort that both Mike and Jason have talked about our overall goal of driving converged revenue."
},
{
"speaker": "Brian Roberts",
"content": "And just to add one last thought on wireless. As I think about the industry opportunity, when they went from four to three, that makes it a business where you tend to see prices go up. And that creates a better business opportunity for a new entrant like ourselves. And so all the dynamics would appear to make that a good growth for many, many years to come. I think for the Media business, the spin, I just want to echo that I think makes a lot of sense. 98% of the viewing on Peacock does not include the spun networks. So they need their own direct-to-consumer digital initiatives and focus and investment. And I think Mark Lazarus and Anand Kini and the team are going to do a superb job and we're -- it will take a little while to get that launch. But one of the things Mike did was begin to operate the company as if it's already happened. So we've got a whole new team in the remaining Media businesses and the leadership that we've announced is in place and functioning. And we were just meeting the other day. And they have a pretty exciting road map. It starts with Epic Universe this May. In the Television business, to your question, I think that the content we make works on Peacock. We are also a provider to other platforms. I think we sell content to every platform and I think with the addition of something like the NBA combined with the Olympics, combined with Sunday Night Football, combined with Premier League and then shows like Day of the Jackal, we have something called the Americas coming up, which will be on NBC and using NBC to drive Peacock and vice versa more than maybe we have in the past, it's a very exciting business. So Mike, you want to add anything on that piece of the question?"
},
{
"speaker": "Michael Cavanagh",
"content": "I think that it really, I agree with everything you said. I think it does two things. One is I think the assets that are going to SpinCo are strong as many of have observed. But the fact of the matter, as Brian called out, the 98% quote, they weren't integral to the emphasis we've put on Peacock and a streaming future for NBC broadcast in particular. And so I think those assets are going to be better managed and have opportunities in the future that are better optimized for our shareholders by putting them in the hands of the strong leadership team Brian described with light debt and sort of strength. So that is an area -- getting management focus has always proven to me to be -- there's great ideas that many of us has as we got this started. And I think Mark and Anand have come up with several others, and it's more to come. What it leaves is an equally focused management team under Donna Langley and Matt Strauss that are now taking the NBC broadcast assets together with Bravo, which Brian did mention sort of the leader in reality television, both of which feed substantially the viewing in Peacock itself along with movies, sports and the like. And I think the opportunity that that team sees in bringing together in a way that I don't think would be possible without separating the two different businesses. They'll create a cohesive management team across programming. So what content gets greenlit with a complete end-to-end view about how you could window across NBC Broadcast or Bravo or Peacock and back and forth make investments that are really end-to-end and get their management teams streamlined, frankly, so that quicker, better decisions get made in support of a singular remaining streaming-focused, but with an important linear elements to it in terms of Bravo and NBC that I think opens up what we've been talking about for a while, which is that we're not really running a Peacock-only strategy. We're running a broadcast plus streaming strategy and looking to optimize that over the years ahead."
},
{
"speaker": "Brian Roberts",
"content": "Last point I would make is, Mike, you have stepped into this, figured it out, executed extremely well. There's more energy bounced to step in both parts, SpinCo and the RemainingCo. So we're very excited, and your leadership is noticed and appreciated."
},
{
"speaker": "Benjamin Swinburne",
"content": "Thanks everyone."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Ben. Operator, next question please."
},
{
"speaker": "Operator",
"content": "The next question is from Craig Moffett from MoffettNathanson. Please go ahead."
},
{
"speaker": "Craig Moffett",
"content": "Hi, thank you. Dave, staying with the broadband business for a minute. Can you talk about what you've learned in your Project Genesis markets as the -- and you talked about now leaning into marketing and promotion around letting people know that, that's done. Talk about what that looks like, if you would? And what you expect will be different in the markets where you now have a symmetrical broadband offering with speeds that are sort of fiber-like, if you would?"
},
{
"speaker": "David Watson",
"content": "Got it. Hey, Craig. So what -- first off, what we're pleased with, what we're learning is we're right on track in terms of Genesis. We -- 50% of the first phase completed, and we're moving at a very good clip. Vast majority of the plant will have that mid-split side of things upgraded by the end of this year. So we're pleased with it operationally. We're pleased with the architecture, the promise of virtualizing elements of it so we can introduce all the things that Mike mentioned in regards to how we manage the network day in, day out that keeps the -- it efficient and effective as a network. So we made significant progress. And -- but maybe the biggest point to what we're saying today is, we're certainly -- this is a vast road map to ubiquitous multi-gig symmetrical. But we're not waiting. We are moving now on the first phase as we upgrade the plant to be able to introduce the simplified packaging that I think will make a difference in the marketplace. This will obviously have our best tiers of broadband. Mobile will be included. It's really simplified and reducing a lot of the pain points that we've seen in the marketplace just -- so including a faster path to everyday pricing. So it is a, I think, a really important moment for us. We're pleased about this opportunity to be able to get going and expect second quarter that we would begin to put the pedal down on that effort."
},
{
"speaker": "Craig Moffett",
"content": "Dave, can you share any learnings for how competition is different in those places? Or is it still too early, because you haven't really launched the marketing around it yet?"
},
{
"speaker": "David Watson",
"content": "Yes, it is still too early, Craig. We'll launch the simplified -- the packaging side of things in the second quarter. So what we have seen is that it's an important first step of upgrading speed capability. And you combine that with great WiFi in the home. So it's a good fundamental step forward, but it's too early to talk about the competitive shift until we get the full marketing going."
},
{
"speaker": "Craig Moffett",
"content": "Got it. Thank you."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Craig. Operator, next question please."
},
{
"speaker": "Operator",
"content": "The next question is from Michael Ng from Goldman Sachs. Please go ahead."
},
{
"speaker": "Michael Ng",
"content": "Hey, good morning. Thank you for the question. I just have two. First, on domestic broadband, could you just talk a little bit about the ARPU outlook? Should we expect ARPU growth to accelerate from here, just given the absence of things like hurricane rebates and some of the price increases implemented at the beginning of this year? And then for Jason, I was just wondering if you could talk about free cash flow for next year. Obviously, a few moving parts between cash taxes, the cash tax refund and CapEx potentially coming down in C&E. So any thoughts there would be great? Thank you."
},
{
"speaker": "David Watson",
"content": "Michael, this is Dave. Let me start with your point on ARPU. So we expect continued healthy ARPU growth. Our overall focus is on broadband and convergence revenue growth though. That is the main point as Mike and Jason have called out. And the good news is there are different levers we have and we'll continue to pull, but in the context of how we really are focused on maximizing overall revenue growth. So in a dynamic environment, we've got those levers to pull, and we will make the right decisions to optimize the levers to build longer-term sustainable revenue growth. So as I mentioned before, we are implementing a number of new approaches, and we'll continue to make the best decisions for now and in the long term. So going to give you an example. Whenever we accelerate wireless and pushing harder there, we think it's the right, smart competitive decision. We may not be right within the range that we have been, but still expect ARPU to be very healthy. Jason?"
},
{
"speaker": "Jason Armstrong",
"content": "Yes, Mike, thanks for the question. So let me round out free cash flow, maybe step back a little bit. We gave an outlook on the call for a number of different parts of the business. As you get down to free cash flow, I'll step you through brief views on working capital, maybe complete the picture on CapEx, and then you mentioned cash tax as well. So it starts with what's the underlying base. The underlying base is very healthy free cash flow generation. As you saw in 2024, we generated $12.5 billion. That's in the context of we did have a $2 billion one-time headwind that we called out in the second quarter. So really, really free cash flow was probably $2 billion ahead of that. That's how we look at the baseline for 2024. And then entering into 2025, you're right. In the release today, we did talk about a tailwind to cash taxes in 2025. That will be roughly a couple billion dollars. So that's going to be a tailwind to us. We'll be clear about that at the time, and I would view that as a one-time thing. But nonetheless, helpful relative to 2024 where cash taxes went the other way. Working capital is another sort of key part to this. I think we're -- it's tough to guide with total visibility and predictability, but I would point you to the last couple of years. 2024 working capital headwind was about $1.5 billion, 2023 was roughly $2 billion. Those in rough terms are probably the right goalpost to think about for 2025. And if you step back, the key things that caused working capital headwinds are attached to our growth businesses. It's handset subsidies. It's production around a lot of the streaming properties. It's sports rights. So those are all still in place for 2025 and beyond. So that's what that category will look like. But hopefully, that helps there. And then on capital intensity, we were clear about cable capital intensity. We landed the year at just over 10%. That's the outlook for 2025, and that's in the context of very strong new homes passed continue to really be aggressive in passing a new home formation. So we'll continue to invest pretty aggressively there, but within that capital intensity envelope and feel comfortable about that. And then on the Content & Experiences side, you're right to point out, we are nearing the tail end of the Epic sort of construction phase. And so we will get relief from that over the course of 2025."
},
{
"speaker": "Michael Ng",
"content": "Great, Thank you, Jason. Thank you, Dave."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Mike. Operator, next question please."
},
{
"speaker": "Operator",
"content": "The next question is from Jonathan Chaplin from New Street Research. Please go ahead."
},
{
"speaker": "Jonathan Chaplin",
"content": "Thanks guys. Following up on the wireless commentary. I'm wondering if you can just -- it looks like revenue growth was strong this quarter even in the context of pretty strong subscriber growth. I'm wondering if you could help pull apart how much of that growth came from ARPU growth in wireless versus equipment revenue. And then we've been hearing that the MVNO contract could be up for renewal this year. I'm wondering if you could give us some context for what you expect in pricing when that renewal does come up and how it might impact margins in the wireless business. Thanks."
},
{
"speaker": "Jason Armstrong",
"content": "So Jon, let me start with wireless growth and sort of I think your question really was sort of service versus equipment. I would tell you, very healthy growth in wireless. We added 1.2 million subs year-over-year. That translated into mid-teens revenue growth. And if you were to break it down in terms of service versus equipment, service revenue growth was sort of right in that range as well."
},
{
"speaker": "David Watson",
"content": "Yes. Jonathan, Dave. There's no new news in terms of MVNO approach. We're pleased with our current position. And as Brian opened up where the marketplace has consolidated, cable is in a unique position to be able to drive real value, not only for us but for our partner. So we're -- no new news though at this point."
},
{
"speaker": "Michael Cavanagh",
"content": "And I think -- Mike just adding in, and we're a sizable partner at this stage, which is important as you think about the -- and we're not the only one in the partnership with -- on wireless. So I think that's different than the discussions from years past."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jonathan. Operator, next question please."
},
{
"speaker": "Operator",
"content": "The next question is from Jessica Reif Ehrlich from Bank of America Securities. Please go ahead."
},
{
"speaker": "Jessica Reif Cohen",
"content": "Thank you. Maybe switching gears a little bit from the new strategy. Last quarter, you announced the restructuring, SpinCo and maybe plans to consolidate on streaming. Can you give us any update? Do you think the market will consolidate in streaming? Any commentary for M&A in terms of cable? Will scale help your competitive position in broadband and wireless? And I guess, Media, are there any pieces that you think are still missing or you would benefit from scale? And then on SpinCo, can you maybe discuss the strategy a little bit more? You mentioned that -- you alluded to streaming, but is the focus going to be on sports, news, acquisitions or cost cutting?"
},
{
"speaker": "Michael Cavanagh",
"content": "Sure, it's Mike. I'll start and Brian can finish. I mean, just quickly on SpinCo, it's exactly as I said earlier. I mean the assets that go into SpinCo are leaders in genre-based entertainment, sports and news. I think running those businesses well, which the team -- leadership team will do is the job at hand. And they're working together naming new leaders and putting together a strategy. So when they're ready to talk about what their strategy will be at some point down the road, we'll come back. But I think the idea certainly is that they're a freestanding strong collection of businesses with lots of cash flow generation capability for many years to come, good market positions and now great focus. So I think I'm optimistic that, that creates good opportunities for our shareholders however Mark and Anand really decide to take that strategy forward. For the remaining Media business inside NBCU that I commented on earlier, I think it's set up to -- we're not looking to need anything other than our own assets and our own focus. So getting, again, Donna and Matt aligned with the teams underneath and combining the assets that we have today that I mentioned earlier into a new media group is, I think creates great fuel for the streaming strategy that is Peacock for those NBC assets. When you zoom -- would we be interested in partnerships? Absolutely, we'll have -- we're wide open to, as I said, when we announced on the last earnings call, openness to possibilities of partnerships, bundling. We'll consider anything. So -- but I think the point of it in partnerships is what do you bring to the table and getting our assets very tightly focused around a strong strategy for Peacock, I think enables us to be a good partner, any partnerships that may or may not come to pass. But if they don't come to pass, I think we're fine running what we have. When you expand more widely to the whole Media or Content & Experiences business, you put that new media company with NBC and Peacock, Bravo and the like alongside a leading Studio business that is a grower in high value and great leadership and sustained success over the past several years and great slates coming in this year and 2026 and a TV studios business that will now be under [indiscernible] or had been, but along with other NBC network and the like as we go forward for programming decisions along with Donna, I think that sets the Studios up for sustained success and growth. And lastly, parks, which we talked about before. So when you look at the -- what remains in the aggregate media company, it's a strong, strong business, one of the best in the country, if not the world. And I think it sets a very high bar for thinking about whether any kind of M&A in that space would be accretive to us versus just running the businesses we have. And that's the work we've been doing to sort of streamline our businesses. So we like what we have with or without anything inorganic. So that's the Media side, and Brian can come in on top of that."
},
{
"speaker": "Brian Roberts",
"content": "Look, I think that's a pretty -- very complete answer. One just on SpinCo, I would say one of the two other points is that we have first mover. We've heard others now talking about perhaps similar idea of the same. And secondly, we're going to have -- they're going to have a great balance sheet, probably the envy of many, which will allow them to have the pick of what strategy Jessica to employ there. And I think we want to give them the time and space to figure that out. And as Mike said, they'll be back and anxious to tell you that strategy. But I think that's not going to happen until later in the year. And I think just generally, you can apply the answer you gave to Media on the rest of the world. We're looking -- we always look at everything and think about everything. I think that's our job as management. That's been -- but we have a high bar, and we don't do things very often and look at the situations and make the best judgment you can. Sitting here today, the company with 38 -- the company we just reported with the best year in 60 years with all the various things we've just been talking about in the call, revenue growth, EBITDA growth, free cash flow. Jason, a while ago kind of created an algorithm goal for us, which is to take maybe slower EBITDA growth than historically. But given the CapEx profile, tax profile, you end up with a free cash flow with -- you're buying back stock, you end up with an EPS and free cash flow per share kind of reliable performance that gets you to the kind of 9%, I think you said, growth kind of close to double-digits. So that algorithm, something has to really help that algorithm accelerate. So I like what we've got, and I thought Mike's answer covered some of the specifics on the Media side."
},
{
"speaker": "Jessica Reif Cohen",
"content": "Thank you."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jessica. Operator, next question please."
},
{
"speaker": "Operator",
"content": "The next question is from John Hodulik from UBS. Please go ahead."
},
{
"speaker": "John Hodulik",
"content": "Great. Maybe for Dave back on the broadband question. Just the change you guys saw in December, was that -- do you think that was more from competition? And then if so, could you break it down? Or were you seeing more pressure from fiber to the home or fixed wireless? And you mentioned satellite for the first time. Are you actually seeing that now? Or is just some expectation in the future? And then for Jason, one of the things where you guys have been very successful over the last few years is improving margins in cable or on the connectivity side. Does that equation still hold as we look forward considering the new strategy to combine broadband and wireless more aggressively? Thanks."
},
{
"speaker": "David Watson",
"content": "John, this is Dave. Let me start. So as Mike led off with, right away, we may have been a little too optimistic with what we're seeing and more in the price-conscious segment in an earlier part of the quarter in December. But the main point bringing us back up, it's intensely competitive in all segments. So it's little bit of a shift, but it's -- you have fixed wireless while it's leveled. They're still out there aggressively marketing, and you got fiber that's overbuilding. So that has continued."
},
{
"speaker": "Jason Armstrong",
"content": "John, let me hit your questions on margins, which I think was in the C&P segment. So we've had, obviously a really good history of driving margin expansion. The things that broadly contribute to that, and I think as I said in the upfront remarks are mix shift in the business, number one, more and more of our business moving to connectivity, which is a higher-margin business. Number two, it's sort of interactions, if you will with the customer service interactions. So whether that's truck rolls, incoming calls to our call centers. We've given you stats historically about each one of those metrics being down 40% to 50% in the last five or six years. So the underpinnings of that continue. As you saw, we expanded margins pretty -- at a pretty healthy clip in 2024. As I said in the earlier remarks, we expect to continue to be able to expand margins maybe at a slightly lower rate this year, given the investments we want to make back into the business, including wireless. But nonetheless, continued very healthy margins in an absolute sense where we're industry-leading. And then on a relative basis and the ability to grow, I think continued momentum there. I would as we step back and look at the -- a couple of the architects in that business. We mentioned earlier and we put out a press release last week about Steve Croney taking on additional responsibilities. He's been CFO of the C&P business for the last several years, incredible financial discipline across the organization. So great that he's able to spread his wings and do more and really lean on some of the things that Dave has outlined here on this call. But kudos to him and the team for driving the type of margin expansion we've seen and expect to continue to see."
},
{
"speaker": "David Watson",
"content": "And John, one more follow-up to your point on satellite, just to clarify. The two main ones are the ones I mentioned between fixed wireless and fiber. Satellite, we see it's just been de minimis, has not been a material thing for us, not being dismissive of it, though. We're going to watch it very closely, but we see it being more active in rural areas and not so much in suburban, urban areas at this point at all."
},
{
"speaker": "John Hodulik",
"content": "Great. Thank you."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, John. Operator, we have time for one final question."
},
{
"speaker": "Operator",
"content": "Next question is from Steven Cahall from Wells Fargo. Please go ahead."
},
{
"speaker": "Steven Cahall",
"content": "Thank you. I just wanted to go back to the broadband ARPU dynamics. I think you said very healthy ARPU growth, but you do lean into mobile. What we've seen with some of your peers is there is some dilution to ARPU. You've historically managed this really strong 3% to 4% growth. So just wondering if you're shifting that strategy a little bit around that 3% to 4% growth as you move into more of the converged bundle? And then on Peacock, thank you for the guidance for losses to improve. I'm just wondering if that's true in the second half of the year as well when the NBA costs come online and push OpEx higher. I know revenue is going to step up, too, but just trying to figure out if you think the NBA will be positive to Peacock EBITDA in 2025? Or if it's a bit of a headwind and then kind of ex NBA, there's a lot of improvements going on beneath the surface? Thank you."
},
{
"speaker": "David Watson",
"content": "Steven, this is Dave. Let me start with ARPU and a couple of points on that. You did hit it that mobile is an important part of our future. It has been a great contributor for a long period of time, but we're excited about accelerating our focus. And -- but there are a number of levers that we have when it comes to ARPU, and we'll manage all of them. And as we roll out these new -- the new packaging approach, we're certainly focused on all segments, but this is following upgrades to our plant and really focused, hyper-focused on the high end, always have been, will continue to be. So that will certainly impact and leads us to our focus on continued healthy ARPU growth. But when you add mobile to your packages and the simple way that we're talking about, there could be some impact to ARPU. But we think the returns are terrific. And for competitive reasons, it's absolutely the right thing to do over the long run. But we still are very, very focused on all levers that would contribute to ARPU."
},
{
"speaker": "Jason Armstrong",
"content": "And I think along those lines, we've been very clear as it relates to North Star for us is how you continue to grow broadband revenue at a healthy clip. And ultimately, how do you grow convergence revenue at an even better clip, right? So in the past year, we grew broadband revenue at 3%. We grew convergence revenue at 5%. Interesting, if you stack us up versus peers and competitors, we realize there's a lot of focus on broadband sub-trajectory. But if you step back, we are at or near industry-leading levels for convergence revenue growth. So the focus here is continue that, find the levers we have to go push into that. It's not to say we can't have a strong broadband ARPU growth. We gave an outlook that broadband ARPU growth will continue to be healthy. But as we look at the levers we have to go drive wireless growth, to drive continued broadband growth, to compete aggressively in the markets and really deliver on everything Dave said he's coming to market with, in particular, in the second quarter, we got a lot of levers, and we have a clear North Star around what we're growing."
},
{
"speaker": "David Watson",
"content": "One other thing that in terms of revenue, Jason hit it perfectly. But I would offer Business Services revenue is a tremendous opportunity, has been, will be, where overall, we're a leader when you compare Business Services growth in terms of our peers and our competitors. It's a $10 billion revenues, great margins, and we have consistently contributed revenue and EBITDA growth. So going right to Jason's point in terms of our focus on overall revenue, Business Services is an enormously important part of what we do."
},
{
"speaker": "Michael Cavanagh",
"content": "And Steven, on Peacock, thanks for the question there. I think we're looking forward to the NBA. It was a big kind of get, and it's going to be the major additive content that will drive -- be the driver of subscriber growth, I would expect in 2025 for us. So in terms of -- I don't really think about halves as a -- what we'll see this year is, as I said, improvement in Peacock revenues and losses. And then as we absorb NBA in the second half of the year, what will happen then is over the remainder of that -- the full first season together with the seasoning of the management changes with Matt and Donna that I described plus SpinCo, we'll be working through a whole bunch of ways in which we absorb the cost that will step up through price increases, shifting ad sales to higher value content that the NBA brings and repositioning some of the programming that the NBA will displace, sort of all the things we talked about. But that will take -- I would give us the full first season of NBA into the second season before we sort of normalize our business to handle the higher expense there. And so I think that's it, everybody. I appreciate you guys spending the time with us this morning, and Happy New Year."
},
{
"speaker": "Steven Cahall",
"content": "Thanks."
},
{
"speaker": "Brian Roberts",
"content": "Thank you all."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "That concludes today's call. A replay of the call will be available starting at 11:30 a.m. Eastern Time today on Comcast Investor Relations website. Thank you for participating. You may all disconnect."
}
] |
cmcsa | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Comcast Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Please note that this conference call is being recorded. I will now turn the call over to Executive Vice President, Investor Relations, Ms. Marci Ryvicker. Please go ahead, Ms. Ryvicker."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you, operator, and welcome, everyone. Joining us on today's call are Brian Roberts, Mike Cavanagh, Jason Armstrong, and Dave Watson. I will now refer you to Slide 2 of the presentation accompanying this call, which can also be found on our Investor Relations website and which contains our safe harbor disclaimer. This conference call may include forward-looking statements, subject to certain risks and uncertainties. In addition, during this call, we will refer to certain non-GAAP financial measures. Please see our 8-K and trending schedule issued earlier this morning for the reconciliations of these non-GAAP financial measures to GAAP. With that, I'll turn the call over to Mike."
},
{
"speaker": "Mike Cavanagh",
"content": "Thanks, Marcy, and good morning. Before I hand it over to Jason, I'll touch on a few topics that are top of mind for me as we report our third quarter results and head into the home stretch of 2024. First is convergence, second is Epic Universe and third is Media. On convergence, which we define as the combination of ubiquitous high-speed Internet along with wireless phone, by that definition, we are positioned to win. And that is because, today, we have 63 million homes and businesses already able to receive gig-plus broadband speed and we also offer wireless service everywhere we provide broadband. This reach far exceeds the fiber footprints of the largest three telecom companies combined, and our footprint is growing at a rapid pace. In fact, we've extended our network to more than 1.2 million additional homes and businesses over the last 12 months, a 50%-plus increase over what we were able to do just two years ago. So, even accounting for the announced fiber buildout plans of those three wireless companies, we expect to maintain this lead well into the future. Broadband usage is skyrocketing. Our broadband-only customers are heavy data users, averaging 700 gigabytes per month. And we want it that way because our existing network can handle significant increases in bandwidth consumption at a very low marginal cost. In addition, we're on a path over the next few years to being able to deliver multi-gigabit symmetrical speeds, which will be competitive with any technology out there. The other side of our converged offering is Xfinity Mobile, which matches the capabilities of any wireless network in America. We bundle Xfinity Mobile with our best-in-class broadband service everywhere we compete at a price that offers great savings to the consumer. And when combined with broadband, our wireless offering both improves churn and increases overall customer satisfaction. We also look for opportunities to enhance our converged experience. An example being a new feature we are rolling out now called WiFi Boost, which automatically increases Xfinity Mobile customer speeds up to 1 gig on our WiFi network, which is also the largest in the nation. To close out these comments on convergence, it's important to note that our strategy is proving out in financial performance. Our domestic broadband plus wireless revenue has been growing at 5%, which consistently leads the industry when you look across our competitors. The second topic I want to touch on is Epic Universe, which will be the most groundbreaking park ever introduced in the United States. We recently announced that Epic will open on May 22, 2025, and have also started to activate our sales and marketing plans, including the sale of vacation packages that provide the opportunity to visit Epic, which we expect to be in very high demand. This park will offer a level of immersion that is unmatched, transporting guests to expansive worlds featuring more than 50 awe-inspiring attractions, entertainment, dining and shopping experiences. Once Epic opens, Universal Orlando will be transformed into a week's long vacation, offering four theme parks, a CityWalk dining, retail and entertainment district and 11 hotels. Epic will build on everything we've excelled at in the present and in the past and make it even better by infusing iconic storytelling with cutting-edge technology in five fully-themed worlds. Each one telling a fantastic story based on world-renowned movies and literature such as Dark Universe, which capitalizes on our Universal Monster franchise; Isle of Berk, which brings DreamWorks' How to Train Your Dragon to life; there is The Wizarding World of Harry Potter - Ministry of Magic; as well as Super Nintendo World, and all of these are connected by Celestial Park, a world in and of itself. We could not be more excited for what's ahead of us with Epic and our entire Destinations & Experiences business. Finally, let me talk about Media, where the truly outstanding and universally praised production of the Paris Olympics demonstrated the power of NBC broadcast and Peacock. We brought new relevance and excitement to the Olympics by flawlessly presenting the biggest and most complex Olympic Games in history, dominating television, streaming, news and social media for 17 straight days. Daily viewership averaged over 30 million across our platforms, an increase of 80% compared to the prior Summer Olympics in 2021, and Peacock streamed 23.5 billion minutes, up 40% from all prior Summer and Winter Olympics combined. All of this leading to a record high $1.9 billion of incremental Olympics revenue in our Media segment this third quarter. We achieved this result by leaning in with the full symphony of Comcast, NBCUniversal playing together and a big bet on new ideas and innovation that paid off. We are all very grateful to our NBC Sports team and look forward to them bringing the lessons learned and momentum to our entire sports portfolio, especially as we begin to prepare for the relaunch of our partnership with the NBA starting with the 2025-2026 season. The regular and post-season NBA games across both NBC and Peacock, in addition to a number of exclusive Peacock games, will bring in broad and diverse audiences, allowing us to also create new entertainment content that will work beyond the basketball season with exciting opportunities for companion programming and marketing collaborations that tap into the NBA's pop-culture appeal. Before I hand it over to Jason, let me talk about our recent execution against an outlook for our capital allocation priorities, which are threefold: to maintain a very strong balance sheet, which we feel great about given the industry-low leverage we maintain; to return significant capital to our shareholders, which we have done consistently since we reinstated our buyback program in May 2021 and have since returned $50 billion of capital, equaling 100% of our free cash flow and reducing our share count by 20%; and third, to invest in our growth businesses both organically and inorganically. Organically, we've invested heavily in our growth businesses, including the upgrade of our broadband network to ubiquitous 1-gig speeds and counting, the incubation, launch and success of our wireless and business services units, the investment in Peacock and our studios, and the creation of the Epic Universe theme park to name just a few. And while we remain most focused on driving our growth businesses, we also look to maximize the significant legacy value in our portfolio of more mature businesses. As you know, we chose not to participate in the M&A process around Paramount in the earlier part of this year, but we would consider partnerships in streaming despite their complexities. And like many of our peers in media, we are experiencing the effects of the transition in our video businesses and have been studying the best path forward for these assets. To that end, we are now exploring whether creating a new well-capitalized company, owned by our shareholders and comprised of our strong portfolio of cable networks, would position them to take advantage of opportunities in the changing media landscape and create value for our shareholders. We are not ready to talk about any specifics yet, but we'll be back to you as and when we reach firm conclusions. And to sum it up, we are very proud of the job we've done on the capital allocation front over the past few years and we are highly motivated to maintain the same level of discipline. With that, it's over to you Jason."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Mike, and good morning, everybody. I'll start with our consolidated results on Slide 3. Total revenue increased 6.5% to $32.1 billion, benefiting from NBCUniversal's highly successful airing of the Paris Olympics. Excluding the Olympics, our revenue was relatively flat year-over-year. Our six major growth drivers, including residential broadband, wireless, business services connectivity, theme parks, streaming and premium content in our studios, generated nearly $18 billion in revenue, well over half of our total company revenue and grew 9% in the quarter and at a mid-single-digit rate over the past 12 months. Total EBITDA decreased 2% to $9.7 billion, while we generated free cash flow of $3.4 billion during the third quarter, and returned $3.2 billion of capital to shareholders, including $2 billion in share repurchases. Over the last 12 months, we've reduced our share count by 6%, contributing to our adjusted EPS growth in the quarter of 3%. Let's dive deeper into our results for the third quarter, starting on Slide 4 with Connectivity & Platforms. As usual, I will refer to our year-over-year growth on a constant currency basis. Revenue for total Connectivity & Platforms was consistent year-over-year at $20.3 billion, reflecting strong growth in our connectivity businesses and political advertising, offset by declines in video and voice revenue, as well as non-political advertising in our domestic and international markets. Residential connectivity revenue grew 5%, comprised of 3% growth in domestic broadband, 19% growth in domestic wireless, and 8% growth in international connectivity. Business services connectivity revenue also grew 5%. In domestic broadband, our revenue growth was driven by ARPU growth of 3.6%, another strong result in the context of a continued competitive backdrop. Our team continues to effectively balance rate and volume through customer segmentation. In terms of broadband subscribers, we reported a net loss of 87,000 in the quarter, which included an estimated net impact of 96,000 associated with the end of ACP. Excluding this ACP-related subscriber loss, we would have reported positive 9,000 broadband net additions in the third quarter. Before I cover ACP in more detail, I want to spend a moment addressing the quarter's underlying results in broadband. Keep in mind that in the third quarter, we typically benefit from seasonal tailwinds due to back-to-school activity, and this year was no different as we performed very well in that category. In addition, we believe we also benefited to some extent from a competitor's work stoppage as well as from leveraging the Olympics by investing in incremental nationwide brand marketing behind our Olympic-related offers. Now, let me cover ACP. As I mentioned, we had 96,000 losses related to ACP in the quarter. That's roughly one-third direct losses we experienced in the quarter and the other two-thirds reflects a reserve we took for the number of subscribers that we predict will churn in the coming months due to a non-pay or delinquency status. Turning to domestic wireless. Revenue growth was mainly driven by service revenue, fueled by strong growth in customer lines, which were up over 1.2 million or 20% year-over-year, reaching 7.5 million in total, including 319,000 line additions this quarter. Importantly, our wireless customers are also broadband customers, and when bundled together, drive overall customer relationship ARPU growth, churn benefits for broadband and higher profitability. With wireless penetration at 12% of our broadband subscriber base, we have a very long runway for growth. We're pleased with our strategy and we'll continue to test new converged offers to capitalize on the significant opportunities we see ahead of us in wireless, including both increasing the penetration of our domestic residential broadband customer base as well as selling additional lines per account. And just to reiterate what Mike mentioned, we have an incredible hand to play in convergence. We currently have an offering for gig-plus speeds and wireless available ubiquitously to our footprint of 63 million homes and businesses today. And by ubiquitous, I mean we are not making any network trade-offs and every customer gets access to the same offerings. We believe we have a leadership position in convergence and we think we can sustain that. We're on a clear path to offer multi-gig symmetrical speeds, and we'll continue to grow our footprint projecting to add over 1.2 million new homes passed this year. International connectivity revenue growth of 8% was driven by broadband, reflecting strong ARPU growth, and in wireless, healthy service revenue growth was offset by lower device revenue. Business services connectivity revenue growth of 5% reflects steady growth in small business and even faster growth in enterprise. In small business, it continues to be a competitive market, but we are growing revenue with ARPU growth driven by higher adoption of a suite of additional products that expand our relationship with our SMB customers. At the enterprise level, we are taking share and continue to scale this business. In advertising, growth of 2% reflects stronger political revenue this quarter, partially offset by lower non-political domestic and international advertising revenue. Finally, video and other revenue declined in the quarter. The 7% decline in our video revenue is a function of continued customer losses, coupled with slower domestic ARPU growth versus last year. And the lower other revenue mainly reflects continued customer losses in wireline voice. Connectivity & Platforms' total EBITDA was consistent year-over-year at $8.3 billion, with margins up 50 basis points, reflecting a decline in overall expenses, driven by the continued mix shift to our higher-margin connectivity businesses and ongoing expense management, partially offset by an increase in marketing and promotion expense, driven by our incremental brand marketing investment during the Paris Olympics. Breaking out our Connectivity & Platforms' EBITDA results further, residential EBITDA was consistent with margins improving 40 basis points to 38.6% and business services EBITDA growth was at a mid-single-digit rate, with margins fairly stable at 57.4%. Rounding out Connectivity & Platforms, I'd note that our business continues to evolve as the mix shifts towards our connectivity growth drivers. As such, you've seen us take some cost reduction actions in our fourth quarter for the past several years. We expect to take similar actions again this fourth quarter at about an equal magnitude to last year. Now, let's turn to Content & Experiences on Slide 5. Revenue increased 19% to $12.6 billion, and EBITDA decreased 9% to $1.8 billion. At theme parks, revenue decreased 5% and EBITDA declined 14% in the quarter compared to last year's all-time record high. The majority of the decline was driven by lower attendance at our domestic parks when compared to last year. As we've highlighted, our view is there was both a pull-forward of demand that we clearly saw in 2022 and 2023, which were record years for the theme parks and beyond our expectations, as well as the new attraction pipeline, which is light this year, but building towards a substantial pipeline next year. We think these factors will likely be in place until the second quarter of next year, which is both when we start to lap the pressure we saw this year and the launch of Epic Universe. Looking ahead, we couldn't be more excited about Epic Universe and how it will transform Universal Orlando into a week-long destination. And as we gear up for the May 2025 opening, we expect to incur pre-opening costs of about $150 million in total over the fourth quarter this year and the first quarter next year. We remain bullish about the long-term trajectory of parks. In addition to Epic Universe, we have a fantastic slate of new attractions and experiences on the horizon. Donkey Kong Country in Osaka and a Fast and Furious roller coaster in Hollywood, as well as Universal Horror Unleashed in Vegas and our Universal Kids Resort coming to Texas. Now, let's turn to Media, where revenue increased 37% to $8.2 billion, including the strong results from the Paris Olympics, which generated $1.9 billion in revenue, a record level for any Olympics. Strength in the Olympics was mainly driven by a record $1.4 billion in advertising revenue, with Peacock contributing over $300 million of that. Excluding the Olympics, total advertising revenue was flat year-over-year as the overall market remained stable, while total media revenue increased 5%, driven by an exceptional quarter for Peacock. Revenue growth for Peacock was 82% and still a very robust greater than 40% excluding the Olympics. This was also a strong quarter for Peacock paid subscribers as we added 3 million net new additions driven not only by the Olympics, but also the return of the NFL, including our Peacock exclusive NFL game from Brazil, the return of the Big Ten, and several entertainment hits during the quarter including Love Island, Bel Air and Fight Night. Looking ahead, we will continue to be focused on strong revenue growth and improving profitability at Peacock in the broader context of expected revenue and profit growth across the entire Media segment. Media EBITDA in the quarter declined 10% to $650 million, but this was largely timing related as a profitable Olympics was offset by higher expenses due to the timing of other sports, including two additional NFL games in the quarter, an additional Sunday Night Football game and Peacock's exclusive game from Brazil. At studios, revenue increased 12% and EBITDA increased 9%, driven by the success of our film slate, including Despicable Me 4 as well as Twisters. Year-to-date, we have three of the top 10 box office titles, including Twisters, Kung Fu Panda 4 and Despicable Me 4, which has already grossed nearly $1 billion and is the first animated franchise in the industry to surpass $5 billion in global box office. Looking to the fourth quarter, Wild Robot debuted in September to terrific reviews and has had nice success at the box office, a great achievement for original animation. And we are particularly excited about Wicked opening in November. I'll wrap up with free cash flow and capital allocation on Slide 6. As I mentioned earlier, we generated $3.4 billion in free cash flow this quarter and achieved this even with significant organic investment. The $3.6 billion in total capital expenditures this quarter reflects spending to bolster our six key growth areas and, most significantly, our efforts in expanding our connectivity footprint through accelerating homes passed and further strengthening our domestic broadband network, and the continued buildout of our Epic Universe theme park ahead of its opening in May of 2025. Turning to return to capital, we returned a total of $3.2 billion to shareholders in the quarter, including share repurchases of $2 billion and dividend payments of $1.2 billion. In fact, our share count has been consistently shrinking mid-single-digits on an annual basis for the past several years. We've been straightforward and consistent in our priorities around investing in our six key growth drivers, protecting our strong balance sheet and returning a significant amount of capital to shareholders. This quarter is yet another example of that. Now, let's turn it back to Marci for Q&A. Marci?"
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jason. Operator, let's open the call for Q&A, please."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Ben Swinburne from Morgan Stanley. Please go ahead."
},
{
"speaker": "Ben Swinburne",
"content": "Thanks. Good morning. Mike, just coming back to your comments on sort of strategic reviews on the media side, which obviously are quite interesting. Can you talk a little bit about the assets you're looking at in this sort of portfolio review? It sounded like domestic cable networks, but you also mentioned streaming and, in particular, around your point about complexity. Trying to think about the ability or challenges of separating Peacock from your linear networks. Maybe it's not as complex as I'm thinking, but operationally, how do you sort of think through those pieces and do those assets need to travel together or perhaps not? And then, for either Dave or Jason, just would love to hear how you guys are thinking about the fourth quarter broadband subscribers. Do you think you can be -- can grow again in Q4 given kind of normal seasonality and other factors as we move beyond ACP? Thanks so much."
},
{
"speaker": "Mike Cavanagh",
"content": "Hey, thanks, Ben. It's Mike. So, let me be clear and just for everybody that maybe just picking up on this, I want to be clear about what I said is that we're going to commence a study of whether there's a good idea in the idea of creating a new well-capitalized company that would go to our shareholders, existing shareholders, comprised of our cable portfolio networks. So that's the group. I'm not talking about Peacock or broadcast. So that's what I said before. And I think the questions about how to do it are the reason we're announcing here that we want to study it. There are a lot of questions to which we don't have answers, so we want to do the work. And we want to do the work with transparency around it, so that as rumors fly and the like, we expect that, but we want our shareholders to understand what we're willing to look at. That's in the context of broader, we look at a lot of things, and I do think in a moment of a lot of transition in the industries we're a part of. I think we've got a very strong hand given the strength of the businesses. We just went through all of them with third quarter results, and I think I'm proud of every part of it. And I think the idea of playing some offense, when you combine the balance sheet strength that we have, the assets we have, and the management team we have, there may be some smart things to do and we want to study that."
},
{
"speaker": "Dave Watson",
"content": "Okay. Ben, this is Dave. Let me go into broadband. I think before getting to Q4, I think providing just a little bit of context on Q3 is important and starts with the underlying market that remains competitively intense. So that hasn't changed, it continues. But we are pleased with our overall performance in Q3, and was driven at the very top level with very good execution on the fundamentals. But as Jason said, there are three factors that were unique to Q3. One is back-to-school, always a contributor to Q3. We did perform well this Q3 and did around the same level as last year in back-to-school activity. So that's number one. Number two, the Olympics are not only good for NBC, it's good for cable and Connectivity & Platforms. So, we did invest in, I think, a really effective go to market plan, strong offers, good product positioning, and the Olympics provide perhaps the best showcase for us to talk about what's fully capable end-to-end with great content, being easy and simple to access, and people are highly engaged. And so, it was a, overall, good plan, but that drove consideration unique to that timeframe. And the third one was the AT&T labor work stoppage. It was limited to part of their footprint, and it was I think about a 30-day thing. Not a major driver, but it did have an impact. So, if you exclude the incremental benefits of the Olympics and the competitor's work stoppage as well as the ACP impact, while it is tough to completely pinpoint, our best estimate is HSD subs would have been slightly worse than last year's Q3. So, then you shift to Q4 to your question, and let me remind you and everyone, first off, we had two hurricanes impact some of our cable systems. And while we're still assessing the impact. From what we can see today, the potential impact looks like it could be really significantly less than the impact from Hurricane Ian in 2022 in terms of both subscriber and financial impacts. But we don't have an exact number to share at this moment, but there'll be some impact tied to the two hurricanes. Also, in Q4, while the return of seasonals to the southeast usually provides a good tailwind, not like back-to-school, but still a nice impact, we'll have to see what the potential impact we see with this activity due to the hurricanes. So, going to Q4, the underlying environment remains the same, very competitive, but remind you also that we expect churn to continue to remain at low levels as we focus on retention channel management, our segmented approach and leveraging offers and product packaging with mobile being front and center, but leveraging everything, including new video products like NOW TV, NOW Latino and StreamSaver, all surrounding broadband with good value. So -- and at the same time we're introducing, we're excited about AI and what we can do in every single sales channel including retention. So, we're rolling that out. But -- and the last point to remind you, Q4 doesn't have back-to-school. So that's where we're at and perspective in Q4."
},
{
"speaker": "Ben Swinburne",
"content": "Thanks very much."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Ben. Operator, we'll take the next question."
},
{
"speaker": "Operator",
"content": "Next question is from Craig Moffett from MoffettNathanson. Please go ahead."
},
{
"speaker": "Craig Moffett",
"content": "Hi, thank you. Two questions, if I could. Let me start on the theme park side. As you look forward to Epic for next year, first, how do we think about the capacity of Epic? And how do you think about balancing the potential demand in terms of volume versus perhaps trying to more significantly price it so that you get a better experience with lower crowds? I'm just wondering kind of how you think about that balance. And then, a housekeeping question by the way is, are you seeing -- you mentioned $150 million of cost expected in Q4. Should we -- was there anything in Q3 that we should be aware of in terms of Epic anticipation costs? And then, on the cable side, if I could just squeeze in one more, how are you thinking about BEAD at the moment? And at the rate that you're expanding the footprint, should we expect any significant capital intensity changes as you have now a little more insight about the BEAD program and what you might do in rural markets?"
},
{
"speaker": "Jason Armstrong",
"content": "Hey, Craig, let me just hit your quick question on just the costs around pre-opening costs around Epic. So, for third quarter, minimal costs there, I'd say in the range of $20 million or so in terms of pre-opening costs. We did say -- just to clarify your comment, you said $150 million for fourth quarter. What I said in my prepared remarks was $150 million in pre-opening costs split between the fourth quarter and the first quarter. I think between the two, it will be more weighted towards the first quarter."
},
{
"speaker": "Mike Cavanagh",
"content": "Yeah, Craig, it's Mike. So, on Epic, like I said, we couldn't be more excited. It is our most ambitious parks experience we've ever put together, right? So, it will warrant a premium and think about ticket pricing at a premium level, but consistent with the market in Orlando. But I think the way to think about how we're going to manage it and we started this with -- we want to drive Orlando. We've got now one of the -- in addition to being what it is, a standalone park that's going to be magnificent, it transforms Universal Orlando into a week's long vacation with the other existing parks. So, I think we'll look at it through the lens of how to optimize the totality of our Orlando footprint, while making sure the park-goer experience is a great experience for Epic, which will be on itself priced at a premium. We are seeing great demand in the early days since we announced that May 22 next year is opening day, and we'll be putting together a lot of Comcast NBCUniversal Symphony effort to now raise awareness of the park as you see in the months and months ahead leading up to opening day."
},
{
"speaker": "Dave Watson",
"content": "Hey, Craig, Dave here. So, on BEAD, obviously the process is ongoing. To the extent, we are successful and we will -- we're looking at it and planning around it. I think we certainly expect to be there. This is more of a 2025-and-beyond opportunity. So, this is active federal -- really the state levels -- a lot of the states have offices of broadband established to look at this. And the rules are being finalized as we speak, and assuming the final state BEAD participation rules allow for rational private sector investment and do not impose price controls or other things that exceed the statute, we will -- we do plan to participate with reasonable conditions, so -- and always -- as long as they're just consistent with our business goals. So, we have tight thresholds. We use a lot of financial discipline around these things. And it's too early to really comment in terms of how much activity, but we do not -- as we anticipate the activity here, we do not anticipate any change to CapEx intensity from what we can see. So, as always, if there are unique opportunities that fit within our financial returns, then we'll always evaluate that."
},
{
"speaker": "Jason Armstrong",
"content": "Hey, Craig, let me broaden that out to footprint expansion in general and just sort of our philosophy there. We've obviously accelerated our footprint expansion couple of years ago. If you rewind the clock, we were at 800,000 homes passed per year. Dave and team has sort of nicely driven that to 1.2 million homes and pacing towards that this year. What underpins that view and how we're underwriting it, because obviously we're putting capital towards it, is a view of sort of structural competitive environment over the long term. And from our perspective as we see it, the two key competitors, as you look at it this past year, fixed wireless has obviously taken its toll. We think that's a market that's going to continue to exist, continue to be around, but it's for the value-conscious consumer. It is carved out a niche in the market that whether it's 10%, 15%, I'm not sure we've got a crystal ball, but it is a niche. Fiber, as we've said, is the real long-term competitor. That's an entity that's been building out against us for almost 20 years at this point. It's been sort of a steady increase in our footprint. Right now, we're about 50% overbuilt. We would tell you that will go higher. Obviously, the carriers have announced plans to take that higher. So, we expect it to go higher and we expect to see competition across the majority of our footprint, including two wires, one of which is ours, which is currently a gig-plus, and we'll go to multi-gig symmetrical through how we're investing, and the others of which is fiber. But the long-term view is we've competed against fiber for almost two decades at this point. And so, we are seasoned in competing against fiber and we know exactly what fiber markets look like. So, if you go back and look at some of the early fiber markets and tenure markets where we've had a chance to sort of see the competitive progression, what you see is initial uptake and then you see the competitive environment sort of leveling out and you see relatively even share between us and fiber. We see ARPUs in those markets that are very consistent with our overall ARPU. So, when you think about sort of a long term, how do you invest against this, are you comfortable taking your footprint expansion to a greater level, these are all things that underpin our current investment and future investment."
},
{
"speaker": "Craig Moffett",
"content": "Thanks. That's really helpful, Jason."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Craig. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "Next is from Michael Ng from Goldman Sachs. Please go ahead."
},
{
"speaker": "Michael Ng",
"content": "Hi, good morning. Thank you very much for the question. I just have two. One housekeeping one, just on the Olympics. Encouraging to see the record $1.9 billion of revenue. I was just wondering if you could comment on profitability as well. And any way to better think about the potential uplift from Olympics on broadband net adds? And then, second, I wanted to ask about video. You had very good video net adds performance in the quarter as well as on programming costs. Anything that you would call out there that maybe improving the trends within video? Thank you."
},
{
"speaker": "Mike Cavanagh",
"content": "Thanks, Michael. It's Mike. So, just on the Olympics, as I said earlier, we couldn't be more proud of what our teams accomplished across the whole company on the Olympics. So, we were cautiously optimistic going into the games that they would perform well given all the effort we put in in Paris to their backdrop, but viewership, ad sales exceeded our expectations and the games were profitable. I won't go into the level of profitability, but profitable games for us. And so, we walk away from it very excited as we look forward to future Olympics from here, because it was a spell leading up to Paris where prior Olympics, for a variety of reasons, had not performed as well as we had hoped. So, I think there's an incredible amount of energy and excitement as we look ahead to LA and beyond and Milan in between. And so, I don't know if Brian wants to jump in here."
},
{
"speaker": "Brian Roberts",
"content": "I just want to add, it was probably the proudest moment that I can think of since we've owned NBCUniversal or certainly right up there, just a tremendous team effort technologically what Peacock pulled off and Xfinity with a combination of using just every athlete, every sport, every country you could search it many different ways, the social media impact with celebrity, the quality, the two broadcasts in prime time, and just really bringing the whole country and nation into the drama, the ratings and the ability to use that platform as we said for things such as broadband growth but also awareness for everything from Wicked to Epic to new shows being launched and many other initiatives in the company. So, one of the proudest moments. We really look forward to LA in four years. We've got Milan in between, and then we go on from there. So, it's a great partnership and kudos to Molly Solomon and many, many, many other people who had made that broadcast happen and Rick at NBC Sports and many others. Dave?"
},
{
"speaker": "Dave Watson",
"content": "Thank you, Brian. Michael, so two things. One, as Brian just said, it really was a great moment. So -- and again, unique to Q3 with the media investment behind it and just the overall go to market plan. And one of the things that we look at is just the engagement. And we're such a -- we have a unique position of streaming and all the other content of how it's delivered. It was a significant Internet moment, quite frankly, and that we are right there and positioned to be able to deliver it all. So, just in a really simple and easy way, the way the Peacock team did it, it was just great. And so -- but we don't have a specific number in terms of broadband impact, but it was a contributor to Q3 for sure. In video, there are two primary drivers. As we look at videos, obviously, still in the negative terrain, but an improvement. And one that there's churn and that we have seen churn continue to stabilize and has been stabilizing for a while. And we look at things that -- and break it down. Most certainly, when we introduce mobile into the mix, mobile helps, and there's churn reduction there. So, surrounding our broadband with the right package, the right segment, it does help video. So -- and then, when you have engagement levels like you see with the Olympics, then that helps. But churn has been a driver, improvement in churn in video. The second side of it are connects. And we've seen on the connect side, it's the NOW portfolio that has helped NOW TV, NOW Latino, these are products that we segment, use it surgically and have helped video, and it's a nice way to reimagine the platform to be able to deliver good content for the right segment."
},
{
"speaker": "Michael Ng",
"content": "Excellent. Thank you."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you, Mike. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "Next is from John Hodulik from UBS. Please go ahead."
},
{
"speaker": "John Hodulik",
"content": "Great. Thanks. Two, if I could. I guess, first, following up on Jason's comments, we're definitely getting a better picture of what the competitive fiber footprint is going to look like in the US over the next five years. And I think Jason's comments addressed the impact on subs, but maybe for Dave, can you talk a little bit about the impact on ARPU and pricing power when a new fiber provider opens in an Xfinity market? And then secondly, I guess, for Jason, I realize we're probably early in what might be a longer process, but maybe at a high level, can you help us -- can you maybe frame the potential change in the growth rate of sort of the remaining Comcast assets that you may see, if you guys -- if you do move ahead with the spin of the cable nets? What kind of bump in terms of the growth rate are we looking at here? Thanks."
},
{
"speaker": "Dave Watson",
"content": "Hey, John, this is Dave. Let me start with the fiber impact on ARPU, just a general impact. When -- there are two things that we look at and we've been balancing throughout: market share and rate. So, when fiber comes into one of the markets, and been dealing with it for two decades, so we have a pretty good track record in terms of when this happens, how it happens. But we do see that there is an impact on penetration levels, so on the market share side, but we compete aggressively, have a very strong playbook that has evolved over time. And then, share does eventually even out between the two of us. So, when you look at the healthy ARPU levels that are really no different, quite frankly, in terms of fiber versus non-fiber markets, and it goes to our playbook in terms of segmentation. And the focus that Jason talked about with the core network and the fact that we start at the premium levels, job one is delivering the best Internet experience that it's not -- it's speed, multi-gig, but it's everything that we do and how we compete around coverage, capacity, latency, all these things we deliver, and critically, the best WiFi in the marketplace with the great gateway device. And that is how content is really delivered in people's homes and businesses. So, great WiFi has helped, I think. And we look at solid churn rates, but ARPU is really no different as we've seen as things level out."
},
{
"speaker": "Mike Cavanagh",
"content": "John, it's Mike. On the question about the potential for a spin and impact on revenue, I would just say I don't want to get ahead of ourselves. Obviously, we do anything like that, it will have an impact on the consolidated company. But I think the point that we'd make is that it doesn't change the fact that within the business today, we've got six growth drivers that represent more than half of our revenues that are growing this quarter at 9% or so, and on a trailing basis, been in that high-single-digits, sometimes 10%. So, the company is transforming itself to a top-line growing company as our mix changes. Whether we do something like a spin or not, I'd focus everyone on what the underlying is."
},
{
"speaker": "John Hodulik",
"content": "Got it. Thanks, guys."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, John. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "The next question is from Jessica Reif Ehrlich from Bank of America Securities. Please go ahead."
},
{
"speaker": "Jessica Reif Ehrlich",
"content": "Thank you. So, of course, one on NBC and one on cable. NBC is actually a multi-parter. There's just a lot going on there in coming years. So, just kind of -- maybe a follow-up on Epic. But can you kind of give us some color on your thoughts on what -- how it will impact the bottom-line over the next three to five years? Obviously, you'll take share in Orlando. It's a big market. But how do you think about it impacting the bottom-line? On NBA, can you talk a little bit about monetization? Obviously, there's a big increased investment, but you mentioned something interesting on the call that there's an opportunity outside of the regular season, and of course, it will be NBC and Peacock. And then finally, one last question on this potential spin-out. Can you just talk about the thought process? Is it -- do you view it as a roll-up vehicle for the industry? And then, on cable, it's kind of a video question, but we see Charter signing agreements with all of the streaming platforms you included. And you've taken a very different approach. Can you just maybe discuss how your video offering will evolve over time? Thank you."
},
{
"speaker": "Mike Cavanagh",
"content": "So, Jessica, it's Mike. I'll hit these quickly. I mean, I think the Epic is, as we said, in the near term, going to have the $150 million of pre-opening costs, and then, it will open midway through the year. So, it will be accretive to the parks' P&L next year. And then obviously, beyond that, we hope it does all the things I said earlier in terms of driving the week's long experience in getting a nice return on the capital put against Epic and the entirety of what we have in the ground in Orlando, period. 11 hotels, the multiple parks, it is something that we feel very confident about in the long term, but I won't give particular guidance on that front. NBA, I think you should think about that as a -- it's a long term. Over the long term, we expect the NBA to be something that adds value to our company broadly, particularly in the Media segment. It's going to help broadcast and benefit from broadcast. We, obviously, saw that during the Olympics, the interplay of broadcast and streaming for sports and the technology for some audiences of what you can do on the streaming side and the reach that broadcast has. So, I think when you think about how it will play into the two audiences, streaming and traditional, which are frankly very different, and there was great viewing of the Olympics on linear despite the unbelievable production in Peacock. So, I think we feel really well-balanced between the broadcast side and the Peacock side. And then, the point for Peacock, NBA makes us -- NBC makes us a year-long sports destination. So, I think that's something that we think is very helpful over the long term as we think about churn as something that needs to be managed a little more carefully, a little differently in the streaming world than the linear world. And then, the point you're really getting at is -- that we've talked about before, is the NBA will bring a younger, more diverse audience. And I think as you bring an audience into a platform like NBC and Peacock, Donna Langley and Pearlena Igbokwe and the team at our studios have the chance to think about how to tap into that audience, together with the talent, frankly, that comes from the NBA themselves. And so, I think that was the point I was making on that. On the spin, really nothing more to say than what I said earlier. These are all the questions that we're going to go off and think about. We think there could be an opportunity to place some offense, like I said, and we'll be back, but that is the thinking. We think we have great assets and a great balance sheet, and that's the thinking. And on Charter, before -- I'll hand it over to Dave on his side, but just a comment for the NBC side on distribution. Obviously, it's a key revenue stream for any media business. And I got to say, we're very pleased that we've now completed 10 renewals in the past 15 months, most recently Charter and Hulu. And it's a mix of both traditional and streaming distributors. And so that just speaks to the power of the content we have and our ability to work with a very important distribution partners, who themselves have different business priorities and objectives from one to the next. So, we're really pleased with that. We're in the middle of -- last one for this year is coming up in a few days, which is DIRECTV. We're in constructive dialogue with folks over there and hope to finish up that negotiation shortly without disruption, just like the rest of the ones we've done in the last bunch of years. And all that adds to just a certain stability and strength of the revenue stream in our business."
},
{
"speaker": "Dave Watson",
"content": "Jessica, this is Dave. So, on the -- in terms of our video strategy, the overall one of the core operating principles that we've had for a long time, we talked about it quite a bit across all of our products, is segmenting the marketplace to give consumers what they want at the right price and the right package. So, no surprise that video follows that. And with a very strong focus on connectivity, how do we surround connectivity with the right package offerings? And that is fundamental to how we look at it. Now having said that, I think the Charter Group does really smart things, and we pay attention to everything that they do. And if there's opportunities, then we always evaluate. But if you break it down further, we all -- we look at the experience that the customer has, we look at choice, and ultimately by segment, the value, those three things. And you look at experience, with our -- because we've invested over a very long period of time and a great platform, we talked about it with the Olympics, but it could be Sunday Night Football, it could be, you name it, Premier League Soccer, we have a unique platform to deliver video content. Then, you have choice, value. A good example of an extension of this is StreamSaver. And StreamSaver for us is an example of choice that we have to try to deliver customers. Could be broadband-only to -- on top of an existing video package. But StreamSaver is a great example of taking the advertising tiers, Netflix, Peacock and obviously, Apple TV, putting it together at a great consumer price point, not subsidizing. It's profitable and it makes a lot of sense. So, I think, it's an example of good video choice, and that is -- look for more of that from us over time."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jessica. Operator, we'll take the next question, please."
},
{
"speaker": "Operator",
"content": "Next question is from Jonathan Chaplin from New Street. Please go ahead."
},
{
"speaker": "Jonathan Chaplin",
"content": "Good morning, guys. Thanks so much. I'm wondering -- so CapEx year-to-date is running a little bit below the 10% in Connectivity & Platforms that you'd expect at the beginning of the year. Should we anticipate a big catch-up in 4Q? And then, I'm wondering if you can give us a quick update on where you are with the upgrade of the cable plant, where you expect to be at the end of the year. Are you moving through that at the pace that you anticipated, or as you've gained more clarity on the sort of evolution of the competitive dynamics, is that maybe not quite as urgent as initially anticipated? And then, on the footprint expansion, Jason, you mentioned this is sort of part of the -- really your competitive strategy. Are you expanding your footprint? If I think about the difference between the 800,000 that you were at and the 1.2 million that you're at now, is that incremental piece mostly in rural markets where you don't expect to have fiber competition? Thanks."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Jonathan. Let me take the first couple and hand it to Dave on footprint. So, on CapEx and capital intensity, yeah, we came into the year and said similar capital intensity to last year. Obviously, the pacing to the first three quarters is sort of on that track, maybe on the low end, but I would point you to -- just stepping back, we're not using capital intensity as sort of a gating factor. We are coming into this saying, what amount do we want to -- what can we upgrade by both in terms of network upgrade and then footprint expansion? What makes logical sense? How fast can the engineers move? And so, that is largely going to dictate our pacing. So, I wouldn't change the guidance for the full year, which implies a little bit of a catch-up in the fourth quarter. On the upgrade of the cable plant, I would say as you step back, our network upgrade is on plan. We think we have a cost-effective strategy that gets us faster speeds across the entire footprint. As I mentioned earlier, we are ubiquitous at a gig now. That's very important from a marketing perspective as you think more broadly about convergence. We've said we think we have the largest convergence footprint, but importantly, we can do things from a ubiquitous perspective, ubiquitous speeds plus ubiquitous wireless on top of it. So, we've got a good path there, gig now and then headed to multi-gig over time. We've got a plan to get there today. Roughly half our footprint is updated with the mid-split technology, which was sort of foundational in that effort. We expect to actually be through the vast majority of that effort by the end of next year. And then, DOCSIS 4.0 sort of rides right on the back of that."
},
{
"speaker": "Dave Watson",
"content": "Yeah. Jonathan, just in terms of the operational planning around it, so as Jason just said and talking about it, we have the fundamental path that's being built, one half and then going to the vast majority by the end of next year in terms of mid-split. And then, on the heels of that will be the DOCSIS 4.0. So, it's a clear path to the strong ubiquitous product offering. And for us, it's an operational, then getting all the components, getting everything ready, everything from SIKs to you name it, we get all these pieces pulled together and then we go. So, we have a really good plan. We are definitely on track and really like the roadmap to where we stand. We're ahead of every single application in terms of broadband capability. And so -- and even, I think, doing a better job in things like WiFi, as I mentioned earlier. So, we're in good position with the network plan."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jonathan. Operator, we'll take our last question, please."
},
{
"speaker": "Operator",
"content": "Okay. The last question is from Steven Cahall from Wells Fargo. Please go ahead."
},
{
"speaker": "Steven Cahall",
"content": "Thank you. A couple of Media questions. So, first, you made the interesting Paramount streaming call out. I was just wondering, since you were both excluded from the [Venu] (ph) initiative, if there's any intentionality there that we can think about in terms of potential bundle that you might have mentioned. It seems like it would be pretty sizable in terms of sports rights, movie and TV library. So, anything you could expand on there in terms of whether you're just looking at a bundle, something that's more of a deeper integration for the customer would be interesting. And then, a related question kind of tying a lot of these themes together, I thought it was how interesting you called out the Olympics as one of the drivers of the broadband strength in the quarter. We don't often think about content as a driver of broadband subscriber acquisitions. Is that something that you think could be happening more in the future? Did that inform your decision on the NBA rights? And is that one of the reasons that you also want to keep the growth media assets together with your connectivity business longer term? Thank you."
},
{
"speaker": "Mike Cavanagh",
"content": "So, Steven, it's Mike. So, on streaming partnerships, I think we are open to having discussions, but as I said, exploring the idea. I think you put it in context. The bar is really high for whole company media type of acquisitions. That's why what I paired together and the answer is streaming partnerships could be interesting. Details matter one to the next to the next. So, my only point is we're open to them, but they are very complicated, and they could vary in form. We like what we've got very much. So, it would just be as and when a good idea comes along, we're just open to it. That's point one. And two, the other side of it, is cable networks, which we talked about earlier. On Olympics and broadband, I think -- and Dave can chime in here, but I think the whole company looks through simply and otherwise to say what makes us unique place and how do we drive value for our company across all swim lanes, especially around something like the Olympics, but not only that. And when you look at what happens through X1 in terms of presentation of content, it's not just ours, but clearly it's ours when it's the Olympics. And we have all the power of the technology to do what we did with them, but it carries over to how we present other streaming services or integrate other content or navigate through that content with the X1 remote. I do think great content does feed into the thinking of why our company is one company, but I'll let Dave and Brian chime in."
},
{
"speaker": "Brian Roberts",
"content": "I'll just jump in for a second and say that last part you made is what I think makes our company pretty special and different. In the Olympics -- during the Olympics, I believe, and Dave tell me -- correct me if this is not right, in many, many of our Xfinity markets, the viewing of Olympics content in those households was, in many cases, double what the national averages were for the same content. So, the ability for consumers to easily navigate, find what they want, be marketed to, we do it for others, we do it for big moments in the company. And we're getting better at that all the time. And a seamless way to log in once to Peacock and also the Xfinity apps that they had, the stream app, it's all getting better every year. And that platform, which a lot of it we call the entertainment operating system, we now syndicate. We partner with Xumo, Sky all over Canada. So, it's a big strategic asset that you saw a great quarter, and really proud of the company."
},
{
"speaker": "Dave Watson",
"content": "No question, and Brian nailed it. It really -- for us, that experience is so key and look for us to do more, to your question. If there's a big sports moment, I think people want to work with us. We love doing it. We make it simple and easy to find what you want in the moment. And then -- and the Sky team does an excellent job of bringing shows to life. And there's unique shows that they do, and we've taken that playbook to the US. So, where there's a big moment in entertainment in any form, look for us to continue to do it."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Steve. That concludes our call. Thank you all for joining us this morning."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes the call. A replay of the call will be available starting at 11:30 am Eastern Time today on Comcast Investor Relations website. Thank you for participating. You may all disconnect."
}
] |
cmcsa | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Comcast's Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Please note, this conference call is being recorded. I will now turn the call over to Executive Vice President, Investor Relations, Ms. Marci Ryvicker. Please go ahead, Ms. Ryvicker."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you, operator, and welcome, everyone. Joining us on today's call are, Brian Roberts, Mike Cavanagh, Jason Armstrong, and Dave Watson. I will now refer you to Slide 2 of the presentation accompanying this call, which can also be found on our Investor Relations website, which contains our safe harbor disclaimer. This conference call may include forward-looking statements subject to certain risks and uncertainties. In addition, during this call, we will refer to certain non-GAAP financial measures. Please see our 8-K and trending schedule issued earlier this morning for the reconciliations of these non-GAAP financial measures to GAAP. With that, I'll turn the call over to Mike."
},
{
"speaker": "Mike Cavanagh",
"content": "Thank you, Marci, and good morning, everyone. Before I hand it over to Jason, I'd like to comment on three key elements from the quarter. One, broadband; two, parks; and three, the NBA. So, first is broadband, where the competitive intensity that we've seen for the past several quarters and which is particularly felt in the market for price-conscious consumers remains essentially unchanged, but throughout this period, our broadband strategy has been consistent and we remain confident in our plan. We are focused on generating healthy broadband revenue growth by striking the right balance between rate and volume and relying heavily on market segmentation that I'll speak to in a minute. As a result, in the second quarter, ARPU grew 3.6%, which was within our historical range of 3% to 4%. Despite the competitiveness of the recent past, we've maintained a market-leading base of 32 million broadband customers by refining our go-to-market approach to create options that fit each of our customers' lifestyles and budgets. Providing the best products with flexibility and choice at different value points, has served us extremely well for many years and remains the core of our playbook. Of particular note, this quarter, we launched our suite of NOW products, which are high-quality internet, mobile and streaming TV offerings designed to be incredibly simple with attractive all-in pricing with no contracts or credit checks. These are great options for the price-conscious segment and especially for those impacted by the end of the government's ACP program. While we are pleased with our enhancement to our offerings for the price-conscious segment, the reality is that the vast majority of our customer base subscribes to more premium products, where we feel great about our market position relative to fiber, which is our true long-term competitor. We are investing in additional network capacity, multi-gig speeds and in-home WiFi technology to capitalize on the Internet consumption trends we are seeing. One of the most important metrics we monitor is the magnitude of data traffic flowing across our network. And again, we saw a double-digit year-over-year growth this quarter, with broadband-only households consuming over 700 gigabytes of data each month. And our customers continue to take faster speeds, with around 70% of our residential subscribers receiving speeds of 500 megabits per second or higher and one-third getting a gigabit or more. These positive consumer trends play to our strengths and will only accelerate with the shift of live sports to streaming, which together with entertainment on streaming accounts for nearly 70% of our network traffic today. My final thought on broadband is the importance of bundling with mobile, with 90% of Xfinity Mobile smartphone traffic traveling over our WiFi network. These two products work seamlessly together to benefit our customers from both the products' experience and financial value standpoint. We are very pleased with the momentum we saw in wireless this quarter, where our line additions were again above 300,000 and nicely up year-over-year. Our new converged offers resulted in better overall yield and awareness as well as higher multi-line attach rates and we are excited for some of the new mobile offers tied to the Olympics, which will be introduced to the market in just a few days. Now, let's turn to parks, where our results were down in both revenue and EBITDA when compared to last year's record performance, with two-thirds of the decline driven by lower attendance at our domestic parks. We attribute this to a number of factors. First, is what now appears to be a COVID recovery pull-forward of a magnitude we hadn't previously appreciated. I think it's important to zoom out and look at how this business has trended over the past few years. Going back to 2022 and 2023, parks were clearly the early beneficiaries of substantial rebounds in tourism and travel after the pandemic, resulting in a surge in demand that contributed to us reaching record results for both of those years. More recently, other travel options, including cruises and international tourism, given the strength of the dollar, have experienced their own surge in demand, which caused visitation rates at our parks to normalize. The second factor affecting attendance at our domestic parks is the timing of our investments in new attractions, where we are light in Florida in advance of next year's opening of Epic and our lapping of Super Nintendo World in Hollywood is creating some headwinds for us as well. While the parks results are below our original expectations for the year, we still view parks as a terrific long-term growth business for us. We couldn't be more excited about the opening of Epic Universe in 2025, as we've been releasing new details about Epic's Five Immersive Worlds, the consumer reaction has been tremendous. And recently, we opened an Epic Universe Preview Center in Orlando and the foot traffic and guest enthusiasm have been off the charts. So, we look forward to Epic Universe having a meaningful impact by driving incremental attendance, longer visits and higher per-cap spending once the park opens in 2025. Finally, let me talk about the NBA. Our expectation is that soon an 11-year rights deal between ourselves and the NBA will be announced. We don't believe that the resolution of matching rights will affect the package that we expect to be awarded. This package, which begins with the 2025-2026 season includes: 100 NBA games each regular season across NBC and Peacock, which is more than any other media partner and more regular season games than each existing partner has under the current rights deal; for playoffs, we will have first and second round games each year, exclusively on our national platforms and six NBA conference final series over the course of the term of the deal, which is more playoff games on average each year, than any other media partner; and exclusively for Peacock will be approximately 50 national regular season and post-season games, including National Monday Night games and doubleheaders. Additional elements of the NBA package include the annual NBA All-Star Game and All-Star Saturday Night each season, the season opening NBA tip-off doubleheader each season, a special doubleheader on the MLK holiday, and Select NBA games in every NBA All-Star game on Telemundo. Beyond the NBA itself, we're excited that our package includes WNBA, where starting in the spring of 2026, we'll have more than 50 WNBA regular season and first round playoff games each season across Peacock, NBC and USA, and we'll also have games in seven WNBA Conference semifinals and three WNBA Final series; for USA Basketball, we'll have the rights to USA men's and women's games leading up to the Olympics and FIBA World Cup; Sky Sports will air all of NBCUniversal's NBA and WNBA games in its markets; and finally, Xfinity will be the NBA and WNBA's marketing partner in the video category. Now, I'd like to take a moment to explain why we're so excited to partner with the NBA. First, it brings in a broad, diverse and youthful audience that is culturally relevant and further expands NBCUniversal's tremendous reach across broadcast and streaming. This new fan base will also allow us to create new entertainment content that will work beyond the basketball season with exciting opportunities for companion programming and marketing collaborations that tap into the NBA's pop culture appeal. Second, the nine-month basketball season completes our year-round calendar for sports, which already includes the NFL, Olympics, Premier League, NASCAR, PGA Tour, Big Ten and World Cup, and our NBA package will establish much-watched Sunday, Monday and Tuesday night traditions on NBC and Peacock. Third, we are uniquely able to drive strong value with the NBA in multiple ways: first, by growing ad sales, by selling NBA ad inventory package with the rest of our marquee programming; second, by acquiring and monetizing subscribers both on Linear and Peacock; and third, by optimizing NBCUniversal programming investment across sports, entertainment and news. The NBA's decision to partner with us is a testament to our breadth and reach, our operational excellence in sports and innovation, and our decades of experience delivering world-class content to consumers. Much like our long-standing relationships with the NFL and the Olympics, we look forward to putting the weight of our entire company behind our partnership with the NBA for decades to come. Before I hand it over to Jason, I want to share one final thought. In just a few short days, we have the honor of kicking off the 2024 Olympic Games in Paris. This will be NBCUniversal's 18th Olympic Games as a US broadcaster, dating back to 1936 when we first covered the historic event on NBC Radio. It is one of the great moments of pride for our company, and I want to thank the 3,000 people working to bring all of the action, excitement and incredible stories to our viewers across the country. Jason, over to you."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Mike, and good morning, everybody. I'll start with our consolidated results on Slide 3. Total revenue decreased 2.7% to $29.7 billion. Within these results, our six major growth drivers, including residential broadband, wireless, business services connectivity, theme parks, streaming and premium content at our studios, generated over $16 billion in revenue, well over half of our total company revenue and grew at a mid-single-digit rate over the past 12 months. Keep in mind that in the second quarter of last year, we had one of our most successful quarterly theatrical results in our history, which included two of 2023's top-five grossing films at the worldwide box office, The Super Mario Bros. Movie and Fast X, and as such created a difficult comparison this quarter. If we exclude our studio results, total revenue would have been consistent with the prior year. Total EBITDA was consistent at $10.2 billion, and free cash flow was $1.3 billion. Free cash flow was impacted this quarter by higher-than-usual cash taxes, which were up $2 billion over last year's level and were impacted by a tax payment associated with our Hulu stake and other tax-related matters. As you'll recall, we received a minimum floor payment for Hulu at the end of last year. During the second quarter, we returned $3.4 billion of capital to shareholders, including $2.2 billion in share repurchases, and over the last 12 months, we have reduced our share count by over 6%, contributing to our adjusted EPS growth of 7%. Now, let's go through our business results, starting on Slide 4, with Connectivity & Platforms. As usual, I will refer to our year-over-year growth on a constant-currency basis. Revenue for total Connectivity & Platforms was consistent at $20.2 billion, as strong growth in our connectivity businesses was offset by declines in video and voice revenue. Residential connectivity revenue grew 6%, comprised of 3% growth in domestic broadband, 17% growth in domestic wireless, and 14% growth in international connectivity. Business services connectivity revenue also grew 6%. In domestic broadband, our revenue growth was again driven by strong ARPU growth, which increased 3.6% this quarter, well within our historical range as our team continues to effectively balance rate and volume through customer segmentation. The environment for broadband subscribers remains intensely competitive, which when combined with traditional negative seasonality in the second quarter, led to 120,000 subscriber losses. Related to this, I would like to spend a minute on ACP. It has been well-documented that the government ended all funding for the ACP program in June. Consistent with our approach to normal promotional roll-offs, we were proactive and prepared for this action early in the quarter, communicating with our ACP customer base and migrating many of these customers to different products and price levels. While this had a bit of an impact on ARPU in the quarter, we still feel very comfortable that we will remain well within our historical 3% to 4% ARPU growth range for the remainder of the year. In terms of subscribers, we saw minimal impact from the end of ACP this quarter. Looking ahead, we expect the bulk of our ACP-related subscriber activity to happen in the third quarter, including losses associated with non-pay churn. While it's too early to assess the full impact, we are encouraged with the response we see from these customers to-date. Outside of ACP, we are seeing the same level of competitive intensity and expect an offset from seasonal tailwinds as the third quarter is typically a seasonally stronger quarter compared to the second. Turning to domestic wireless, revenue growth was mainly driven by service revenue, with some modest growth in equipment revenue this quarter as well. Customer lines increased 20% year-over-year, reaching 7.2 million in total, including 322,000 line additions this quarter. The acceleration in line additions compared to the prior several quarters was driven by some early success with new pricing plans launched in April, targeted at multi-line customers, as well as continued traction with our Buy One, Get One line offer. And you will see us continue to test new ways to capitalize on the significant opportunities we see ahead for us in wireless, in terms of both increasing the penetration of our domestic residential broadband customer base, which currently sits at 12%, as well as selling additional lines per account. Wireless continues to be a key growth area for us and one in which we are striking the right balance in delivering exceptional value to our customers, bundling to enhance our opportunities in broadband, and continuing to drive profitability higher. International connectivity revenue was mainly driven by broadband, which accounts for over two-thirds of our international revenue and grew at a mid-teens rate, reflecting strong ARPU growth. The remainder is wireless, which grew due to both additional lines and ARPU growth, but at a lower rate due to the variability in handset sales. Business services connectivity revenue growth of 6% reflects steady growth in small businesses with even faster growth in mid-market and enterprise. While the SMB market remains competitive, we are competing aggressively by delivering best-in-class products and services and growing revenue through ARPU growth, driven by higher adoption of additional products that expand our relationship with our SMB customers, like Mobile, Security Edge, Connection Pro, and WiFi Pro, as well as through targeted rate opportunities. At the mid-market and enterprise level, our revenue growth is primarily fueled by the increase in our customers, driven by the investments we have made in this space to build sales and fulfillment, as well as expanding our capabilities in managed services, wide area networking, and cyber cybersecurity. Finally, video and other revenue declined in the quarter. The high single-digit decline in our video revenue is a function of continued customer losses, coupled with slower domestic ARPU growth versus last year, and the lower other revenue mainly reflects the continued customer losses in wireline voice. Connectivity & Platform's total EBITDA increased 1.6%, with margin up 90 basis points, reflecting a decline in overall expenses driven by the continued mix-shift to our higher-margin connectivity businesses, coupled with ongoing expense management. As I have previously mentioned in prior quarters and think is worth noting here, is that the only expense line item that had a meaningful increase over last year was direct product costs, which are success-based and tied to growth in our connectivity businesses. Breaking out our Connectivity & Platforms EBITDA results further, residential EBITDA increased 1.1%, with margins improving 100 basis points to 39.9%, and business services EBITDA growth rebounded nicely this quarter, returning to a mid-single-digit rate, while margin declined 70 basis points to 57%, reflecting the investments in sales and fulfillment we are making to scale in the mid-market and enterprise space. Now, let's turn to Content & Experiences on Slide 5. Revenue decreased 7.5% to $10.1 billion, and EBITDA decreased 11% to $1.9 billion. I'll detail these results further, starting with theme parks. Revenue decreased 11% and EBITDA declined 24% in the quarter compared to last year's record level for a second quarter. As Mike highlighted, two-thirds of the decline was driven by our domestic parks, due to lower attendance compared to last year, largely reflecting two factors; normalization in demand post-COVID, combined with the timing of our domestic attractions. This is the first full quarter comparison to the highly successful opening of Super Nintendo World in Hollywood early last year, which drove that park's record results in the second quarter of last year. And we haven't launched a major new attraction in Orlando since VelociCoaster in 2021 in anticipation of Epic Universe, which we originally planned to open this year. On the international side, underlying growth at our park in Osaka continues, partially offset by foreign currency as well as some softness at Universal Beijing due to the local macroeconomic environment. To reiterate, we couldn't be more bullish about the long-term trajectory of parks. In addition to Epic Universe, we have a fantastic slate of new attractions and experiences on the horizon, Donkey Kong Country in Osaka and a Fast and Furious Roller Coaster in Hollywood, as well as the Universal Horror Unleashed in Las Vegas and our Universal Kids Resort coming to Texas. Now let's turn to media, where revenue increased 2% and EBITDA was up 9%, driven by Peacock. Peacock revenue grew 28%, with 9% growth in advertising and 61% growth in distribution, driven by the 38% year-over-year increase in our paid subscriber base to 33 million. On a sequential basis, we held subscribers fairly steady. As we noted, during our last earnings call, our focus in the second quarter was on subscriber retention due to the lack of new tentpole content in the quarter. This timing and content also contributed to some relief in our expenses, which helped drive year-over-year Peacock EBITDA improvement of $300 million. We are pleased with the progress we are making, with media EBITDA for the first half of the year up nearly 3% as the improvement at Peacock outweighed the pressure at our TV networks. As we look to the second half of the year, we expect continued modest growth in overall media EBITDA, but with some variation in the degree of year-over-year improvement between the quarters, driven by the timing of sports, entertainment launches and marketing. Beginning in the third quarter, we are loaded with incremental content, including the Olympics, Sunday Night Football, which will have an additional game fall into the third quarter, as well as Peacock's exclusive NFL game from Brazil and the return of Big Ten. Given the timing of this content, EBITDA growth will be skewed to the fourth quarter. At studios, revenue decreased 27% and EBITDA decreased 51%, reflecting both the timing of our film slate and a tough comparison relative to last year's second quarter, which included the tremendously successful Super Mario Bros. movie as well as Fast X. We have said our film slate is weighted to the back-half of the year, which we believe will drive better year-over-year performance, and we're off to a strong start. Despicable Me 4 had a terrific opening weekend earlier this month, making the Despicable Me series of movies the first animated franchise in history to cross the $5 billion mark. And Twisters is off to a strong start, landing at number one at the box office this past weekend. And we're excited about our upcoming titles, including Wild Robot in September and Wicked in November. I'll wrap up with free cash flow and capital allocation on Slide 6. As I mentioned earlier, we generated $1.3 billion in free cash flow this quarter, which includes a $2 billion increase in cash taxes over last year's level. Total capital spending declined 10% compared to last year with the $3.4 billion in spending reflecting the significant investments we continue to make to support our growth drivers, such as expanding our footprint and further strengthening our domestic broadband network, scaling our streaming business and supporting the continued build of our Epic Universe Theme Park ahead of its opening in 2025. Turning to return of capital. For the quarter, we returned a total of $3.4 billion to shareholders. This includes share repurchases of $2.2 billion and dividend payments of $1.2 billion. Notably, since we restarted our buyback program just three years ago, we have reduced our share count by 16% and returned just under $50 billion to shareholders through a combination of buybacks and dividends, prudently balancing investments we've made in the business around our six core growth drivers, protecting a strong balance sheet and providing strong capital returns to shareholders. Now, let me turn it over to Brian for some closing remarks. Brian?"
},
{
"speaker": "Brian Roberts",
"content": "Thanks. And just to tie everything together what Mike and Jason have just said and as our results continue to show, I really believe we are dealing with the competitive landscape shifts exceptionally well and that's because we have a great team across the company that knows how to execute and innovate. We have the scale, balance sheet and relevancy to compete with anyone. So, if you think about what we're doing to position ourselves for growth, we've expanded our broadband network by 1.2 million new homes passed in the last 12 months, the most in the company's history, and we put plan to continue to do that. We're upbeat about the long-term in parks despite this quarter and are about to finish building the biggest, most technologically advanced theme park to hit the US market in decades with Epic Universe next year. And as you've seen recently, instead of engaging in a process to buy content companies, we have focused primarily on organic opportunities like the NBA, one of the most coveted sports franchises across the globe, which will help drive growth for us well into the future. With that, let's hand it over to Marci to take your questions."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Brian. Operator, we are ready to open the line for questions, please."
},
{
"speaker": "Operator",
"content": "Thank you. We'll now begin the question-and-answer session. [Operator Instructions] Our first question today is coming from Ben Swinburne from Morgan Stanley. Your line is now live."
},
{
"speaker": "Ben Swinburne",
"content": "Thank you. Good morning. And Mike, thanks for all the detail on the NBA contract. Appreciate that. I wanted to ask about parks and broadband. Maybe, Jason, on broadband, you made some comments about ACP and how Dave and the team are managing it, it seems like it's going well. It seems like you were implying third quarter losses might be down from Q2. I don't want to put words in your mouth, but you talked about an offset around seasonality, I was just wondering if maybe you could revisit that in a little bit about how you guys are managing it from a product and marketing point of view in the third quarter. And presumably, that's the end, we can move on beyond 3Q, we can put ACP behind us, so wanted to ask about that. And then, on parks, thank you for all the color. When you guys look at your pacing data, which I imagine you've got months ahead of you that you can see, is there any -- do you see any churn, or should we be thinking about year-on-year pressure on this segment moving at least through the end of the year and into next year as we get ready for Epic? Any more color on sort of what the outlook looks like would be appreciated. Thanks so much."
},
{
"speaker": "Dave Watson",
"content": "Hey, Ben, this is Dave. I'm going to jump in a little bit on the ACP part first. So, on -- I think it's important to just cover a little bit of context and then we'll get to the outlook in view of Q3. Most of the enrolled ACP customers as we said before have been with us and they are on a postpaid basis, so I think that's an important thing to remember. And our strategy has been consistent. We've been looking to help the ACP customers stay connected through a variety of options, starting with Internet Essential. And since 2011, we've connected millions in the largest, most comprehensive private sector Internet adoption program in the country. The good news is that our ACP customers are eligible to switch to our IE, Internet Essential tiers that we have, and we have a couple. In addition, we have Xfinity Mobile and we have good offers through this transition and to help them save money on their monthly bills. The Internet Essential customer, the plus tier, customers could take a free line of Xfinity Mobile for a year and ACP customers who add Xfinity Mobile can get an additional free unlimited line for a year. So -- and then we just started with NOW Internet, NOW Mobile, and so nothing material on that, but I think it puts us in good position as we complete the transition. We spent -- as Jason said, we've spent a lot of time thinking about this, been very proactive, prepared for this, and in many ways, it's similar to the promotional role activity that we've managed for decades, so we're used to that. On the -- from a subscriber viewpoint, also as Jason said, we saw a minimal impact in ACP in Q2. Looking forward, we expect the bulk of the ACP subscriber-related activity to happen in the third quarter, including losses associated with non-paid churn. Very focused on retention. It's early, but the biggest impact I think we're going to see will be on the non-pay side, and as we're just getting into the beginning of the non-pay cycles. Encouragingly, we're not seeing much voluntary churn in this group. So, our goal, we'd like to get through the ACP impact as quickly as possible, and right now we're planning to take a reserve on incremental non-pay activity in the third quarter, but again, it is too early to quantify and we just won't know until we're further through the cycle. So, we have a normal disconnect process that we managed for a long period of time, and again, this is the post-pay universe that we have managed through. So, we'll -- that is our view. I think it will be primarily within Q3, but encouraged by at least the voluntary churn aspect. Jason?"
},
{
"speaker": "Jason Armstrong",
"content": "Yeah. I think Dave said it perfectly, as you think about third quarter, Ben, I think unpacking it and similar to what we saw in the second quarter, the competitive environment remains intense, but it's stable. It's sort of no worse, no better than we've seen over the past couple of quarters, I think that's the starting point. Second, as we pointed out, it's a quarter where we do get seasonal tailwinds, the same things that were headwinds in the second quarter largely become tailwinds in the third quarter. And then there's ACP that works against that where we will see an impact. As Dave said, the intention is to be largely through the impact by the end of the third quarter between actions we've seen and then a reserve we will take. And so, that's the thing we have to make sure we're executing very well against, but as Dave said, the early trends on that, whether it's voluntary churn or trends we've seen so far in non-pay and building non-pay and reserves around that are encouraging."
},
{
"speaker": "Ben Swinburne",
"content": "Great."
},
{
"speaker": "Mike Cavanagh",
"content": "And, Ben, it's Mike on parks. So, to hit on that again and appreciate the question, I think we covered a lot in the earlier remarks, but I'll start where Brian last finished, which is, we couldn't be more excited about and confident in the long-term trajectory of the parks business, particularly as we look ahead to next year with Epic Universe, which is truly -- looking truly unbelievable. And then, other attractions coming, Hollywood is going to get a Coaster and Donkey Kong Country into Osaka in the latter part of this year. Timing, TBD on both of those. But in the near term, I think the domestic attendance challenge that was -- what drove two-thirds of the poor comparison, the factors causing that, which is really the COVID pull-forward that we talked about and the timing of attractions, particularly in Hollywood lapping Super Nintendo, and in Florida, the fact that we originally planned to have Epic opened this year, but with COVID pushed it back, and so have a lull in the action. We haven't started a new big attraction since VelociCoaster in 2021. So, as a result of that, I think the factors, even though we're excited about Hollywood Horror Nights in the second half of the year and a little bit of moving past the lapping, I think the trends that we are experiencing likely continue until we get to -- until we get to Epic opening up sometime next year."
},
{
"speaker": "Ben Swinburne",
"content": "Thank you, guys."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Ben. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "Certainly. Next question is coming from Craig Moffett from MoffettNathanson. Your line is now live."
},
{
"speaker": "Craig Moffett",
"content": "Hi, thank you. Good morning. A little bit more on ACP, if I could. Mike, could you just give us any early insight you've got on the delinquency rate for people that are 30 days or 60 days past due, just so we can sort of get a sense of what non-pays may look like? And then, presumably, there was some impact, certainly, there was in the first quarter, of just lower gross adds in the category because new enrollments were shut off and somebody moving across the street, for example, would lose it at their old address, but not be able to get it at their new one. Do you have any estimate for how much ACP impact there might have been in the gross add category? And then, just two -- one just simple housekeeping question. You typically report cable margins on the conference call, in the script. I didn't hear it, maybe I missed it, but I'm wondering if you could tell us what cable margins were in the quarter."
},
{
"speaker": "Mike Cavanagh",
"content": "I'll let Dave handle the ACP question, Craig. It's Mike."
},
{
"speaker": "Dave Watson",
"content": "Hey, Craig, Dave. So, in terms of delinquency rates, there's nothing. We're watching, it's just -- we have a normal process that we manage through based on due dates and voices and it goes anywhere from two to three months. There's nothing at this point to report on at this stage. We watch it closely. Other than to go back to what I said, been very proactive, and I think it we're helped by experience and promotional roles and the fact that we tried to put customers into packages that made sense for them proactively. So, there's a lot of work that went into that ahead of time, but nothing at this stage and we'll give more as we go. In terms of -- the question in terms of lower gross adds impacts on connects, it was not material that we saw in Q2. So maybe just a little bit in terms of things that we said, but yeah, it wasn't a substantial impact in Q2 and we think the bulk of what we're seeing is really going to be on the non-pay side, which will occur in Q3."
},
{
"speaker": "Jason Armstrong",
"content": "Hey, Craig, let me hit the margin question real quick. So, I would say, the way we're looking at the business is really across Connectivity & Platforms. So, looking at it that way and managing the business that way. But to unpack it, legacy cable margin, if you wanted to look at it that way, the margin was up 110 basis points in the quarter, so really strong operating improvement to up to 48.4%."
},
{
"speaker": "Craig Moffett",
"content": "Okay. Thanks. Could I squeeze in one more and just [Technical Difficulty] your thinking is right now about BEAD and whether we might see more capital investment on the BEAD side?"
},
{
"speaker": "Dave Watson",
"content": "Yeah, this is Dave. BEAD, we're looking at it very closely. It is going to be worked out on a state-by-state basis. We're optimistic in a lot of cases, but we'll have to look for the guidelines and the specifics tied to it. Nothing at this point would suggest we're going to be beyond the capital intensity that we've already given out. I think with all -- I mean, we're optimistic. One of the points that Brian mentioned, the 1.2 million that we've done in the last 12 months is astounding. And the machine is really going. So, we're leaning in, going for it, but BEAD will be on a state-by-state basis."
},
{
"speaker": "Marci Ryvicker",
"content": "Operator, we are now ready for the next question."
},
{
"speaker": "Operator",
"content": "Certainly. Next question is coming from Jessica Reif Ehrlich from Bank of America. Your line is now live."
},
{
"speaker": "Jessica Reif Ehrlich",
"content": "Thank you. I have an NBA question and also one on advertising. The benefits, as you outlined, are pretty obvious of getting the NBA, but it does come at a significant price. I was hoping if you could walk us through how you expect to make a positive financial return and maybe elaborate a little more on what role Peacock will play since there's a clear benefit there. But how does it affect -- how does this new deal impact programming spend for other areas including general entertainment? And then, as part of Peacock, maybe you could talk about like the StreamSaver, the bundle with Netflix and Apple TV, and the response you've had? And then, on advertising, the upfront is now done. Maybe you can talk about a little bit about the unique selling position you've had relative to others and what the volume is overall on pricing, et cetera, just what you're seeing in the overall market?"
},
{
"speaker": "Mike Cavanagh",
"content": "Sure. Hey, Jessica, it's Mike. So, I think I've essentially covered everything that I wanted to cover and can cover at this stage on NBA in the prepared remarks. Obviously, when the NBA makes its ultimate announcements, we'll -- that will be another moment where we can go deeper. But just to the point generally is that we are looking at the NBA as we all said as some of the premier content that is culturally relevant, excellent audience, widens out the calendar year for us across Peacock and NBC, can do a lot with the demographics that follow the NBA around other programming. So, when you think about the business case for it, when you look at the long-term and as we are managing the media business, broadcast and Peacock as one, I think the unique reach that we have and ability for a sport like the NBA to reach so far with our existing broadcast business and use, as I said earlier, plenty of exclusive games for Peacock to drive excellent acquisition in Peacock and we've talked about before using NBA. And as we've talked about before, sports has been a great source of acquisition for us in Peacock and a great source of value to the consumer. But what's very interesting to us is how significant the viewership is of sports viewers on Peacock of things other than sports. So, when you take a zoom out and think about the total picture of what we're trying to do, which is to bring our excellent TV media assets into the future, I think you can -- we view the NBA as an excellent piece in that puzzle and it will allow us to rebalance programming from other areas. Obviously, we'll fill a few nights on NBC with this content versus other content, and we'll use this to do acquisition spend in Peacock and lighten up in some other places. But the long-term goal for Peacock is to have a service that is a balance of sports, entertainment, and news. And so our content teams are now very focused on that new audience and what we're going to be able to do to drive entertainment content with the advantage of being linked closely to the NBA and to the audience that follows it. And then, on advertising, so second quarter, pretty -- only a slight step down from the first quarter, but clearly we had a much heavier load of sports in the first quarter than the second quarter, and so that -- adjusting for that, I'd say again that the advertising market remains pretty stable, and we feel very well-positioned for the second half of the year with the Olympics coming up starting this Friday, elections, and a great slate of content coming to NBC and Peacock. In terms of the upfront, we're pleased with our results. Total volume for us is going to be basically in line with last year as is linear price. We got well over $1 billion in upfront volume for Peacock again, which -- a nice growth over what we had last year. And so, if you step back, we'd say the overall upfront market was pretty solid. We moved quickly given our strength of our assets to secure the volume that we got. So, we feel we were a success in this more challenging upfront given the arrival of so many of the new players, especially in the AVOD and SVOD space. So that's the report on the upfronts, but we're moving forward and feel like the team did quite a good job."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jessica. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "Our next question today is coming from John Hodulik from UBS. Your line is now live."
},
{
"speaker": "John Hodulik",
"content": "Great. Thanks. Maybe on the cable side, a little bit better trends in both video and wireless. On the video side, what's driving the improvement there? Do you expect it to continue? And are you seeing any effects of the launch of the NOW brand? And then, in wireless, you guys talked about some new pricing and promotion, but do you guys think you're benefiting at all from some of the ACP losses on the prepaid side? I don't know if you guys saw yesterday, Verizon announced they sort of turned off 400,000 subscribers. I think we'll see something similar with the rest of the wireless companies. But do you think this underlying growth is sustainable, or do you think that ACP is somehow boosting the growth at this point? Thanks."
},
{
"speaker": "Dave Watson",
"content": "Hey, John, Dave. So, in terms of video, as Jason said, it's -- our video losses are lower than the ones -- last year, it's tied. We did take a slightly less rate increase this year than last year. And the key for us in video is just positioning video with broadband and that video does help in that regard. We've seen positive churn in terms of video, reimagining video around the NOW TV product and IP and that has been steady. It's still early, but has been helpful. So, video, I think for the right segment, we offer a lot of value and we continue to position it, I think, very well with broadband. But difficult -- and still in terms of some of the fees and things that we have, but I think an important category for us. So on -- in terms of the Mobile side, NOW Mobile is not material at this point, way too early. The acceleration in line adds over Q1 driven by the early success of the new pricing plans, really competitive now in multi-line pricing. Launched in April, we targeted it for a while, now it's scaling, and it's really got traction, as well as the Buy One, Get One line offer to our base. So, wireless is such an important part of our overall strategy and key that it's 12% penetration, we've got great runway ahead. Business Mobile is just getting going and it's a great position for us in terms of convergence. I think, we're uniquely positioned in terms of ubiquitous offers across our entire footprint, and mobile will be front and center as we approach the Olympics and we will have a great offer with broadband, with mobile, being able to tie all this together, so very excited with it. The comment -- just one other part in terms of what happened in terms of Verizon's unpacking that, the only thing I'll say is, I think it's an important distinction that our ACP customers are postpaid versus their prepaid. It's a different group, a different dynamic. And so, not really -- we're just getting going on our NOW products. And so, it's very, very early on. Excited about that. And I think we're introducing it at a very good moment, but it's not material at this stage."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, John. Operator, we're ready for the next question."
},
{
"speaker": "Operator",
"content": "Certainly. Next question is coming from Jonathan Chaplin from New Street. Your line is now live."
},
{
"speaker": "Jonathan Chaplin",
"content": "Thanks, guys. I guess for Jason, two quick ones on content costs in the connectivity business. They came in quite a bit lower than we expected, and I'm wondering if you can give us a little bit more color on what's driving the trend there and how sustainable it is. And then, we're trending a little bit lower than guidance on CapEx so far this year. I'm wondering if that's just timing-related if it picks up in the back half of the year. And then, Mike, I'm not sure if you -- I heard you loud and clear on having sort of said what you can on the NBA deal. I'm wondering if you can just give us a little bit of context around the timing of costs and revenues though. When -- I recognize it's forward-looking, but when should we expect to see the costs from the new contracts start to hit? Thank you."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Jonathan. Why don't I start with CapEx, Dave will hit content costs, and then Mike with NBA. So, on CapEx, you're right, we've had some variability this year. I would say, relative to the initial guidance we gave both on the Content & Experiences side, where we talked about this is the final significant year of Epic spending and then we get relief beyond this. And then, on the Connectivity & Platform side, which I think is probably where more of your question was, we gave a capital intensity envelope as we entered the year. We also said intend to do 1.1 million-plus in terms of homes passed. We're obviously trending a little bit above that at this point, but still feel comfortable with the capital intensity envelope that we gave. And so, there are some timing aspects around equipment purchases within the year. I would say, still feel comfortable with the existing capital intensity envelope. And within that, doing more and more homes passed at a really efficient rate, I think that's a testament to how the team is executing here."
},
{
"speaker": "Dave Watson",
"content": "Hey, Jonathan, Dave. So, just on the content cost side of things, that's also timing related. We -- in the sports side, well-known thing in terms of RSNs and -- but there are other timing-related things. Every contract with the programming partner is different, every relationship is different, so won't go into the specifics. But it is key that we focus on, for us flexibility, increasing market choice. We segment the marketplace both video and broadband, and together, and that is important that we're competitive in every segment. And at the end of the day, we're focusing on value. Combining linear streaming considerations on a case-by-case basis, but mostly at this point is timing related."
},
{
"speaker": "Mike Cavanagh",
"content": "And Jonathan, it's Mike. On NBA, I wish it were sooner, but the contract doesn't start till the 2025-2026 season. So, it's fall of 2025 that we would start to bear the expense of the right side of it. And obviously, that is also as we build into that when we would begin to see the benefits of subscriber acquisition around the NBA."
},
{
"speaker": "Brian Roberts",
"content": "And this is Brian. Just want to -- just to close out perhaps Mike's opening comments on the NBA. Doesn't -- opportunities like this come along very rarely when there's long-term relationships up for grabs. Inside and we'll have -- when it gets all announced, the detail that Mike described, we have probably more content than anybody and it's all, I think, at a value that we'll be able to, as one of the other questions asked, support and demonstrate. And one of our real advantages here is the way we're running the media business, and Mike created one group with our existing assets like NBC and our growing asset like Peacock, and putting that together is very appealing for the reach, for the consumer access, for the innovation that we'll have in the years ahead, and you'll see some of that innovation during the Olympics. There'll be a lot of content on NBC, but way more content on Peacock, and it allows for the trends that we're seeing in viewing behavior. So, it's a very exciting moment and I think we'll have more to say in the weeks ahead."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jonathan. Operator, next question, please."
},
{
"speaker": "Operator",
"content": "Certainly. Next question is coming from Michael Ng from Goldman Sachs. Your line is now live."
},
{
"speaker": "Michael Ng",
"content": "Hey, good morning. Thank you for the question. I just have two, one on business services and one on wireless. First on business services, I was just wondering if you could talk about some of the key initiatives or things that might be changing at Comcast business following Ed's appointment as President to more aggressively pursue the mid-market or enterprise? What are you seeing in terms of the competitive side within SMB? Is it just fixed wireless, or is there more to that? And then, on wireless, given the strong potential upgrade cycle on the back of AI smartphones and the iPhone 16, I was just wondering if you could talk about the Xfinity Mobile strategy to capitalize this -- on this from a promotional marketing perspective. What levers are you planning to pull this holiday to potentially lean into wireless to help the broadband business and wireless at large? Thanks."
},
{
"speaker": "Dave Watson",
"content": "Got it. Thank you. This is Dave. So, a couple of things. Let me start with business. As you said, it is competitive in the small business categories, competitive in every category, but in particular, the small business one. There certainly is some fixed wireless that we've seen, and saw it in the Verizon results, pretty high percentage of the fixed wireless that are in the small business thing, and we're -- we look at that closely. We are intensely focused on our competitive playbooks and we're going to constantly compete for share. But we're also focused on revenue per relationship. And so, in the small business area, before getting into mid-market, we're doing a lot of product upgrades, adding value and speed, WiFi, security. And so, we made good progress and revenue focus around in small business. And it's such a huge opportunity for us and still in terms of small business. But Ed has stepped right in. It's a terrific team in the business services group that he's working with. And there really is, I think, a unique opportunity. When you look at the overall addressable market of $60 billion, less than 20% there, and a huge chunk of this will be mid-market and enterprise. And we're -- and you add on top of that international opportunities that we're beginning to coordinate and work well with Dana and the team at Sky. So, yeah, we really are seeing nice relationship growth in mid-market and enterprise. That's the starting point, but in addition to like all of our strategies, we're adding more products and attaching new products on these relationships, and going beyond just connectivity into a full managed relationship basis. So, Ed is driving that, and we're in a good competitive position for growth, and I think we have a good ability to increase ARPU across an increasing higher-end base of customers. So, on the mobile side of upgrade, it is -- every single upgrade moment pay close attention to that one too, and we're optimistic. We're in good position. We have a great trade-in program for mobile that we've had in place now for a while. And then, in addition to that, we go in and out in terms of subsidies on top of that trade-in program. And then, when good upgrade moments happen, we are the switching provider. So, when people -- we have great core rates and we have good handset offers and good position for it. So, being a switching provider, I think we are -- I think in a unique position to really take advantage of that. And when you look at things going into the optimism for Q3, one of the most important programs that we'll do, along with the handset upgrade initiative on mobile will be the Olympics. And the Olympics are such a unique opportunity for us to showcase the best broadband, the best mobile service offering, combining those two things together in such an attractive offer. On top of that is the greatest UI in the marketplace that helps you find whatever you want. So, really excited about that. Look for that in the next couple of days, but mobile will be front and center along with broadband when that happens."
},
{
"speaker": "Michael Ng",
"content": "Great. Thanks, Dave."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Mike. Operator, we have time for one last question."
},
{
"speaker": "Operator",
"content": "Certainly. Our final question today is coming from Steven Cahall from Wells Fargo. Your line is now live."
},
{
"speaker": "Steven Cahall",
"content": "Thanks. So, with mid-splits now reaching over 40% of the footprint, I was just wondering if you have an updated outlook on when you think you'll be at DOCSIS 4 for most of your broadband passings. And maybe within this you could just update us on where fiber overlap is, but also as you get through this network investment architecture that you laid out earlier this year, when you think about the capital intensity in C&P coming down and we'll start to see that benefit in growing free cash flow. So, timing on that, I think, would be really interesting. And then, how are you thinking about getting to just breakeven on Peacock? You talked about media EBITDA on a total basis growing in the first half and in the second half, too. It seems like if the Peacock losses keep getting better at this pace, you could be close to breakeven this time next year, but I know you've got NBA coming. So, just wondering if we could think about that benchmark quite yet. Thank you."
},
{
"speaker": "Dave Watson",
"content": "Hey, Steven, this is Dave. Let me start and then hand it over on the Peacock side. So, we're 42% mid-split right now. We expect to be 50% by year-end. And the DOCSIS 4.0 that follows, multiple markets so far, it's early, no specifics in terms of the final rollout on that. But it really is tracking very well on top of the lot of new footprint expansions of 1.2 million over the last 12 months, this upgrade program is moving along very well, and it tracks to where the customers are, and our steady focus around the higher end. And one of the things that we see, we have the most effective and efficient build that's ubiquitous that is addressing speed, capacity, coverage and it helps us because as we're doing this, remember, we're virtualizing huge parts of the network and avoiding future node split. So, it's very efficient in helping us with the -- 70% of our customers are 500 megabits or higher, a third are taking a gig. And it's tracking to maybe one of the biggest tailwinds that is out there and that's the fact that our network consumption is still low double-digits increasing. And that's not stopping. And so, we're putting ourselves in position with a great upgrade program. And so that to me is, I think, a great advantage that we do have. In terms of competition, in terms of fiber, we're now 50% in terms of the overbuilt. We expect by the end of '25, that'll get to 60%. We'll probably go higher than that. We have a long track record of competing against fiber 20 years at this point. So, we do think fiber is quite frankly the longer-term competitor, keeping our eye on, compete fiercely against fixed wireless and every competitor, but we anticipate where they're building, what they're doing and keeping track of all of that. So, like our results -- and encouraged, when you look going into Q3, one of the reasons of optimism is that voluntary churn that continues to perform very well. And I think it's our superior network combined with better products and extreme focus on competition."
},
{
"speaker": "Jason Armstrong",
"content": "Hey, Steven, I would just round that out on the capital intensity question, because I think embedded in that was sort of a long-term capital intensity question. If you look at what we're doing now, the path towards mid-splits, which as Dave mentioned, really good progress there, that kicking off DOCSIS 4.0 and then adding 1.2 million homes passed, which is a record for us in the last 12 months and doing that all within through the existing capital intensity envelope, which is one of, if not, the lowest in the industry. So, very good progress there. As you think about longer term, a lot of people ask this question in the context of is there the next big thing coming in terms of the network upgrade. We feel very comfortable between mid-splits and DOCSIS 4.0, that leading to multi-gig symmetrical speeds that, that is the network for the future. So, we don't see the next big thing coming. The one area that I'd point out, we'd love to do more homes passed. We've accelerated the rate from 800,000 in the past couple of years up to currently 1.2 million. We won't get capital intensity because of that. If those are good returns and things we should be doing, we'd love to do more there."
},
{
"speaker": "Mike Cavanagh",
"content": "Steven, on Peacock and media EBITDA, I think you heard us right anyway, heard me right. I've been talking since I've been doing this that I don't really look at Peacock as standalone. I mean, it's an interesting exercise and I'm happy to share the numbers of what the loss is on Peacock as we're building it. But strategically to not pursue that path would leave the existing media business on a downward trend. So, I think we are thinking about it over multiple years. I'm very confident that what we're doing around Peacock and the media business together, operating together is going to put us on a path to optimize that business. And as you said, I think this is a year where we see the growth in Peacock offsetting the decline in some of our linear businesses, and that's basically a trend I would expect to see carry forward. There's going to be ebbs and flows. As Brian said, something like NBA is once in a generation almost to get an opportunity like that. So obviously, we'll make some adjustments and it might pause our trajectory the year we take it on board, but I think it's part and parcel of the idea that we're bringing the media business to a better future by investing behind Peacock and doing it together with all our assets, entertainment, sports and news as what our media business will look to be in the future. Well, thank you everybody. I think that's it. I stole Marci's line. Go ahead."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Steve. This concludes our second quarter earnings call. Thanks for joining us."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's question-and-answer session and today's conference call. A replay of the call will be available starting at 11:30 am Eastern Time today on Comcast Investor Relations website. Thank you for participating. You may all disconnect."
}
] |
cmcsa | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Comcast's First Quarter Earnings Conference Call. [Operator Instructions] Please note this conference call is being recorded. I'll now turn the call over to Executive Vice President, Investor Relations, Ms. Marci Ryvicker. Please go ahead, Ms. Ryvicker."
},
{
"speaker": "Marci Ryvicker",
"content": "Thank you, operator, and welcome, everyone. Joining us on today's call are Brian Roberts, Mike Cavanagh, Jason Armstrong and Dave Watson. I will now refer you to Slide 2 of the presentation accompanying this call, which can also be found on our Investor Relations website and which contains our safe harbor disclaimer."
},
{
"speaker": "",
"content": "This conference call may include forward-looking statements subject to certain risks and uncertainties. In addition, during this call, we will refer to certain non-GAAP financial measures. Please see our 8-K and trending schedule issued earlier this morning, for the reconciliations of these non-GAAP financial measures to GAAP. With that, I'll turn the call over to Mike."
},
{
"speaker": "Michael Cavanagh",
"content": "Thanks, Marci, and good morning, everyone. Across the company, our team is managing extremely well in a highly competitive and evolving marketplace. We have a clear vision for how we are going to compete now and into the future, combined with a sharp focus on execution. Equally important, our disciplined capital allocation strategy, coupled with our strong balance sheet, puts us in an enviable position relative to our peers to invest organically and aggressively in our 6 scaled and diverse growth businesses namely: Residential Broadband, Wireless, Business Services, Theme Parks, Studios and Streaming. These businesses comprise more than 55% of the company's total revenue today, and that proportion will only grow over time."
},
{
"speaker": "",
"content": "In the first quarter, these businesses generated a high single-digit increase in revenue on a trailing 12-month basis. And when combined with our substantial share repurchase activity, enabled us to deliver double-digit adjusted EPS growth as well as significant growth in free cash flow per share. In fact, since 2018, we grew adjusted EPS over 50% and free cash flow per share nearly 25%."
},
{
"speaker": "",
"content": "Now for some of the highlights of the first quarter, I'll start with Broadband. The broadband market remains extremely competitive, particularly within the market for more price-conscious consumers. We continue to be intensely focused on segmentation, providing customers with options that meet both their lifestyle and budget. Importantly, we are striking the right balance between ARPU and subscribers, which is clearly reflected in our first quarter results, where despite modest subscriber losses, ARPU grew over 4%, driving mid-single-digit growth in residential broadband revenue to over $6.5 billion."
},
{
"speaker": "",
"content": "We continue to see extremely encouraging broadband consumption trends across our base of 32 million customers. Usage on our network rose double digits year-over-year with broadband-only households consuming over 700 gigabytes of data each month, and our broadband customers continue to value faster speeds. Today, over 70% of our residential subscribers receive speeds of 500 megabits per second or higher and around 1/3 are getting a gig or more."
},
{
"speaker": "",
"content": "We believe that consumers' expectations for their broadband experience in terms of speed, reliability, security and performance will only increase over time. It is extremely important to us that our network upgrades stay well ahead of this demand, our deployment of mid splits doubled year-over-year and now reach 40% of the footprint. The investments we are making to increase capacity and incorporate multi-gigabit symmetrical speeds everywhere we offer service put us in a great position to capitalize on these very favorable consumer trends. And when combined with our rapid footprint expansion, set us up to gain market share and return to broadband subscriber growth over time."
},
{
"speaker": "",
"content": "Turning to wireless. We increased our domestic customer lines by 21% year-over-year to nearly $7 million, yet with wireless penetration of our residential broadband customer base still only 11%, we have plenty of room to grow. We continue to see the benefit of bundling broadband and mobile, which decreases churn and improves customer lifetime value. Our customers also benefit by being connected to our WiFi network, which is the largest in the nation. In fact, 90% of all Xfinity Mobile traffic is delivered over WiFi, not cellular, and we are constantly adding new features to further differentiate the experience. The most recent example is our introduction of WiFi Boost, which enables any Xfinity Mobile customer to experience speeds of up to 1 gig whenever they connect to our 23 million hotspots at no additional cost."
},
{
"speaker": "",
"content": "Across our Connectivity & Platforms business, we're focused on profitably serving each segment of the market from our premium and traditional customers who want fully featured products to more price-driven consumers. With regard to the latter, we are introducing NOW, a new brand and product portfolio targeting the prepaid market that delivers high-quality, low-cost Internet, mobile and streaming TV products with simple all-in pricing."
},
{
"speaker": "",
"content": "NOW Internet and mobile will be particularly helpful to those Americans impacted by the end of ACP, bringing them another option for affordable, reliable connectivity and supplementing our Internet Essentials program, which we offer to eligible households as part of our long-standing commitment to help close the digital divide in America."
},
{
"speaker": "",
"content": "Turning to Content & Experiences. Let's start with parks. We continue to see strong underlying demand in both Hollywood and Japan, where healthy attendance and per cap levels were once again driven by the success of Super Nintendo World. Building on our momentum, later this year, we're opening our newest Nintendo-themed land, Donkey Kong Country, which will increase the size of Super Nintendo World in Japan by 70%."
},
{
"speaker": "",
"content": "Switching gears to Orlando. We started to feel some pressure on attendance levels late in the first quarter, which tends to occur in tandem with the ebbs and flows of new attractions in the market. Right now, we happen to be lapping the multiyear surge in attendance from our opening of new attractions in prior periods, but we remain confident about our longer-term growth opportunities, especially as we look ahead to next year with the opening of Epic Universe. With 3 new hotels and 5 immersive worlds featuring more than 50 attractions, entertainment, dining and shopping experiences, it will be the most technologically advanced park in the world. Together with our 3 current gates in Orlando, Epic will enable us to offer a full week's vacation experience to even more guests."
},
{
"speaker": "",
"content": "Moving to Studios. We're incredibly proud of our film team and our recent ranking as the #1 global studio by worldwide box office and winner of Academy Awards, including Best Picture for Christopher Nolan's Oppenheimer. On the back of our fantastic performance in 2023, the power of our studios continued this quarter with the theatrical release of Kung Fu Panda 4, which has grossed over $480 million in worldwide box office to date. And we have an exciting slate still ahead. For the third year in a row, we'll release more movies than any other major studio with The Fall Guy, an action thriller starring Ryan Gosling and Emily Blunt coming this May; Despicable Me 4, Illumination's newest installment of this highest grossing animated franchise as well as our adaptation of Twisters, both debuting in July; and Wicked, one of the most highly anticipated movies of 2024 coming in November."
},
{
"speaker": "",
"content": "Finally in media. We are successfully managing the segment as one business across linear and streaming, by providing the tens of millions of traditional pay TV subscribers as well as streamers with choice in how they engage with us, we continue to generate significant audience for our programming. Big events like the Olympics, Sunday Night Football, Big Ten; top entertainment shows like Saturday Night Live and Law & Order, with strong consumer demand for our content, we're well positioned to evolve with the changing market."
},
{
"speaker": "",
"content": "Our exclusively streamed NFL Wild Card game was a big success this past quarter. We added and then retained even more new Peacock subscribers than we expected. Overall, people are staying with us to engage in a broad range of content, spending 90% of their time on the platform viewing nonsports programming. This includes scripted shows like Ted and reality shows like The Traitors, both of which ranked within Nielsen's streaming top 10. And our award-winning collection of films like Oppenheimer, which premiered exclusively on Peacock in February and was the most watched film across all streaming in its first 7 days on the platform."
},
{
"speaker": "",
"content": "Clearly, Peacock has been on a great trajectory since our launch 4 years ago, where 34 million paid subscribers having grown 12 million year-over-year and at a $10 ARPU. Looking ahead, our content offering provides such a great value proposition that we should have some real pricing power over time."
},
{
"speaker": "",
"content": "Of course, sports also play an important role in our media business, and that's especially true this year. Following the Kentucky Derby in May, we'll have the Paris Olympics for 17 nights this summer. With more programming hours on the NBC Broadcast Network than any previous Olympics and over 5,000 hours of live coverage on Peacock, the games are on track to generate the most advertising revenue in history with $1.2 billion in ad sales commitments."
},
{
"speaker": "",
"content": "Right after the Olympics, we have the return of football with Big Ten, Sunday Night Football and the NFL's first-ever Friday night opening game from São Paulo, streaming exclusively on Peacock."
},
{
"speaker": "",
"content": "So wrapping up, I'm really proud of the work that our teams across the company are doing. Together, we're executing at the highest level and positioning ourselves for growth in a challenging and dynamic marketplace. So Jason, over to you."
},
{
"speaker": "Jason Armstrong",
"content": "Thanks, Mike, and good morning, everyone. I'll start with our consolidated results on Slide 4. Total revenue increased 1% to $30.1 billion. And within this, our 6 major growth drivers generated nearly $17 billion in revenue, well over half of total company revenue and once again have shown steady and consistent growth at a high single-digit rate over the past 12 months."
},
{
"speaker": "",
"content": "While EBITDA was in line with prior year's level at $9.4 billion, we generated a high level of free cash flow this quarter at $4.5 billion, and we returned $3.6 billion of capital to shareholders, including $2.4 billion in share repurchases. And over the last 12 months, we have reduced our share count by nearly 6%, contributing to our adjusted EPS growth in the quarter of 14%."
},
{
"speaker": "",
"content": "Now let's go through our business results, starting on Slide 5 with Connectivity & Platforms. Note that our largest foreign exchange exposure is to the British pound, which was up 4% year-over-year. So as usual, in order to highlight the underlying performance of the Connectivity & Platforms business, I will refer to year-over-year growth on a constant currency basis."
},
{
"speaker": "",
"content": "Revenue for total Connectivity & Platforms was flat at $20.3 billion, reflecting strong growth in connectivity revenues, offset mainly by declines in video revenue. Residential Connectivity revenue grew 7%, driven by 4% growth in domestic broadband, 13% growth in domestic wireless and 19% growth in international connectivity, while Business Services Connectivity revenue grew 5%."
},
{
"speaker": "",
"content": "In domestic broadband, our revenue growth was driven by very strong ARPU, which increased 4.2% and came in a bit above our historical range. Our team is doing an excellent job of customer segmentation while balancing rate and volume. And we are encouraged by the positive consumer behavior trends we see in our base of 32 million customers."
},
{
"speaker": "",
"content": "Bandwidth requirements and engagement are increasing at a rapid clip while the vast majority of our customers are now on speeds of 500 megabits or higher, and adopting advanced tier as a service like xFi complete at a higher rate. But as Mike mentioned, it continues to be a very competitive environment. And we lost 65,000 subscribers in the first quarter, following a loss of 34,000 subscribers in the fourth quarter of 2023."
},
{
"speaker": "",
"content": "As we sit here right now, we do not see this trend improving in the near term. We expect churn could be elevated given the end of ACP, which is only fully funded through April and partially funded through May. We remain in constant communication with our ACP customers and we'll continue to be diligent in helping this customer segment stay connected through various options. Whether that's our successful Internet Essentials program or our new prepaid NOW offerings, as Mike described."
},
{
"speaker": "",
"content": "In addition, I want to remind you that the second quarter also tends to experience seasonal headwinds. While it's a competitive market, especially for the price-driven segment, we will continue to compete aggressively, yet in a financially balanced way and expect to drive healthy broadband revenue growth through growth in ARPU, which we expect to remain well within our historical range of 3% to 4% growth even as we manage through the ACP transition."
},
{
"speaker": "",
"content": "Turning to domestic wireless. Revenue growth of 13% was due to higher service revenue, driven by a 21% year-over-year increase in our customer lines, ending the quarter at $6.9 million in total, including the 289,000 lines we just added in the quarter. We are consistently in the marketplace testing new offers, including some recent pricing plans targeted at multiline customers, the new NOW Mobile product as well as our Buy 1, Get 1 line offer."
},
{
"speaker": "",
"content": "We continue to see significant opportunity in wireless to increase the penetration of our domestic residential broadband customer base, which currently sits at 11% and to sell additional lines per account. International connectivity revenue reflects strong growth in broadband revenue, driven by solid ARPU growth as well as growth in wireless due to additional customer lines and also higher ARPU."
},
{
"speaker": "",
"content": "For business services connectivity, we generated 5% revenue growth driven by higher ARPU in small business and broader growth in both customers and additional solutions for mid-market and enterprise. The SMB market has gotten more competitive but will aggressively defend our position. And similar to this quarter, we'll grow revenue by increasing ARPU, driven by higher adoption of additional products like Mobile, Security Edge, Connection Pro and WiFi Pro and through targeted rate opportunities."
},
{
"speaker": "",
"content": "Meanwhile, our momentum continues to build in mid-market and enterprise as our expanding capabilities in managed services, wide area networking and cybersecurity have led to increasing customer wins and the expansion of existing relationships."
},
{
"speaker": "",
"content": "The strong growth in our Connectivity businesses was offset by a decline in video and other revenue. The decline in our video revenue was driven by continued customer losses and slower domestic ARPU growth versus last year, and the lower Other revenue reflects continued customer losses in wireline voice. As I mentioned earlier, Connectivity & Platforms total EBITDA increased 1.3% with margin of 50 basis points, reflecting a decline in overall expenses driven by the mix shift to our high-margin connectivity businesses, combined with a continued focus on expense management."
},
{
"speaker": "",
"content": "While margins for our domestic legacy cable business improved even more, our international business was impacted by a reclassification of some expense from capitalized software to operating expenses, creating a tough comparison to last year. We will see a similar trend until we start to lap this change at the end of this year."
},
{
"speaker": "",
"content": "I'll note that absent this change, EBITDA growth in the first quarter would have been about 1 point higher, and our margin improvement would have been about 50 basis points higher. While this change increased our operating expenses this quarter, there was an offsetting decline in Connectivity & Platforms capital, resulting in a neutral impact on net cash flow, which was up 5% this quarter."
},
{
"speaker": "",
"content": "Breaking out our Connectivity & Platforms EBITDA results further. Residential EBITDA grew 1.1% with margins improving 60 basis points to 38.3%. And Business Services EBITDA growth was lower than our typical mid-single-digit level at 2.6% with margins declining 160 basis points to 56.7%. These results include significant investments in the enterprise space, including in sales and fulfillment that we are making to drive future revenue growth. Business Services generates well over $5 billion in annual EBITDA, which is margin accretive, and we expect it to continue to be a material contributor to overall connectivity and platforms growth this year and over the longer term."
},
{
"speaker": "",
"content": "Now let's turn to Content & Experiences on Slide 6. Overall, revenue increased 1% to $10.4 billion and EBITDA decreased 7% to $1.5 billion. Let's take a closer look at the details. Starting with Theme Parks. Revenue increased 2%, while EBITDA decreased 4% for the quarter. These results reflect the negative impact of currency as the Japanese yen is at a 34-year low against the dollar."
},
{
"speaker": "",
"content": "Adjusting the results to exclude the impact of foreign currency, Parks' revenue would have increased 5% and EBITDA would have been flat compared to last year's first quarter. We had strong underlying growth at our park in Osaka, which continues to benefit from demand for Super Nintendo World. We're also seeing growth in Hollywood despite lapping the opening of Super Nintendo World in that park during the quarter."
},
{
"speaker": "",
"content": "Beijing results were relatively flat in what is typically a seasonally light quarter, and Orlando results were below last year, but still roughly in line with pre-pandemic levels. We are seeing some pullback from the unprecedented attendance we realized immediately after the pandemic, which we believe is driven by the timing of new attraction openings and some increased competition from other entertainment venues, notably cruises."
},
{
"speaker": "",
"content": "At Media, which includes our TV Networks and Peacock, revenue increased 4% as Peacock's strong growth of 54% more than offset a low single-digit decline at our linear networks. Distribution revenue growth of 7% was driven by Peacock with subscription revenue growth of 68%, powered by the 55% year-over-year increase in our paid subscriber base to 34 million including 3 million net adds in the first quarter."
},
{
"speaker": "",
"content": "We are really pleased with Peacock's trajectory. We started the year with an incredibly successful NFL Wild Card game, which resulted in a nice lift to paid subs. But even more important was how our broad content offering enabled strong consumer acquisition, retention and engagement. We've had success across a broad range of content during the quarter, including films moving into our Pay-One window like Oppenheimer, the most watched Pay-One film in Peacock's history; and The Holdovers, as well as successful originals, including Apples Never Fall, Ted and the second season of The Traitors."
},
{
"speaker": "",
"content": "Looking ahead, we'll continue to be focused on retention, particularly in the second quarter as we look forward to the second half of the year, we will have a substantial amount of acquisition-oriented content lined up. This is consistent with Peacock's historical trends, and this year is expected to be driven by the Olympics this summer and the NFL and Big Ten returning in the fall, in addition to the steady stream of films landing in our Pay-One window as well as upcoming originals."
},
{
"speaker": "",
"content": "Finally, domestic advertising revenue was flat in the quarter, reflecting a stable overall market with strong advertising growth at Peacock, offset by lower advertising revenue at our linear networks. Media EBITDA decreased 6%, reflecting the revenue pressure on our linear networks, partially offset by continued year-over-year improvement in Peacock EBITDA losses even with the addition of the wildcard rights costs. And we expect to see, on average, even better year-over-year improvement for Peacock in the coming quarters."
},
{
"speaker": "At Studios, the revenue decline of 7% reflects lower content licensing, which was impacted by the timing of deliverables related to our film licensing business, which was partially offset by a modest increase in theatrical revenue, driven by the strong performance of Kung Fu Panda 4 at the box office this quarter. Studio's EBITDA declined 12%, reflecting the difficult comparison to last year's film slate, including the highly successful carryover title, Puss in Boots",
"content": "The Last Wish and the timing of licensing deals at film."
},
{
"speaker": "",
"content": "Now I'll wrap up with free cash flow and capital allocation on Slide 7. As I mentioned previously, we generated $4.5 billion in free cash flow this quarter, and we achieved this even with the significant investments we continue to make to support our growth drivers. Specifically, our $3.3 billion in total capital spending this quarter incorporates our efforts in expanding our footprint and further strengthening our domestic broadband network, scaling our streaming business and supporting the continued build of our Epic Universe Theme Park ahead of its 2025 opening. And working capital was a $940 million drag for the quarter, a significant improvement over last year, a lot of which is timing related."
},
{
"speaker": "",
"content": "Turning to return on capital. For the quarter, we returned a total of $3.6 billion to shareholders, an increase of 13% year-over-year. This includes share repurchases of $2.4 billion and dividend payments of $1.2 billion. Putting it all together in the last 12 months, we've returned over $16 billion in capital to shareholders between share repurchases and dividends, reducing our share count by nearly 6%."
},
{
"speaker": "",
"content": "At the same time, we invested nearly $17 billion back into our businesses in the form of capital and working capital, carefully and consistently balancing reinvesting in our businesses for growth, returning significant capital to shareholders and doing so with a very strong balance sheet, which facilitates this consistency through a variety of operating environments."
},
{
"speaker": "",
"content": "Now let me turn it over to Marci for Q&A."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jason. Operator, let's open up the call for Q&A, please."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question today is coming from Ben Swinburne from Morgan Stanley."
},
{
"speaker": "Benjamin Swinburne",
"content": "Two questions maybe for Dave on the Cable side. Could you talk maybe bigger picture about customer segmentation, particularly some of the new efforts around prepaid and the NOW brand as well as some of the speed boost you've done, and just how you think about that impacting the business over time? And then if you're willing to give us a little more on how you are able to deliver ARPU growth within the historical range through the CP transition, just given, obviously, the subsidies going away."
},
{
"speaker": "",
"content": "And then I think for Jason. We expect EBITDA growth this year, free cash flow growth this year. You guys had a nice free cash flow, first quarter. I guess, I would have expected buybacks to grow as well year-on-year. And as you point out on that last slide, trailing 12 months, $11.5 billion, $2.5 billion in the first quarter. So it looks like it's slowing a bit. So just wondering if you could comment or if there's anything that's changed on sort of the capital allocation leverage math that we should be thinking about with Comcast this year?"
},
{
"speaker": "David Watson",
"content": "Ben, Dave. So let me start with segmentation and a little bit more context on NOW. So stepping back, our segmentation strategy is really key. It starts with the beginning point always for us is premium and traditional broadband customers. We've focused there and invested in terms of better network, better products around providing a better service for the premium segment."
},
{
"speaker": "",
"content": "We have consistently competed for all segments. And as we break it down, we've focused where we think the main point is where broadband is going. And broadband is going is the engagement. And so our focus is to continue to deliver multi-gig symmetrical and build towards that point. And do this for a variety of Internet options. And the proof is in the footing in terms of segmentation in that 70% of our HSD-only customers receive speeds of 500 megabits per second or higher and 1/3 of our customers -- resi customers receive gig plus. So it never has been one-size-fits-all."
},
{
"speaker": "",
"content": "[ There is ] start there and the focus of premium. But there is currently a lot of activity at the low end of the market. And we've not been as competitive in this space. We've had great products and several options, but we -- in the prepaid area, in particular, we believe there is an opportunity to improve our effectiveness there."
},
{
"speaker": "",
"content": "And so thus NOW. And NOW, there are 3 components of NOW. One is prepaid broadband, which, by the way we've had prepaid broadband for some time. We've just approved upon the value proposition there. So it's a NEW prepaid broadband update. And second, we have prepaid NOW mobile, which is new and then we feel that it's positioned for an alternative to fixed wireless and just a lot of activity there. The focus there is there are no credit checks. It's easy."
},
{
"speaker": "",
"content": "It's no contract and on an everyday price point. So not a lot of movement in terms of just a competitive value-based price point. At the time we're doing NOW, obviously, it's a good alternative to ACP and where that goes. So early to talk about any progress but we're real pleased with the positioning of the NOW product for the income-constrained segment of the market. We've had NOW TV for some time and traction there. So it's a stand-alone product suite. I feel very good about that."
},
{
"speaker": "",
"content": "On ARPU, this is a strength that we've had. We've been balancing ARPU growth, along with share volume for a very long time. So we feel good about this quarter, came in very strong at 4.2% and a bit above the historical 3% to 4% range. It's a very competitive marketplace, to say the least, and we're just striking the right balance, we think, in volume and rate. And our approach is reasonable rate increase. The teams have managed this well leading to rate yield results that exceeded our expectations a bit."
},
{
"speaker": "",
"content": "But also it goes back to the first point. We're segmenting the marketplace and tailoring product approaches that meet each specific segment. So it starts with the high end that I've talked about and very focused there and the results that I've talked about. So that's the starting point. But when you look at our long-standing approach to pricing and packaging, we're going to compete for every segment. And it's really focused, though, where the market is going and making sure that in the long run as the overall usage goes up."
},
{
"speaker": "",
"content": "And to me, that is the main point. You have double-digit increases in terms of overall broadband consumption. You have lots of customers, a lot of interest in our high end of our portfolio and strength in a ubiquitous, reliable, great network that can stand up for every segment, but power through every application that is there. So I think for us, pleased with ARPU. And I think we can muscle through this ACP thing and feel good about the guidance that we've been giving at 3% to 4% historical range."
},
{
"speaker": "Brian Roberts",
"content": "This is Brian. I just want to just underscore that last point that Dave was making. As you look with a longer lens, which I -- hopefully, the company tries to do, there's -- and we -- just even yesterday, we're looking at our technology road map internally and seeing some demonstrations of innovation. It's inspiring and exciting to think about what broadband will actually help you do in the next 5, 10 years as a consumer and as a business. And it's kind of in some levels, unimaginable. A lot of discussion about AI but so much happening in the entertainment sector, sports sector and also in the health care sector, and then things we're not even talking about."
},
{
"speaker": "",
"content": "And so our strategy is pretty simple. But having NOW, this NOW strategy to help consumers with are super easy-on, it's all there in a prepaid market. But the main strategy has always been to have the superior product in the market with fantastic service and constant innovation and do it in a capital way where our investment is consistent and within the guidelines that we've previously talked about."
},
{
"speaker": "",
"content": "All that's happening, and we're making great inroads on that. And if I had to pick one number this quarter that excites me, it was a double-digit growth of bits per home, which is showing that usage for whatever it is, gaming, multi streams, whatever. And then the actual high definition becoming even higher definition over time with the quality of the picture. So hopefully, all that's useful, and we're pretty pleased with how the team is executing. Jason?"
},
{
"speaker": "Jason Armstrong",
"content": "Yes. Great. Thanks. So just to round that out, Ben, just you think your question specifically on ARPU and how do you go through the ACP cycle and have confidence in ARPU growth. I think all these points are relevant and valid. Number one, we continue to see usage grow at a rapid rate. So the value that the consumer is getting is higher. That's a tailwind in general for ARPU growth. I think number two is segmentation that Dave's talked about. We see a lot of competition in a certain segment of our base, the value-conscious segment of our base. The segmentation allows you to keep that from seeping into other segments of the base. And the team has done a nice job executing there."
},
{
"speaker": "",
"content": "Final thing I'd point out is as we said, ACP customers have got about 1.4 million in our base that we'll need to manage through. This is very similar, though, to -- if you think about how this business is wired, Dave and his team, it's promotional roll-offs. This is something we're dealing with every single quarter, how do you navigate a base of customers that's on promotion and roll them into new rate plans and keep them as customers? So this is very much what the Cable business is wired to do."
},
{
"speaker": "",
"content": "On buyback spend, I would go back and over the last few years. We've had a very consistent capital allocation strategy starting with reinvesting in our business, layered into protecting the balance sheet. We really like our current credit rating and have committed to metrics that are associated with the credit rating as you've seen. And as you point out, very strong free cash flow last year and expectation for similar this year. As you mentioned, allows for substantial share repurchase activity. So since we restarted the buyback in 2021, we bought back over 15% of our share count. If you look at the last year, we bought back over 6% of our share count. So both very strong metrics."
},
{
"speaker": "",
"content": "I would point out the tail end of last year, we were pretty clear in the third quarter that we were going to accelerate the buyback, anticipating minimum floor Hulu proceeds, which came in at the very end of last year. And that's in advance of more full proceeds for full value this year, but we did get a minimum floor payment last year and hence, accelerated the buyback in 3Q and 4Q to $3.5 billion."
},
{
"speaker": "Michael Cavanagh",
"content": "And Ben, I'll just come in on the back of the question about any changes in how we think about capital allocation. I think Jason and team are carrying on a phenomenal tradition. I've been here now close to 10 years. And I think the idea of taking our well-generated capital across our businesses, and first and foremost, investing them back in the business with a very long-term view of what the future can be, where there's expected return. Whether that's the Parks business, whether that's the broadband network, whether that's streaming, whether it's just broad innovation."
},
{
"speaker": "",
"content": "I think it's in our DNA at this place to try to figure out ways to invest wisely for the future, while at the same time, maintaining a very strong balance sheet and we like the way the balance sheet is set up. When you go through these long arcs of change across industries with disruption, it allows you to sleep better at night knowing the strength of balance sheet we have and allows us to continue making those earlier investments. And then so to do those 2 things together with the very substantial interest on the part of the management team and the facts that we've done it to just get lots of capital return to shareholders. Not many companies are inclined to manage those 3 priorities as much as we are. And I can commit that that's where our head is as we look forward to the next 10 years ahead."
},
{
"speaker": "Operator",
"content": "Your next question is coming from Craig Moffett from MoffettNathanson."
},
{
"speaker": "Craig Moffett",
"content": "Two questions about broadband, if I could. First, you talked about how your broadband business -- or sorry, your wireless business is helping broadband churn. I wonder if you could just talk a little bit more about that. How you -- first, can you put some numbers around the churn reduction that you see when a customer bundles broadband and wireless together?"
},
{
"speaker": "",
"content": "But more importantly, how do you think about wireless? Is it a stand-alone business to you? Or is it really in service of broadband churn? And then I wonder if you could -- maybe I was just -- I missed it. But Jason, I think you mentioned the margins for this domestic Cable-only business. But I think I may have missed the number. I wonder if you could just repeat that for us."
},
{
"speaker": "David Watson",
"content": "Craig, Dave. Let me start with wireless and then hand it over to Jason and folks. But let me -- wireless is an absolute integral part of our overall strategy. And specifically to your question, we've always thought the main value for us, wireless is connected with broadband. And that it adds -- it surrounds broadband with value. I think we don't give specifics on exactly the churn benefits, but we do see it. And whether it's acquisition-oriented, connected to broadband; whether it's base management upgrading; whether it's retention, wireless plays a role in all of them."
},
{
"speaker": "",
"content": "So it's a key growth opportunity. But it's also -- it's a product where our marginal economics are strong. So it's good to have that, but it's -- the way we go to market, it's connected to broadband and it's connected to packaging. So it's performing well. We like our consistency in the marketplace and love the fact that we have a good runway ahead only about 11% penetrated, now 7 million lines. And so I really like the opportunity in front of us. And for us, we've constantly been evolving our approach towards wireless and how we connect it with broadband and how we use it."
},
{
"speaker": "",
"content": "So we have, for example, new pricing plans. Our new mobile plants that are really targeting multiline customers excited about that. The new mobile product and segmentation. We've already talked about that in the prepaid area. And for that segment, we've had a Buy 1, Get 1 program for the base. So almost every single segment. And then just announced, the WiFi boost for our mobile customers being able to open up the public. The WiFis, hotspots and open it up as fast as devices can go and leveraging WiFi complement to mobile. So I think we've demonstrated that we're in this business, we love this business, and it's -- but it is definitely the core part of our strategy is how it impacts broadband over the long run. Jason?"
},
{
"speaker": "Jason Armstrong",
"content": "Craig, so on margins, we said overall connectivity and platforms margins were up 50 basis points and said domestic was an even greater increase. The domestic was up 70 basis year-over-year, sort of continuing the formula of a mix shift in our business to higher-margin businesses. Our connectivity businesses are growing faster than our nongrowth video businesses. So that's a margin favorable trade-off for us as we said historically and then operating efficiencies in the business. I think we gave a stat last call that I'd reiterate, we've taken 50% of our truck rolls out of the system in the last 6 years. We've taken 40% of customer interactions out of the system in the last 6 years. So lot of good progress on expense efficiency. But Craig, the domestic margin's up 70 basis points."
},
{
"speaker": "Operator",
"content": "Next question is coming from Jessica Reif Ehrlich from Bank of America Securities."
},
{
"speaker": "Jessica Reif Cohen",
"content": "I have a question on NBCU and also on Comcast Cable. On the Theme Parks, which is clearly one of your growth pillars, can you give us the investment levels you expect over the next 5 years? Obviously, Epic will be in there, so it will be a little elevated. But you have other new parks and you're also investing in the existing parks. And how different is the return on invested capital for Theme Parks versus your other businesses? And then one more on NBCU, are there other areas that NBCU should or you're thinking about investing in like video games?"
},
{
"speaker": "",
"content": "And then on Cable, on Comcast Cable. Just a question on your programming expense or programming contracts. Presumably, you have MSMs, I think you've always had them. How should we think about the impact on Comcast Cable programming expenses as some major programming contracts come up with other distributors?"
},
{
"speaker": "Michael Cavanagh",
"content": "Jessica, it's Mike. So on parks, as we've said, this is a year in 2024, where CapEx in parks and at NBCUniversal overall will sustain at the level it was in '23. So it remain elevated. In '25, when we open Epic, it will begin to step down. And then after that, it will return to a more normal level with adjustments for the Hollywood Hard Nights and the Kids park in Frisco, Texas that we've talked about. But those, as we've said, are not of the same size and scale as a large park like Epic but we do have a bigger footprint of parks than we did, say, 5 years ago."
},
{
"speaker": "",
"content": "So you're right, part of the part of the capital equation for parks is to continue to invest in new attractions within existing parks. So again, once we get to '26, you'll see us easing into a new steady state that does include continued experimentation with some of our alternative concepts. And then certainly, we hope over the longer term to come up with some ideas for bigger deployments of capital, but that's what we have in our plans as we sit here right now. But we love the business."
},
{
"speaker": "",
"content": "And to the question of returns, we think the returns are very strong. We take a careful look at that every time we're greenlighting a new park. And I think we like the stability of the long-term nature of the return. It's us and one other great company that are world leaders in that level of park experience. The response to our parks has been phenomenal coming out of COVID. And so we see that being a place, live entertainment at the level we're talking about, being just a strong pillar of the media and entertainment side of the company for a long time ahead."
},
{
"speaker": "",
"content": "And then in terms of other areas. I think the success that we've had across parks and experiences are -- lead us to plenty of opportunities to think about gaming and other areas around live entertainment that go around and cross between our businesses. So we experiment with things and we look, and it's our job to see if there are great opportunities to do that, but nothing to report today."
},
{
"speaker": "David Watson",
"content": "Jessica, Dave. Just so on your question on renewals and our point of view. Yes, look, from our view, there's not a single approach towards -- we handle it on a case-by-case basis. When you step back for a second though, we evaluate each one in 3 primary areas. One, the overall cost relative to the content, flexibility that's required in a very fast-changing environment and the overall consumer value. And so -- and we're going to look at this significant transition that has been going on. We'll continue to go on between linear and streaming. And so that is something that we think we can play a unique role in, in terms of win-win opportunities between the content providers and distribution."
},
{
"speaker": "",
"content": "And for us, we have a unique platform that is positioned well to be able to do -- handle everything that video can handle, linear channels, on-demand, DVR and streaming. We've been doing streaming packaging on the platform for some period of time. So we can build bridges as these things come up. And -- but our goal consistently has been to find win-win opportunities as we examine each and every specific renewal, but that's how we'll evaluate each one."
},
{
"speaker": "Operator",
"content": "Our next question is coming from John Hodulik from UBS."
},
{
"speaker": "John Hodulik",
"content": "Two, if I could, maybe first for Jason. Just finishing up on ACP. Given the strong start you guys had to the year and the strong ARPU, do you guys think that you can keep domestic cable EBITDA flat to up for the year even with ACP going away? That's first."
},
{
"speaker": "",
"content": "And then maybe for Dave, the wireless companies are definitely talking at sort of bigger game on fixed wireless in the business market. I know you guys had some sort of strong comments in the prepared remarks about the business market. But are you starting to see some increasing competition leak in at the low end because of fixed wireless?"
},
{
"speaker": "Jason Armstrong",
"content": "Yes, John, let me hit domestic or Cable EBITDA, C&P EBITDA over the course of the year. So I think as you mentioned, it's competitive market. We've got ACP coming our way. At the same time, the balance, I think about broadband specifically. The balance between rate and volume we've seen, obviously, a little bit of pressure on volume. But 4.2% ARPU growth in the quarter, an outlook for -- we continue to stay at 3% or 4% during the year. So we still think there's tailwinds for broadband revenue growth. We had 3.9% this quarter."
},
{
"speaker": "",
"content": "We're growing business Services, we're growing Wireless, and we're offsetting video and other revenue declines. But at the total level, that's a margin accretive mix shift. I'd go back to what I've said before on some of the expense initiatives across the company and being very disciplined, taking volumes out of the system and that's providing a tailwind as well. So without giving specific guidance for EBITDA growth, I would give you the components and our confidence in them."
},
{
"speaker": "David Watson",
"content": "John, Dave. So just a follow-on to Jason's point in terms of ACP. Remember, I think a really important point. We've been segmenting the marketplace, and I think we've had the industry-leading platform in terms of Internet Essentials for a very long time so a decade-plus. So we are familiar with the segmentation in this area and we're very familiar in terms of promo roles and bigger moments like this. So I -- because of that, in particular, the ARPU point that's connected to it is we feel pretty good about the historical range of 3% to 4%. So -- but we've had a long-standing approach towards this."
},
{
"speaker": "",
"content": "On your question around business services, there's no question, John, that we -- the SMB market has become a bit more competitive and fixed wireless is a part of that. So they are -- you've seen it in the results. We now have 3 fixed wireless competitors that are in it. When you have that much all at once, there's some impact. So we're seeing it in SMB. It's unique to SMB. But our game plan consistently has been to focus on both the share and the overall -- the rate and we have a great slate of products. We have multiple segments within Business Services, mid-market and enterprise that offset a lot of this and great product road maps that have."
},
{
"speaker": "",
"content": "But really important point as you feel competitive pressure, I think it's important to keep in mind, uniquely to SMB that reliability and ubiquity of our products and business services is really key here. For businesses, they get 24/7. They're always on. It has to work. I think over time, we will continue to press that point and have -- we're not going to chase things down to zero in terms of discounting. We're going to offer better products and surround those products with features that make sense for business customers. But we will make sure that customers know the reliability and ubiquity of what we do is unique and different than fixed wireless."
},
{
"speaker": "Brian Roberts",
"content": "And just -- Brian. One -- just again, just as we talked about in the residential market, the long-term opportunity where we're only just getting started is that large enterprise and medium-sized business. And as you think about cybersecurity and other data reliability and just consumption behavior of businesses and think of your own businesses and where that might lead to the use of new tools and video and everything else, you want to have the best network. And once again, we have a really exciting team and road map on that front. So again, we're battling the reality in one segment with great opportunity in others and long-term love our situation."
},
{
"speaker": "Operator",
"content": "Our next question is coming from Steven Cahall from Wells Fargo."
},
{
"speaker": "Steven Cahall",
"content": "Maybe first just on broadband trends. I think you've been pursuing a line extension strategy for, at least, 18 months and that will continue. So is it correct to assume that your gross adds on broadband are starting to pick up just as you add more passings in the market? And if that's true, can you give us any color on within the deactivations where they're headed? I think you've always said that you view fiber as the bigger competitive threat. And so does that kind of help us understand what's going on between gross adds and net adds?"
},
{
"speaker": "",
"content": "And then separately on Peacock. You talked about retaining subs between some of your big marquee sporting events and you've got a lot of great film on Peacock as well. I'm wondering what your tolerance is for original content and original content spend and how we think about originals on Peacock maybe, vis-a-vis, a long-term breakeven goal."
},
{
"speaker": "David Watson",
"content": "Steven, this is Dave. Let me start with footprint and then go to competition views. So let me -- in terms of overall footprint expansion, the vast majority of our new passings each quarter are fill-ins within our existing footprint. The balance of the growth is mostly from our organic edge-outs into adjacent areas. And so with some government subsidized builds representing a much smaller, albeit increasing portion. So it's really the kind of 3 different components of it that we're looking at."
},
{
"speaker": "",
"content": "And so it's still early and -- but we are very disciplined. We evaluate the risk adjusted returns of each -- one of these network builds on a case-by-case basis. And generally, though the edge outs as that will increase, they're adjacent, sometimes located in between geographic markets that we currently serve. So looking ahead, we expect these edge out projects to continue to contribute to the future growth in our total passings. And we don't give -- to your question, the specific numbers on this."
},
{
"speaker": "",
"content": "I could tell you that we're going to reach very healthy penetration levels in a few years on these edge out projects. So the ramp-ups happen pretty quickly, and we're pleased with the returns though. So pretty disciplined process. We look on the returns. And then as you shift towards the competition, the environment, let me back up and just its overall -- it's a very intense competitive environment that is very consistent the last several years."
},
{
"speaker": "",
"content": "And so it's picked up a bit. And when you have, again, 3 fixed wireless competitors coming in pretty much at the same time and you have the fiber level, about half of our footprint now has fiber competition of some form and it's an intense competitive environment. But we have adjusted. We've been going up against fiber competition now for over 15 years. And it is -- we've made adjustments. We've done, I think, very well in going toe-to-toe for the -- exactly as Brian laided out, that our long-term game plan is to focus on a better network, ubiquitous network, better products."
},
{
"speaker": "",
"content": "Surround it with the full portfolio of better products and not chase units just for the sake of it. And we've had moments going up against fiber where they've gone way down market. They've become rational. We've had different cycles. And so I think we've made adjustments and we have proven that we more than hold our own in that footprint. What we're seeing now is kind of an intense -- more intense competitive focus around the lower end of the market."
},
{
"speaker": "",
"content": "And that's why we're segmenting. That's why we're doing what we're doing, never losing sight though. That we're going to have a better product than anybody in the marketplace. The better network and backing it up with better devices, that can eventually -- as we get to multi-gig symmetrical. And that's the key. Every single application ubiquitously delivered, that's our focus. So it's a tough competitive environment but I think we have a unique differentiated approach."
},
{
"speaker": "Michael Cavanagh",
"content": "And so on Peacock. I mean we're very pleased as we split -- both Jason and I said earlier, with a quarter where we ended at 33.5 million subs, 3.5 years in. We are at a place now where we really are seeing traction in our approach to providing a service for consumers that is a combination of both entertainment and sports and how those 2 go together."
},
{
"speaker": "",
"content": "Very much a reflection, as we said from the beginning, of our -- a mirror image of what we see as our strengths at NBCUniversal itself. And so when you look at this quarter in particular, you end up with a start with a Wild Card game that brought in a tremendous number of subs ahead of where we expected it to be. And then retention, that was ahead of where we expected it to be. And so that's obviously great and the power of sports to bring audiences together and will stay committed because of our strength in sports."
},
{
"speaker": "",
"content": "But when you really reflect on what then happened in the weeks that followed our viewing was the record highs across all parts of our non-sports portfolio. And in fact in the quarter, we launched our biggest original, Ted, to the greatest success of any of the originals we've ever launched. And Traitors 2, our reality series on Peacock, both of those were in the Nielsen Top 10 streaming in the earlier part of the year."
},
{
"speaker": "",
"content": "So I think we see the 2 -- the parts of the portfolio interplaying well with each other. And obviously, the strength of our movie studio, which we talked about earlier with Oppenheimer and Holdovers and now coming up in future quarters, Kung Fu Panda 4. That is another great source of strength into our portfolio. So I think you can expect to see us having a very broad approach to it' sports, it' originals, it' next-day airing of NBC content, it's our library, and it's our Pay-1 movies. All those things going into a service that we think is one of the best values in streaming and a very distinct place over time in the streaming marketplace for consumers."
},
{
"speaker": "And when you look ahead from where we started the year, we are now in continue to focus hard on retaining the growth in subs we had. Second quarter will be a little lighter in terms of the cadence of our content. But when you look to the middle of the year, we've got Olympics. Right after that, we've got the return of NFL, Big Ten and our exclusive NFL game in São Paulo, Brazil, along with the tremendous movie slate",
"content": "Fall Guy, Twisters, Despicable Me 4, in addition to Kung Fu Panda 4."
},
{
"speaker": "",
"content": "And so we feel great about what we're doing and the progress we're making, and it's very consistent with the way we've described Peacock as taking advantage of what makes us great at NBCUniversal to begin with, and taking our existing strengths and assets into a digital future. So that's -- and it's one of our 6 big growth drivers, so glad to get a chance to comment on it."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Steve. Operator, we have time for one last question."
},
{
"speaker": "Operator",
"content": "Our final question today is coming from Jonathan Chaplin from New Street."
},
{
"speaker": "Jonathan Chaplin",
"content": "One for Dave and one for Jason. Dave, taking a step back from the sort of the increased competitive intensity you're seeing in the broadband market, I would love your perspectives on how the overall market is trending. As we tally up all the ads from the quarter, it looks like we're sort of trending to somewhere around half of what we normally see for the industry in the first quarter. Everybody's adds are down. And I'm wondering if you've got any thoughts as to what might be driving that?"
},
{
"speaker": "",
"content": "And then, Jason, on the segmentation strategy. You hit the low end of the market with some offers last year and then pulled back because you're worried about cannibalization. I'm wondering how the NOW -- you've sort of structured NOW differently so you don't end up seeing that cannibalization impact."
},
{
"speaker": "David Watson",
"content": "Jonathan, Dave. Let me start with the broadband in its entirety, the whole market and a viewpoint. So let me begin with the broadband market as a whole is still growing, maybe at a slower pace than it was last year and the year before, but there's still going to be a pretty healthy amount of net adds in 2024 and likely beyond. The right way, though, in addition to that, I think you got it. Everything we've talked about before, the right way we think to look about it is it's holding our own, growing relationships responsibly, but it's also where the market is going and how broadband is being used."
},
{
"speaker": "",
"content": "And that -- as we've talked about the utility of the broadband product itself is only going up. So when you look at the health of the entire category, it's the relationships, but it's also the overall usage and consumption. And for us, you can see usage is up double digits. Broadband-only subs using over 700 gigabytes of data a month. Over 70% of our subscriber base is on speed tiers of 50 megs or more, nearly 1/3 of our customers are on 1 gig. Those are great trends for us over the long term and gives us the great confidence as we're investing, continuing to invest in a better network and a better customer experience, as Brian has said."
},
{
"speaker": "",
"content": "So when you look at things, I think it's clearly competitive as we've talked about. One other factor that enters into it, in some cases, in certain segments. There are some people that revert back to mobile-only, that can happen. So there's a variety of factors that could enter into it. But overall, as a category and a growth opportunity, quite optimistic about broadband."
},
{
"speaker": "Jason Armstrong",
"content": "Jonathan, let me start on segmentation and Dave probably wants to chime in as well. So on NOW, I think what's interesting and exciting about it is it's a dedicated sort of flanker brand strategy. We've had prepaid offers in the past sort of wedged into our existing portfolio. This is a more dedicated and branded strategy around it."
},
{
"speaker": "",
"content": "By the way, the branding around this has worked very well in our U.K. market for Sky. It's actually where the brand name came from. And so we expect this to have some resonance. I would point out the -- if you look at where it's sort of targeted, we've got 100 meg offer for $30. It's inclusive of taxes, fees and equipment. We've got a $45 offering that's 200 megs and inclusive as well, very competitive versus fixed wireless, right? That is in this range, maybe slightly higher without the same reliability and ubiquity that we have."
},
{
"speaker": "David Watson",
"content": "Yes. Just adding on to that, Jonathan. But again, we've been doing prepaid broadband for a while, years. And it's just we needed to refresh it, needed to update it and put it in a more competitive position. The prepaid mobile is new, and NOW TV is relatively new. But it's a segmented approach. And if you think about -- it's all in pricing, it's very simple. It's really easy."
},
{
"speaker": "",
"content": "There's no contracts, no credit checks, customers can sign up, pause, cancel online, anytime. It's a very straightforward -- but feature-light product as we keep our focus on the high end in terms of fully featured things. We'll continue to do that. But this just gives us a brand, gives us a product suite to be able to clearly and define segmentation in a way that we can manage through."
},
{
"speaker": "Marci Ryvicker",
"content": "Thanks, Jonathan, and we want to thank everyone on the call for joining us this morning."
},
{
"speaker": "Operator",
"content": "Thank you. That concludes the question-and-answer session and today's conference call. A replay of the call will be available starting at 11:30 a.m. Eastern Time today on Comcast Investor Relations website. Thank you for participating. You may all disconnect."
}
] |
cme | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Welcome to the CME Group Fourth Quarter 2024 Earnings Call. At this time, I would like to inform all participants that your lines have been placed on a listen-only mode until the question-and-answer session of today's conference. I would now like to turn the call over to Adam Minick. Sir, please go ahead."
},
{
"speaker": "Adam Minick",
"content": "Good morning, and I hope you're all doing well today. We released our executive commentary earlier this morning, which provides extensive details on the fourth quarter 2024, which we will be discussing on this call. I'll start with the safe harbor language and then I'll turn it over to Terry. Statements made on this call and in the other reference documents on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance. They involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results and outcomes may differ materially from what is expressed or implied in any statement. Detailed information about factors that may affect our performance can be found in the filings with the SEC, which are on our website. Lastly, in the earnings release, you will see a reconciliation between GAAP and non-GAAP measures following the financial statements. With that, I'll turn the call over to Terry."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Adam, and thank you all for joining us this morning. I'm going to make a few brief comments about our record year in 2024 and some thoughts on the current business environment. Following that, Lynne will provide an overview of our financial results and our 2025 guidance. In addition to Lynne, we have other members of our management team present to answer questions after the prepared remarks. 2024 was the best year in CME Group's history and our fourth consecutive year of record volume with average daily volume increasing 9% to 26.9 million contracts. This growth was broad-based, with volume increasing year-over-year in all six asset classes, including all-time volume records in our interest rate, foreign exchange, metals and agricultural complexes. It was also a record year for our international business, which averaged 7.8 million contracts per day or up 14% from the previous record set in 2023. In addition to our impressive volume results, we continue to provide unmatched capital efficiencies for our customers. We have previously discussed that within our interest rates alone, the breadth of our offering results in margin savings in excess of $20 billion per day for our clients. It is worth noting that this margin savings applies across all the asset classes we clear. As you may have seen in the commentary we released this morning, our customers are now saving approximately $60 billion per day across all six asset classes. Commodities were the third fastest-growing asset class in 2024, with metals volume up 23%, energy up 17%, and ags up 13%. These businesses combined to generate a record $1.7 billion in revenue in 2024, up 16% versus 2023 and are off to another great start in 2025. Commodities growth came from every customer segment, led by the buy side, where we've seen significant increases in activity by global multi-strategy hedge funds as they expand in commodity-focused strategies. Geographically, the fastest-growing growth came from EMEA, where our year-over-year volume was up 34% across the commodities business. Commodity options also demonstrated strong growth with volumes up 29% versus 2023. Our growth has been driven by strong new client acquisition across both institutional and retail sectors. I've said many times in recent years that it's going to become more and more difficult to distinguish between retail and institutional trading behaviors. Technology is equalizing the access to data and improving the flow of information. This is bringing a new type of trader into our markets and will continue to grow the overall financial system. Over the last year, several large retail broker partners have joined our markets to meet this customer demand. As discussed throughout this year, we have increased our allocation of expenses to marketing and education of potential new clients. Given the strong financial results, we further increased this investment during Q4. In total, new clients added in the last five years have generated approximately $1 billion of revenue, including approximately 5% of transaction and clearing revenue in 2024. Moving into 2025, we continue to see strong volumes to start the year with new volume records in January and ongoing customer needs through efficient trading and hedging solutions. Shifting views around the global economy, persistent inflation, potential for changes in tariffs, and ongoing geopolitical tensions, all contribute to potential market movement and the need for effective risk management, which we will continue to provide to our clients. In addition to the impressive volume results I've outlined, we've delivered record financial results. With that, I'll turn the call over to Lynne to review these results in more detail."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thanks, Terry, and thank you all for joining us this morning. As Terry mentioned, we had very strong financial results, delivering our third consecutive year of record revenues and earnings in 2024. Our revenue of $6.1 billion grew 10% compared to 2023 and included all-time revenue records in all six of our asset classes. Our annual adjusted expenses, excluding license fees, were approximately $1.59 billion, including $85 million related to our cloud migration. Our adjusted operating margin for the year expanded to 68.3%, up over 140 basis points from 2023. We delivered $3.7 billion in adjusted net income, resulting in 10% earnings per share growth for the year. During the fourth quarter, CME Group generated more than $1.5 billion in revenue, a 6% increase from Q4 2023 on similar volumes. Market data revenue grew 9% from last year to $182 million. Expenses were very carefully managed, and, on an adjusted basis, were $520 million for the quarter and $436 million excluding license fees. CME Group had an adjusted effective tax rate of 21.8%, which resulted in adjusted net income of $919 million. Our adjusted earnings per share were $2.52, up 6% from the fourth quarter last year. Capital expenditures for the fourth quarter were approximately $28 million, and cash at the end of the year was $3.1 billion. CME Group declared dividends during 2024 of approximately $3.8 billion, including the annual variable dividend of $2.1 billion, which was paid in January. Turning to 2025 guidance, we expect total adjusted operating expenses, excluding license fees, but including cloud migration expenses, to be approximately $1.65 billion. Total capital expenditures are expected to be approximately $90 million, and the adjusted effective tax rate should come in between 22.5% and 23.5%. In December, we announced transaction fee adjustments, which became effective February 1st. Assuming similar trading patterns as 2024, the fee adjustments would increase futures and options transaction revenue by approximately 1% to 1.5%. Market data fees were increased by 3.5% at the beginning of the year. Additionally, we announced a 10-basis-point non-cash collateral surcharge effective in April for participants that do not post at least 30% of their margin requirement in cash. This change will ensure a minimum level of cash for risk management purposes. The financial impact of this requirement will be dependent on customer decisions and may result in an increased average rate on non-cash collateral or an increase in cash posted at the clearing house. As always, we focused on the total cost of trade for our clients and considered the impact of the collateral fee changes when reviewing adjustments to the clearing and transaction fees this year. In aggregate, the fee changes and cash minimum could add 2% to 2.5% to pre-tax income, assuming a similar volume and collateral levels. In summary, we're very proud of the results we were able to deliver as a firm this year, driving 10% revenue growth and 10% adjusted earnings growth from our previous record year of 2023. Consistent with the growth goal we discussed coming out of 2022, this year represented our third consecutive year of double-digit earnings growth. We'd now like to open up the call for your questions."
},
{
"speaker": "Operator",
"content": "Certainly. [Operator Instructions] The first question will come from Patrick Moley of Piper Sandler."
},
{
"speaker": "Patrick Moley",
"content": "Yes, good morning. Thanks for taking the question. In the release today, you mentioned that retail remains a bedrock of the new customer acquisition strategy. You're currently in the process of rolling out futures to Robinhood's 24 million customers. So, I know it's still pretty early, but I was hoping you could talk about maybe how additive you think that this rollout could be to volumes this year, and then if you could just maybe speak to the broader retail strategy and any other opportunities that you see out there on the horizon."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Patrick. Let me turn it over to Julie Winkler. She can discuss a little bit about that and I'm going to chime in after she's done."
},
{
"speaker": "Julie Winkler",
"content": "Sure. Thanks for the question, Patrick. On the new client acquisition front, about two-thirds of that $1 billion number that Terry referenced in his comments are driven by our retail business. Q4 was another really strong quarter for us in terms of total participation being up, the number of traders being up 6%, and that NCA number was up another 23% year-on-year. All regions, we saw growth there as well, and that was great because we saw that really also across all of our asset classes with kind of FX and metals certainly leading the charge there. The micros, volume is in product, I think it's continued to be a sweet spot for us in our retail business. So that volume was up 2.8 million contracts and ADV in Q4. So that was up 11%. And what this all has meant and you referenced it is we've been working with many new futures brokers over the last year. I think their interest in coming into this space is that sophistication of trader that Terry mentioned earlier, a lot of this is about reaching this customer base with education and growing awareness. And what is also appealing is our very diversified product offering. So, while we have the micro equity suite, we are also seeing a lot of uptake in crypto and commodities as well, which is great. Robinhood did launch a couple of weeks ago. They are continuing to do a phased rollout among their customer base, so very similar to what we've seen with other broker partners as they enter into the space. We're excited about that and certainly opportunity to work with all of these global partners. We have about 100 that we partner with around the globe, and we do have some other additional ones coming online as we look ahead into 2025. And I think the other kind of context around this is just this retail business is also a huge contributor to that international performance as well. And so, as we see retail grow, that is a big contributor to those international results with the 7.8 million in ADV, which was up another 13%. So, we're excited with our diverse product offering, the global appeal of our products and certainly being able to partner with these great broker partners and providing education and awareness. So, we feel like the outlook is good."
},
{
"speaker": "Terry Duffy",
"content": "So, Patrick, what I would just add to what Julie said is that I think, as I said earlier, the lines between institutional and retail are continuing to get more and more blurred. We're referring to our current institute -- our current retail business, which is more of a professional sell trader. I think the definition of that retail participant is going to continue to evolve over the next several years, and we might be saying something a lot different about what a retail participant looks like. So, to say what it can look like just that one particular broker or another may not be fair. How they access markets, the ease of accessing markets, the new risk management tools that technology and artificial intelligence will allow us to deploy will help us broaden the scope of what we define as retail today, tomorrow. So, that's what's more exciting to me than just a current retail trader. Even though it's an exciting business, I think that's going to continue to evolve and be defined in different ways in the upcoming years."
},
{
"speaker": "Patrick Moley",
"content": "Okay. Thanks for that. And then, one quick follow-up, Terry. In the fourth quarter, you received approval from the NFA to establish your own futures commission merchant. You did put out a press release after saying that you're committed to the existing FCM model. But just was hoping you could maybe talk about what strategic benefit does this give you going forward, and would there ever be an instance where you would look to utilize it. Thanks."
},
{
"speaker": "Terry Duffy",
"content": "I don't know if there would be a situation for me to utilize it or not. At this given moment in time, there is not. And I have said that we will not dislocate our current FCM partners with our FCM license that we now hold. I think it's important and I've said this for a lot of years, you cannot try to get prepared when things change. You need to be prepared prior to that happening. And this is just another step in us putting pieces of different parts of the equation in place if in fact, market structure changes, behavior changes or the business changes a little bit. I'm not going to wait or the future of this company will not wait until that happens and try to deploy those types of assets that you don't have at the time. So, it's really important for us to have those in place. My viewpoint has not changed. I am not looking to dislocate or disintermediate any of my FCMs today."
},
{
"speaker": "Patrick Moley",
"content": "Okay. Thanks. That's it from me."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Patrick."
},
{
"speaker": "Operator",
"content": "The next question will come from Alex Kramm of UBS. Your line is open."
},
{
"speaker": "Alex Kramm",
"content": "Yes, hey, good morning, everyone. Just quickly on capital allocation and more specifically on buybacks. I don't think you've spoken since you got the authorization for the $3 billion. Any updates or can you just elaborate a little bit on how you're thinking about buying back stock? Is it consistent? Is it more dependent on what the stock is doing? And then, of course, how -- what have you been doing with it so far? Have you been buying stock? And what are the near-term plans? Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Alex. Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. Thanks, Alex. So, I would say, as you saw with our most recent announcement on our dividend last week, we raised that from $1.15 to $1.25. We continue to view that as an important use of our capital. And just a reminder that we did pay out the variable dividend here in mid-January. So, our excess cash that we built up over the course of last year just was paid out in that variable dividend. So, as we look to go forward with this new lever we have with the repurchase program, I would describe it as opportunistic. We're viewing this as kind of the third means that we have to return capital to our shareholders, and we'll continue to use those three levers that we have."
},
{
"speaker": "Alex Kramm",
"content": "All right. That's it from me."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Alex."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thanks, Alex."
},
{
"speaker": "Operator",
"content": "The next question will come from Michael Cyprys of Morgan Stanley. Your line is open."
},
{
"speaker": "Michael Cyprys",
"content": "Hey, good morning. Thanks for taking the question. Just wanted to ask around product development opportunities around climate events. Just given we've seen more severe weather patterns and natural disasters and events in recent years, just curious how you see the opportunity to help more customers manage risk here. You already have weather contracts. I guess, what's the potential to broaden out that product set more fulsome? It seems the insurance industry may have some challenges from some of these events. To what extent can a capital markets-based contract be part of the solution? How are you thinking about that?"
},
{
"speaker": "Terry Duffy",
"content": "Yeah. Thanks, Mike. I'll let Derek address that and then I want to give a comment also to it."
},
{
"speaker": "Derek Sammann",
"content": "Yeah. Thanks, Mike. The short answer is the market is already using our products and services today. You made a great point about weather patterns. That's one of the primary drivers of what's going on in our record activity in our ags markets from 2024. And if you look at where we're starting 2025, our ag business is up 32% year-to-date and growth in almost 20% of open interest as well. So, I think we're seeing significant participation for folks looking to understand the impacts on real economies. They're playing that through our ag markets and our grains and oilseeds markets. We're also seeing that play through the energy markets, particularly in nat gas, since nat gas is becoming increasingly the power source for both heating and cooling. When you look at our record results in last year from nat gas and carrying over into this year, most important, our options is up 61% last year. So, as these unplanned but now is, to some degree, expected dislocations in weather patterns, we're actually seeing folks increase their use of our energy products to adapt for that and using options as a large proportion of that. You also rightly mentioned our weather-driven market. We are the largest weather-driven market out there. We finished the year at about 90,000 contracts open interest. 70% of that is in the form of options. And that tells you I think we've got sophisticated end user buy side and commercial customers using that market, not just directly in our own derivatives, but that actually sets a lot of the prices for a number of indexes and OTC transactions that trade-off the back of that are indexed to and then hedge back into our weather market. I think the kind of last piece to this that we're seeing this play out is in the energy transition economy. When you look at our metals business, we are the leader and putting up substantial growth in our battery metals business, whether it's cobalt, lithium or the spodumene product we launched just a few months ago, as folks are looking at not just the disruptions to market, but what the alternatives are. They are playing that through our battery metals market. They're playing that through our ethanol contract with the largest ethanol market out there. And we just launched a physical ethanol contract last week. And the first two trades were actually two large agricultural customers. So, the last piece of that is what we're seeing in the industrial metals market. So, as more work is put into the grid to reinforce our energy sector here in the US and globally, that runs right through the middle of the copper market as well as the battery metal market. And those are two markets where we're seeing record growth. So, we certainly see that the weather-driven niche itself has room to grow, but we're seeing the market already adopting market-based solutions in CME Group products. And that's why Terry referenced at the top of the script that our commodities asset classes, energy, ags, metals, are the three fastest-growing products in '24 and we're out of the gate strong in 2025 with ags up 32%, energy up 25%, and metals up 14%. So, we'll continue to talk to our customers and fill that need into the portfolio, but we're seeing them already use market-based solutions here at CME Group."
},
{
"speaker": "Terry Duffy",
"content": "Just to add to that, Mike, I think what the comment that I read yesterday by Fed Chair Powell about -- talking about how mortgages could be unattainable in many parts of the country due to insurance reasons, and you raised this in your question, and I think it's a much bigger concern than people are thinking about. Derek referenced our products today that can help manage and mitigate some of those risk, but we're looking at other ways to continue to roll out products that might be more tailored towards that industry. Again, this is just in the pipeline with nothing to announce now. But I do think that is becoming more and more of an issue when it's not so much about can you qualify for a mortgage, can you qualify for a mortgage and get insurance also. So, that's a big issue, and again, I think that's another reason why risk management is going to be a priority in the outyears going forward."
},
{
"speaker": "Michael Cyprys",
"content": "Great. Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question will come from Benjamin Budish of Barclays Capital. Your line is open."
},
{
"speaker": "Benjamin Budish",
"content": "Hi. Good morning, and thanks for taking the question. Terry, I was wondering if you could talk a little bit about -- a little more about your product expectations on the retail side. Curious, it looks like looking through some of your micro products, the equity indices have been sort of the lion's share. I'm curious what your sort of expectations are in terms of engagement. How do you think about maybe for that product, specifically competition with other sort of S&P derivatives? And then, I have a follow-up on pricing."
},
{
"speaker": "Terry Duffy",
"content": "Okay. Thanks, Ben. I look at the retail business, as Julie referenced, it's a massively growing business. And as I said earlier, technology is just enabling more and more participants to facilitate their own risk management, learn these products. I think education is absolutely key for retail. And those are a couple of things that we are really focused on, making sure they understand what they're doing. But with retail, as you know, the speed-to-market is critically important. They don't want to sit around and wait for two weeks to be facilitated to try to open an account. They need to expedite that process. So, I think that business will continue to grow and bolster. More and more people today -- the young people today are managing their own risk. That's only going to continue. It's not going to go the other way. I'm really excited about retail. And as I said a moment ago in the previous question or two, I really think the definition of retail is going to be critically important to the growth of that industry and see how we define it. Is it more mainstream versus professional? Is it a combination? Does the professional just get a little bit larger? There's a lot of different factors here. I think a lot of those can all come true at the same time. So, this is pretty exciting. I'm going to ask Julie to comment more on the retail as it relates to the growth of it."
},
{
"speaker": "Julie Winkler",
"content": "Yeah, it's a great question. I do think similar to my answer from earlier, I think the diversity of our product suite is a real differentiator for CME. So, while we have historically seen retail customers come to us first to trade our micro equity suite, I'd say that trend is -- tends to shift given those strong macro trends that Derek spoke about earlier. The commodities interest there, especially when we look over to APAC is really strong, which is kind of contributing to our recent announcement as well about the micro ag contracts coming. So, we believe both with that as well as what we see with crypto, it's interesting that we are attracting customers with new products differently than maybe what we had in the past. I think the other trend that supports that is some of our new to futures participants are actually targeting a different segment, right? So, they may be existing CFD providers. And so, their entry point to come over into futures is going to be different than our traditional partners in this space. But the great thing is, we're still continuing to see great -- really strong year-on-year growth from our existing partners as well. So, a lot of this comes down to building awareness, making sure they have the product education that they need, and our team is working very closely with them on that front. And this allows us to easily cross-sell with what is interesting and what products are moving at that point in time."
},
{
"speaker": "Terry Duffy",
"content": "And just to add to that, the new reference competition, and Julie touched on a little bit, for us, with all the different asset classes that I referenced in my opening remarks hitting all these new highs, it is really important that you introduce new potential retail clients into something they feel they know something about today. So, if you come up with a very difficult product for them to try to understand, so if you listed a SOFR contract to the retail participants, they might have a more difficult time participating in that than they would in a gold, silver, oil, or some of our other contracts that are more mainstream that they hear about every single day. So, the question is how could we customize those products for their ability to participate? And those are the things that we're working on. So, I think from a competitive standpoint, to your competitive question, Ben, along with the crypto, we're in a really strong position to introduce these to a whole new audience of retail participants."
},
{
"speaker": "Benjamin Budish",
"content": "Great. I appreciate all the color. And just one housekeeping question maybe for Lynne on the sort of pricing change expectation. I just want to make sure I had it correct. The fee adjustments on the trading side, side, 1% to 1.5%, and then adding the sort of fee changes to cash minimum, so that add another 1% on top. So, the total is 2% to 2.5%. And I also wanted to double-check, does the transaction fee piece, is that sort of net of incentive changes, or is that the sort of pricing changes in isolation?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, the incentives are included in that. So that's the expectation. We always are looking at not just rack rate changes, but also incentive changes. So, if you look at that 1% to 1.5%, that is inclusive of the changes being made there. Now, the thing you have to be conscious of on the other elements, so the collateral fee, it's going to be based on customer choice. So it could lead to a higher rate that we capture on the non-cash collateral that would flow through other revenue, but it also could mean that our customers would post more cash, which is the goal of this structure because we want that cash from a risk management perspective. So, if we see a shift to cash, you would see more of that come through in the non-operating income. So, when we talked about that 2% to 2.5%, that's a pre-tax earnings number because we don't know yet if we'll see the increase in the other revenue or in the non-operating income. It will depend on that decision by the customer base."
},
{
"speaker": "Benjamin Budish",
"content": "Okay. Very helpful. Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Ben."
},
{
"speaker": "Operator",
"content": "The next question will come from Chris Allen of Citi. Your line is open."
},
{
"speaker": "Chris Allen",
"content": "Good morning, everyone. Thanks for taking the question. Wanted to ask about your securities clearing build-out there. Just kind of where that stands currently? You talked in the past about having this as an option if the marketplace demanded relative to the kind of incumbent. So I'm just wondering where that kind of stands and how you think about it from a revenue opportunity standpoint longer term."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Chris. It's a good question. And I'll turn it over to Suzanne Sprague, our Chief Operating Officer and Head of Risk and Clearing. Suzanne?"
},
{
"speaker": "Suzanne Sprague",
"content": "Yeah. Thanks, Chris. So, we're pleased that our application for our securities clearinghouse has been published now in the Federal Register in January of this year, and we continue engaging with the SEC toward approval. We are excited about the opportunities that that license could bring in terms of generating additional value for our customers. We also continue partnering very closely with the Fixed Income Clearing Corporation to expand our cross-margining program with FICC, not only for the existing house account structure that's in place today, but to expand that offering to clients as well. So, capital efficiencies is a large focus for us as we've talked about already on this call, and both with our own securities clearing offering and continuing to expand that partnership with FICC, we're looking forward to being able to deliver that in a larger way."
},
{
"speaker": "Terry Duffy",
"content": "So, Chris, sometimes you hear folks, especially recently, say that this could be delayed and that's not a surprise. Anytime you implement a new policy, everybody thinks they might be ready, but they're not. But I think what's really important, Suzanne touched on it, and we've been touching on this for quite a while is the benefits that this clearing offering offers to the clients by freeing up a bunch of capital for them. So, even though it may be delayed and some people think that they don't want it, when you look at the savings, they're just truly undeniable. We're referencing $60 billion of margin efficiencies when we're referencing $20 billion of rate efficiencies alone within CME. These are -- I testified a lot back in 2010, during Dodd-Frank. And the biggest opposers are the biggest beneficiaries today of central clearing and the offsets that they get to free up their balance sheet in lieu of some of the other requirements that have come at them on their balance sheet. So, this is a huge bonus for the participants going forward. So again, whether they use fixed offering or whether they use ours or someone else's, we think this is a benefit for the industry. So, we're looking forward to pursuing it."
},
{
"speaker": "Chris Allen",
"content": "And just on that point, have you done any work to kind of quantify what the margin-saving potential that you would theoretically see for the industry?"
},
{
"speaker": "Suzanne Sprague",
"content": "No. At this point, it's hard to tell. I think choice is important here. We have seen an increase in clearing members to take advantage of the existing house account program with the Fixed Income Clearing Corporation, and with expanding it to client, that presents additional opportunity for clients to be able to maintain that relationship that they have today in the marketplace and gain the efficiencies at the clearing level through the existing structure, as well as bringing online new offering through the CME securities clearing house. So, there's a lot of moving parts. I think choice is key for these market participants, especially as the clearing mandate evolves. It's hard to anticipate what those numbers will look like given all of those variables."
},
{
"speaker": "Chris Allen",
"content": "Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Chris."
},
{
"speaker": "Operator",
"content": "The next question will come from Dan Fannon of Jefferies. Your line is open."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. Terry, I was hoping you kind of -- you could expand upon your comments on just the outlook for activity, knowing you obviously don't have a crystal ball, but maybe just discuss the set up as we sit here in kind of mid-February of 2025 after several record years of growth for you, what are the kind of building blocks you think of growth and activity as we think about 2025 from a transaction perspective?"
},
{
"speaker": "Terry Duffy",
"content": "Yeah. Dan, my outlook really hasn't changed a lot over the last several years. I think it's going to be a very difficult environment for a lot of companies and individuals around the world and you need to manage and mitigate that risk. I mean, nothing has really changed from a year ago except we acquired just a touch more debt. So, when you're looking at $36 trillion here in the United States of debt, $36.5 trillion, $1.9 trillion deficit, you have the political issues in Washington about people trying to cut spending, potentially cutting taxes. There's so many moving parts right now. It's hard to say that people can -- will not be able to manage that kind of risk because it has such an impact on everyone's business, what rates do or don't do. Even the smallest rate increase or decrease could have a massive impact on the balance sheet with these kind of numbers outstanding. So, I think geopolitically, we're still looking at, the conversation around deregulation, which we haven't really gotten to in President Trump's agenda. He is dealing with other issues right now. He's got a very large agenda. So, it's going to be fascinating. But I think all these twists and turns that he has presented, which is exactly what the American public devoted him in to do and he's telegraphed it to a [T] (ph), so this shouldn't be a surprise. They all have a cause and effect on the economies, not only in the United States, but globally, and I think people need to mitigate and manage that risk. So, I do believe that you're going to continue to see a very active marketplace. Derek referenced some of the commodity products. I think -- and I referenced them in my early remarks for a reason. I actually think that you'll start to see more commodity index funds participating, trying to manage that risk, whether it's due to tariffs, whether it's due to weather, whether it's due to a lot of things. And then, of course, when you look at foreign exchange, right now, foreign exchange is jumping around quite a bit because of the potential tariffs that we haven't seen in a while. These are all things that you don't -- we haven't seen. They've been a little quiet lately that could come to the forefront in 2025. So, actually, I'm pretty optimistic, again, across all six asset classes for CME. There is a lot out there, Dan, as you know. And so, even though we feel like our lives are going well and things are going good, there are still a lot of dangerous places, especially economically around the world that we have to deal with. So -- and I think that's what we're here to manage."
},
{
"speaker": "Dan Fannon",
"content": "Great. That's helpful. And then, just as a follow-up, in terms of capital return, I understand the buyback and the dividend, but on an inorganic or M&A perspective, can you remind us around the framework of how you're thinking about that? And ultimately, has that changed at all given maybe looser potentially standards around M&A that maybe broadens what you would be looking at under the current administration versus prior?"
},
{
"speaker": "Terry Duffy",
"content": "Yeah, I'll take the second part of the question, and then I'll give the first part to Lynne. It's yet to be seen what the regulations are going to be around M&A or not. It was a difficult environment under the Biden administration from the DOJ perspective to get some deals done and even IPOs out the door. People are talking about how this could be different this year. It's really hard to draw a conclusion, Dan, when we're a couple of weeks into the year and we haven't seen a whole lot of activity just yet on deregulation or new companies coming forward. So, I think that's going to take some time to get into the system to see if that materializes one way or not. And I will let Lynne talk about the former, on the repurchase."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, I think, Dan, our approach to M&A is the same that it has been. We put ourselves in a good position from a balance sheet perspective. We're very conservative there so that if the right opportunity comes up, we have the capacity and the ability to act, but we tend to be a bit more choosy, I guess, I would say, and not as acquisitive as some of the others in our space. We typically are looking for things where there's a clear path to value and something that is in our core competencies, if that's risk management, running markets, creating capital efficiencies for our clients. So, we continue to look just as we always do, and if the opportunity were to be there, we're more than happy to execute on M&A."
},
{
"speaker": "Terry Duffy",
"content": "Yeah. Dan, we're focused on so many different things. But one of the things I keep telling my team is you have to be able to look over your shoulder and see a pipeline of clients coming down in the future in some way, shape or form, because there's a lot of business turning around right now and not seeing anybody. That's not the situation for CME and we're going to make sure it continues that way. So, we are looking at not just some of your traditional ways if you want to call M&A, but other avenues in how we build this business. But it's really important, as I referenced earlier, to make sure that, that customer base is continually educated and coming into your doors at the pace that they need to come in here with. But it's important to make sure you look over your shoulder and know there's a pipeline of participants coming. And that's what we are working towards and doing right now."
},
{
"speaker": "Dan Fannon",
"content": "Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Brian Bedell of Deutsche Bank. Your line is open."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thanks. Good morning. Thanks for taking my questions. If I can come back to the retail theme, and Terry, especially your comments around the blurring of the retail users, it sounds like it's mostly between individuals and professionals. I mean, just in terms of identifying that, I guess, the simple question is, aren't they all coming in from retail-oriented FCMs, or where is there a mix that you can't tell? And is the blurring simply on, say, retail professional traders and then how you treat them differently from retail? And then, the tangent question to that is, to what extent are they interacting directly with CME in things like data and analytics as opposed to say at their retail brokerages? And is that -- to what extent is that an opportunity to create more vibrant data and analytics for that retail class?"
},
{
"speaker": "Terry Duffy",
"content": "Yeah. Thanks, Brian. Appreciate the question. And again, what I was referring to in my opening remarks between retail blurring was more on the institutional, not splitting the hairs of what a retail client is today versus what it might look like tomorrow. I did reference that I thought that the definition of retail is going to change over the years. I didn't reference that it's changed to date. So, I think what I'm referring to when I say they're blurred, I'm referring to the retail versus institutional today. Why? Because the professional retail has technology and a lot of other tools that did not have five, six, seven, 10 years ago that they do have today and they're coming more at a much cheaper cost than they historically have. So, that was my comment around blurring between current retail and individual. Now, as it relates to retail to retail versus the individual that you referenced, I think that definition will change as well. It just hasn't been defined yet what it's going to look like. So, I want to make sure I'm clear on that. I'm not saying that's changed to date. I'm suggesting that it will change tomorrow. And why will it change? I think it is going through our existing FCMs today. I think it will continue to go there as they continue to embrace, bring in new tools to allow clients to -- that they feel comfortable with managing. There's been kind of a pushback from some people about not wanting to have certain clients in their FCMs because of the risk profiles associated with that. And I can certainly understand that. But I do believe that some of the new technology tools and risk management protocols will allow that universe to grow. So, that's what I was referring to. As it relates to the data and analytics, I'm going to ask Julie to comment on that."
},
{
"speaker": "Julie Winkler",
"content": "Yeah. No, great question. And I think we have seen some great trends there. I think it plays to the point earlier about just the growing sophistication of these users. They are big users of data. They are looking at analytics to make their trading decisions. And I also think, right, that trend towards just how these communities are connecting online and getting trading ideas from one another is also contributing to what we're seeing with this retail flow. So, as it relates back to our data business from -- we had a record quarter, certainly, we are up 9%, but specifically as it relates back to this non-professional device usage, we saw an increase just even from Q3 to Q4 of almost 40% from our vendors and our brokers in terms of increased units that they were reporting to us on a non-professional or retail basis. So, the demand and the interest is there. And our retail brokers are also offering things in that way. They know they need to provide robust data and analytics in order to continue to attract and educate them about what's going on in the marketplace. So, I think that is a key component as we think about this. I think the other trend that I would look at is we're seeing a lot of increased usage of options among the retail client base as well. And that again, I think, speaks to increased sophistication and we're seeing a lot more of our retail brokers being in a position to offer options as 2024 progressed and looking into 2025, and I think that blends nicely with just the need for data and analytics as well."
},
{
"speaker": "Brian Bedell",
"content": "That's helpful. And can you cite like what portion of your revenue you think is coming from that retail or pro-retail? Or is that too difficult to assess?"
},
{
"speaker": "Terry Duffy",
"content": "We have broken out some of the retail revenue, but not by -- not so granular by individual. I think, Julie, you have some..."
},
{
"speaker": "Julie Winkler",
"content": "Yeah. I don't think we've historically disclosed what that portion is. What we've said is of our new client acquisition, that's two third of the $1 billion that we've seen over the last five years, which was contributing 5% of our transaction revenue."
},
{
"speaker": "Brian Bedell",
"content": "Got it. And then if I could just ask one last one for Lynne on the cash collateral? If you can go through the rates coming into 1Q on the cash collateral? And is there -- has there already been any change with the new program coming into this year?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, if you look at the start to this quarter, the US cash balances have ticked up a bit from where they were in Q4. So, we had $75 billion on average in cash in Q4. Quarter-to-date, we're running at $77 billion. On the non-cash collateral, we were at $178 billion in the quarter, and quarter-to-date Q1 is $175 billion. Now, the change on the non-cash collateral fee and the cash minimum does not take effect until April, so you won't see that change this quarter."
},
{
"speaker": "Brian Bedell",
"content": "Got it. Okay, great. Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Brian."
},
{
"speaker": "Operator",
"content": "The next question will come from Bill Katz of TD Cowen. Your line is open."
},
{
"speaker": "Bill Katz",
"content": "Okay. Thank you very much. Just circling back to the regulatory backdrop, Terry, I'd be curious what is the most recent update as it relates to the competitive backdrop on the interest rate contract and the US Treasury contract. I know there's been a lot of back and forth during the quarter in terms of some congressional commentary, but what's the sense here in terms of the sort of regulatory scrutiny around US/non-US interplay for that part of the platform? Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Yeah. Thanks, Bill. And I think the change is more clarity. And I think there was a lot of miscommunication of what I was saying and what CME was saying as it relates to the competitor's offering, which was that LCH is a duly registered clearing house in the UK and the US. I totally agree with that, where the monies of the depositors could be kept in US banks or non-US banks, I totally agreed with that. So, I never argued the things that they said I was arguing about. I argued about the default and resolution of the lending clearing house, which falls under the exclusive jurisdiction of the Bank of England. Now, if you took the rate swaps market that's cleared at LCH is bigger than the damn country, that is going to be a massive focus for the Bank of England when you look how big that market could be and if there was ever a default. If they were to try to clear US foreign sovereign debt on futures, which is larger than the cash market on a turnover basis, in that country and the US did not have a seat at the table or have any authority on default and resolution, we feel that that's detrimental not only to the US Treasury market to the people who own that debt because when you tear up trades, it's not where even a small portion if someone gets sick, we all get a cold. When you're talking about a market as big as $28 trillion, if someone gets sick, we all get cancer. That's a bad outcome. So, it's important for the US under sovereign debt under the Treasury Department, and you heard what Secretary Bessent said at the hearing that it's important that the United States of America has the resolution authority embedded in the US. So again, I've been making this argument for a long time and I think people are realizing it and we'll see where it goes. But I feel good that people are understanding the differences now versus where we were at just a few short months ago where others on the other side were trying to confuse the issue. And even our new Commerce Secretary, which will probably be voted on this week, when asked in the committee by Senator Cantwell, he gave a very convoluted answer that had nothing to do with what I just referenced."
},
{
"speaker": "Bill Katz",
"content": "Okay. Thank you. And maybe just coming back to pricing for a moment, just want to make sure I understand this. Just looking at my notes from a year ago, I think your pricing in futures and options was up 1.5% to 2%, and I think I heard today a little bit lesser rate, about 1% to 1.5%. A, am I thinking about that on a like-for-like basis? Is that the right way to think about it? And B, if that is the case, can you talk a little bit about maybe the puts and takes of where you saw the greatest pricing capabilities maybe by either trading class or geography or by clientele type? Thank you."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, Bill, thanks for the question. So, you're correct. The adjustment on the clearing transaction fee is a bit lower this year than it was last year. It's not unusual for us to pull different pricing levers. What we're always trying to make sure is that we don't impact the velocity of trade coming across our system. To us, it's not just focused on RPC. It's how we continue to drive healthy volume given the high incremental margin that we deliver -- that we achieve on that next trade. So, you have to balance not just changes on clearing and transaction fees, you got to look at the changes on data as well as the changes on collateral. As we talked about, there was this new soft minimum that was put in on the collateral side, which did have an impact to our client base. So, the mix shifted a bit away from the clearing and transaction fees. You want to look at where those changes were impacted the most. We made changes in the crypto complex as well as metals, both on the micro side and options, also in nat gas and our grains complex in our agricultural commodities. So, those were the contracts that we saw the largest increases this year."
},
{
"speaker": "Bill Katz",
"content": "Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Bill."
},
{
"speaker": "Operator",
"content": "The next question will come from Owen Lau of Oppenheimer. Your line is open."
},
{
"speaker": "Owen Lau",
"content": "Good morning, and thank you for taking my question. So, you mentioned crypto multiple times on the call. With increasing regulatory clarity, how does CME think about further expansion into this space? Would you consider launching more derivative products for tokens other than Bitcoin and Ether? And what does it take to go there? Thanks."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Owen. And I think it's a very interesting asset class. As you know, we were one of the first to come out with a crypto -- with Bitcoin in 2017 under the regime and rules that we put forward and we think that was a very smart way to approach listing Bitcoin. And then, you can see in the numbers today, it's reflective of the growth of that product and along with Ether. As far as other products go, I think it's going to be really important for us to consult and work with the SEC to make sure we get their comfort level about what's deemed to security and what is not. And that is yet to be decided from that agency. We continue to work with them, but we will not front-run them in any way, shape, or form on other cryptocurrencies until we have much deeper conversations. But there are some -- there is an appetite out there. I'll turn it to Tim McCourt, who runs that asset class, to talk a little bit more about the potential appetite for those other currencies."
},
{
"speaker": "Tim McCourt",
"content": "Great. Thanks, Terry. And Terry is absolutely right. Our longstanding approach to the cryptocurrency business at CME Group is to be the trusted and transparent regulated venue, and we're going to continue to wait for the regulatory clarity and certainty before we introduce additional products on additional tokens and cryptocurrencies. We've been rewarded to date because of that because the secret to our success is listening to clients for demand-driven product development to meet their risk management needs in this new asset class. It continues to grow. nd when we look at just even this month in February, we had our largest trading date in cryptocurrency with almost 700,000 contracts trading on February 3rd, continuing to establish records across Bitcoin and across Ether in both standard and micro-sized contracts, and continuing to innovate in the Bitcoin and Ether lanes. That is where we have the certainty and clarity at present with our regulators, and we continue to introduce products like the Bitcoin Friday futures, the financially cash-settled Bitcoin Friday future options, and continuing to introduce additional order types and transactional handshakes around Bitcoin and Ether. And that will continue to grow in 2025, and we look forward to working with our clients and the regulators to see what additional products make sense in the future."
},
{
"speaker": "Owen Lau",
"content": "Got it. That's super helpful. And then quickly, going back to the fourth quarter futures and options RPC, it was $0.701, up from $0.666 in the third quarter because of a mix-shift towards higher-price commodity activity and less volume tiering. Could you please unpack a little bit more on that volume tiering and how could it potentially impact your RPC in 2025? Thanks."
},
{
"speaker": "Terry Duffy",
"content": "Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, it's separate for each asset class and the products within that asset class. And so, it really depends on the volume that we're seeing flow-through. You will see a downward bias as you see large increases in volume and the opposite is true as you see decreases just because of that structure. It's an important part of our structure because we do, as I mentioned earlier, want to see that incremental trade and we do want to help our clients and incent them to continue the trading activity. So, it does provide a little bit of flex to our pricing structure, but that mix is really important. So, you will see pricing on that individual tier -- individual asset class basis. It's not across the whole enterprise, if that helps."
},
{
"speaker": "Terry Duffy",
"content": "And let me just add to that, Owen, I think -- Owen, just to add to that, our philosophy around whether it's a full-sized contract, a micro or mini, we look at the constituency who is participating in this. We don't look at just a notional value, which may have been a historical look at the way we did things 10 years, 12 years ago. So, I think that can also have an influence on the RPC depending on how those products grow that are -- the people that are using them. So, it's going to fluctuate as Lynne said, but we feel from a pricing standpoint, we're understanding the client better versus just looking at the product and saying, here is the value of the product, so we'll charge a half if it's a half a contract. That doesn't make sense to me. It all depends on what's the use in the case for the participant."
},
{
"speaker": "Owen Lau",
"content": "Got it. So, just want to understand better. So, does that 1% to 1.5% capture that volume tiering, or this is not the right way to think about that?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, the assumption for when we put forward the pricing estimates, it's assuming a similar mix and volume level as the prior year. So, if you had changes in those elements, it would adjust that percentage, but we're basing it based on a similar trading experience we saw in 2024, that would be the impact."
},
{
"speaker": "Owen Lau",
"content": "Got it. Thanks a lot."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Owen."
},
{
"speaker": "Operator",
"content": "The next question comes from Kyle Voigt of KBW. Your line is open."
},
{
"speaker": "Kyle Voigt",
"content": "Hey, good morning. Maybe I just wanted to come back to the commodities discussion, but more specifically around the increases in activity by global multi-strat hedge funds that you mentioned in your prepared remarks. I guess, can you just expand a bit on when you start to see those or a material pickup from that user base? What specific products you mostly seeing those users trade? And I'm just trying to get a sense if this is cyclical because there is simply more going on with inflation and tariffs and macro volatility? Or whether this is the start of a secular trend in growth from that user base?"
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Kyle. Derek?"
},
{
"speaker": "Derek Sammann",
"content": "Yeah. Kyle, it's a trend we pointed to in previous calls. 2024 was a record year for us on the commodity side, as Terry mentioned, not just on the revenue side across all each of those asset classes, but by penetration into particularly EMEA, but APAC, and Julie mentioned a little bit of that as well. When you actually look at the fastest-growing client segment among that record of generated activity in 2024, the fastest-growing client segment was that buy-side community. So, this isn't a trend that we're seeing emerging. We saw this emerge over the last 18 months that accelerated into the back-end of '24, helping us put up the record volumes, and most importantly, the record revenues because that buy-side business tends to come at a higher RPC for us in already high RPC commodities products. So that's a trend that we've seen in place for the last 12 months to 15 months. Given the movements in headcount from places like bank trading desks and commodities trading desks into multi-strat hedge funds globally, we see this as very much an investment by the buy-side community to build this out as an alternative income stream beyond just typical equities and fixed income. So, we are seeing, I would say, some secular trends of growth and the enhancement on buy-side serving client need who are seeking access to physical markets in a way that we haven't seen in a very, very long time. So, I would say that, that has been a significant component in growing our 34% growth in EMEA over the course of 2024. And as I mentioned that in one of my earlier comments, our business kicking off into 2025 has started extremely strong with our overall business up, in ags up 32%, energy 25%, and metals up 14%. So, we see the secular trend. And the only other point I would make inside of that is that, and Julie mentioned this before, we're seeing an increased participation not just on the future side, but an outsized growth in options as well. So, that was an area saw record growth in 2024, and we're seeing that kick-off very strong in 2025. So, we see this as additive to the overall customer mix that we have. Julie spends a lot of time working with myself, and Tim and Mike making sure that healthy ecosystems of each different kind of clients in our markets. Buy side is crucial to come up alongside banks, commercial customers and retail, and their client-segmented sales teams bring to us ideas and opportunities for unmet need and that is a source of new product development. That's one of the reasons we built out a physical ethanol contract, micro ags, and short-dated options in ags as well. So, we see that a secular continuing and continuing a trend from the last 12 months."
},
{
"speaker": "Terry Duffy",
"content": "And Kyle, I just think that when you look at the world today and what's going on, not just with inflation, but the amount of people that we need to continue to feed, and these products, even though they come and they go, it appears from the front page, they are always critical to each and every one of us as we go forward. So, I don't know if I don't want to call them secular, secular, or whatever, I think that they're constant. And the question is what page of the newspaper are they on. So, we're going to have ebbs and flows, but these are products that we are very excited about. We have been for a lot of years, and I think they'll continue to go forward and people will need to use them."
},
{
"speaker": "Kyle Voigt",
"content": "That's great. And if I just ask a quick follow-up for Lynne, really sorry, but just to be very clear on the pricing changes, the 2% to 2.5% pre-tax impact that you mentioned, that is an aggregate figure inclusive of the transaction fees, correct?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "As well as market data and the collateral fee changes. Correct."
},
{
"speaker": "Kyle Voigt",
"content": "Perfect. And then, on the collateral fee changes, roughly what percentage of the non-cash collateral balances would that additional 10 basis point fee apply to you today if no customers change their cash collateral allocations? Just for modeling. Thank you."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah. So, we can't break that out right now, Kyle, just given it's a customer-based decision. We'll continue to provide updates as we see the change roll through, but there's still a couple of months for them to optimize their positioning. If you look at the total cash collateral versus the total collateral, you're going to see that in the high 20% right now, but it's going to be based on the individual firms, not the aggregate."
},
{
"speaker": "Kyle Voigt",
"content": "Yeah. Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Kyle."
},
{
"speaker": "Operator",
"content": "The next question comes from Ken Worthington of JPMorgan. Your line is open."
},
{
"speaker": "Madeline Daleiden",
"content": "Hi. Good morning. This is Madeline Daleiden on for Ken. Thanks for taking our question. May you please talk about BrokerTec and the updated market share trends there with leadership likely moving to Washington at Phoenix? Do you feel that this puts BrokerTec in a better or worse position in the coming years to drive higher market share? Thanks so much."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Madeline. I will ask Mike Dennis to address that."
},
{
"speaker": "Mike Dennis",
"content": "Good morning, Madeline. I appreciate the question on BrokerTec. When we benchmark ourselves for market share around BrokerTec, we focus on the FINRA TRACE number. Our share versus TRACE fell slightly in Q2, it's down about 1.2%. January is much better with ADV up 29% month-over-month, and market share ticking up about 0.5% versus December despite volatility remaining near recent lows. I think one thing that's important to highlight around BrokerTec is, BrokerTec is more than just a central limit order book for US treasuries. BrokerTec is a strategic asset of the CME Group, and it helps us drive our core futures and options business. Overall, revenues for BrokerTec were up 7% in Q4. We have a strong business in both US and EU repo, where we saw record ADV in 2024 across the repo complex. So, additionally, we've had some solid client adoption in some of our newer trading modalities, which we launched via our relative value curve offerings, which include cash spreads and cash butterfly spreads. And then lastly, one thing I want to focus on as it relates to BrokerTec is when the clearing mandate happens, we feel that BrokerTec can provide benefits as clients adapt to this new regulatory landscape. So, I hope that answers your question."
},
{
"speaker": "Madeline Daleiden",
"content": "Thank you."
},
{
"speaker": "Terry Duffy",
"content": "Thank you, Madeline."
},
{
"speaker": "Operator",
"content": "The next question is from Simon Clinch of Redburn Atlantic. Your line is open."
},
{
"speaker": "Simon Clinch",
"content": "Hi. Thanks for taking my question. A lot of them have been answered already, but I was wondering if you could talk about the market data business. You mentioned that there's, I think, it was 3.5% pricing taken already this year. How should we think about the breakdown of volume growth here and the growth going forward given it's been consistently in that kind of high-single-digit range for some time now? Thanks."
},
{
"speaker": "Terry Duffy",
"content": "Julie, do you want to address that?"
},
{
"speaker": "Julie Winkler",
"content": "Yeah, thanks for the question. The data business, we had a very strong quarter, right, $182 million in revenue, up another 9%. And that was driven, I would say, by a couple of different factors. Certainly, we had a price increase of 3.5% that took effect throughout 2024, but also that we're seeing interest in professional subscribers and access to our real-time data. And that is contributing to the growth of the business, as well as that non-professional component that I talked about earlier, as well as the drive data business. Because we haven't talked about the drive data business, just the detail there is that we continue to see increased use of our data by institutional clients as they look to create more of their own financial products and things like indices and benchmarks for their end customers. So, we're looking at some new things in terms of enterprise drive data licenses that really give clients more flexibility in that regard, and then we're also continuing to evaluate what additional analytic offerings that we can provide. So, a lot of good innovation there across the entire suite that I think really bodes well for a strong outlook there as well. And as Lynne mentioned, we have another 3.5% of pricing increases that took effect on January 1 for the core business."
},
{
"speaker": "Simon Clinch",
"content": "Great. That's really useful. Thank you. And just as a follow-up, maybe this is more of a housekeeping question for you, Lynne. Could you give us the latest update on the Google Cloud spend for 2025, and what spend was in fourth quarter '24? And also just give us a sense of the priorities for that investment. You've already talked about the marketing element of going after new retail customers, et cetera, but I just wonder if you could flesh that out a little bit more for us. Thanks."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Sure. So, in the fourth quarter, Simon, the total spend was about $22 million on the migration. It was about $18 million within technology and about $4 million within professional services, bringing the total for the year to about $85 million. Within our guidance for 2025, it's including $115 million related to the migration. That will skew a bit more towards the technology side versus the professional services just given where we are in our migration timeline. So, the focus for this year is continuing to migrate some of the non-latency sensitive applications. So we have a number of our clearing systems moved, our data systems. We're continuing that progression as we move through 2025, and continuing to work with our partner on the opportunities for building out additional capabilities and services for the client base to use that data in a more effective way."
},
{
"speaker": "Simon Clinch",
"content": "Okay, great. Thank you very much."
},
{
"speaker": "Terry Duffy",
"content": "Thanks, Simon."
},
{
"speaker": "Operator",
"content": "And that was our final question for today. I will now turn the call back over to management for closing remarks."
},
{
"speaker": "Terry Duffy",
"content": "We want to thank you all for joining us today. We appreciate very much. Look forward to any follow-up questions you may have and look forward to talking to you next quarter. Thank you very kindly. All stay safe."
},
{
"speaker": "Operator",
"content": "Thank you all for your participation on today's conference call. At this time, all parties may disconnect."
}
] |
cme | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Welcome to the CME Group Third Quarter 2024 Earnings Call. At this time, I would like to inform all participants that your lines have been placed on a listen-only mode until the question-and-answer session of today's conference. I would now like to turn the call over to Adam Minick. Please go ahead."
},
{
"speaker": "Adam Minick",
"content": "Good morning. I hope you're all doing well today. We released our executive commentary earlier this morning, which provides extensive details on the third quarter 2024, which we will be discussing on this call. I'll start with the Safe Harbor language and then I'll turn it over to Terry. Statements made on this call and in the other reference documents on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance. They involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statement. Detailed information about factors that may affect our performance can be found in the filings with the SEC, which are on our website. Lastly, on the final page of the earnings release, you will see a reconciliation between GAAP and non-GAAP measures. With that, I'll turn the call over to Terry."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Adam, and thank you all for joining us this morning. I'm going to make a few brief comments about the quarter and the overall environment. Following that, Lynne will provide an overview of our third quarter financial results. In addition to Lynne, we have other members of our management team present to answer questions after the prepared remarks. Our record breaking performance in the third quarter demonstrated the continued growing need for risk management globally. The third quarter average daily volume of 28.3 million contracts was the highest quarterly ADV in CME Group's history and increased 27% compared to the same period last year. This strong growth was broad based. We achieved year-over-year growth in both volume and open interest across every asset class for the second consecutive quarter. In aggregate, our financial products volume grew by 28% and our commodity sector volumes grew by 20%. This record volume was aided by the effectiveness of our volume tiers, including the 36% year-over-year growth in our interest rate complex to 14.9 million contracts a day with all-time record volume levels for both SOFR, futures and treasuries. We achieved this growth without lowering any fees or introducing any new incentive programs for these products. The lower RPC was driven by increased trading volume and our focus on tiering allowed our incremental earnings growth, given the operating leverage in our model. Our SOFR complex traded over 5.9 million contracts per day in the quarter and 6.9 million per day in September, all while seeing the customer network broaden with large open interest holders reaching a new record high in September. As you know, we often hear the view that a rising Fed rate environment is best for CME's interest rate volumes. However, over the last year, there have been no Fed rate hikes and one rate cut and our interest rate complex grew 17% over the prior year, which had six rate hikes totaling 2.25%. Opposing views of potential and actual Fed rate changes combined with ongoing levels of issuance and deficit financing should continue to provide tailwinds for interest rate trading. The uncertainty around the US election and geopolitical events around the world also contribute to a growing need for liquid and efficient markets to manage these risks and interest rates and across all of our asset classes. Q3 was also a record quarter for our international business, where average daily volume reached 8.4 million contracts, up 29% versus last year. This was led by a record 6.2 million average daily volume for EMEA, which was up 30% and 1.9 million contracts per day in APAC or up 28%. The record international volume was driven by growth in all six asset classes in both EMEA and APAC with the highest volumes coming from interest rates and equity products. In addition to the impressive volume results, we delivered record financial results for the second consecutive quarter. With that short summary, I will now turn the call over to Lynne to review these results in more detail."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thanks, Terry, and thank you all for joining us this morning. CME Group set all-time records for quarterly revenue, net income and earnings per share in the second quarter this year and immediately surpassed each of those records this quarter, starting with the highest ever quarterly revenue at nearly $1.6 billion, up 18% from the third quarter in 2023. Clearing and transaction fee revenue increased 20% on our record quarterly volume. Market data revenue of $178 million increased 6% from the same quarter last year and other revenue increased 29% to over $109 million. Our strong cost discipline led to adjusted expenses of $489 million for the quarter and $391 million excluding license fees. The resulting operating income of approximately $1.1 billion set a new quarterly record. Our adjusted operating margin of 69.1% was up 260 basis points from 66.5% in the same period last year. CME Group had an adjusted effective tax rate of 22.3%. Terry talked about the strength of our international business. The strong growth coming from outside the US has resulted in a lower effective tax rate. We expect this trend to continue in Q4, and we're lowering our tax rate guidance for the year to a range of 22.5% to 23% as a result. Driven by the strong revenue growth and operating margin level, we delivered the highest quarterly adjusted net income and earnings per share in our history at $977 million and $2.68 per share, respectively, both up 19% from the third quarter last year. This represents an adjusted net income margin for the quarter of 61.7%. Capital expenditures for the third quarter were approximately $30 million and cash at the end of the period was approximately $2.6 billion. Our continued product innovation, new customer acquisition and deep liquid markets across the six major asset classes has led to a consistent higher level of demand for our products. CME Group's daily trading volumes surpassed 25 million contracts on 55% of the trading days in the first three quarters of 2024 versus 35% of the days in the same period of 2023. Also, each of the last six months were monthly volume records, helping us deliver our best quarterly financial results in Q2, which were immediately surpassed by new records this quarter. We're very proud of the team for their efforts to provide our clients with the technology and products they need for risk management, while driving earnings growth for our shareholders. We'd now like to open the call for your questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question is from Dan Fannon with Jefferies. You may go ahead."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. CME has had a longstanding capital return policy. And Terry, you've given some thoughts around M&A, but wanted to get your updated thoughts on both of those after you -- as you just highlighted, record quarter-after-quarter and also a valuation that continues to compress versus peers. So curious about a buyback in the context of those two other things around the dividend policy as well as potential M&A?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Dan. I think I heard you correctly. A little soft coming in, but you asked about buybacks and potential M&A."
},
{
"speaker": "Dan Fannon",
"content": "Right, exactly."
},
{
"speaker": "Terrence Duffy",
"content": "I think that's what you asked for. So, on the capital return to shareholders, I have said that we will always be monitoring this to see what is in the best interest of our shareholders at any given point in time. Our dividend policy over the last several years has suited the company extremely well in a zero rate environment, with the rates changing dramatically and other things happening throughout the world, we always constantly monitor this and we will continue to do so again with my board at its upcoming meetings. It doesn't mean we're doing anything, we just continue to monitor it. As far as M&A activity goes, Dan, we've been very fortunate to be put ourselves in a very strong position to be competitive around the globe with the transactions we've already done. But at the same time, if there's something there that we think makes sense, we're not afraid to take a look at it. But right now, that's all I'll say about M&A."
},
{
"speaker": "Dan Fannon",
"content": "Great. And then just, I guess as a follow up, last quarter you gave us updates around the efficiencies that you provided to your customers. I think with both DTCC as well as more broadly. Can you update us on the number of customers, as well as the dollar amounts around that and ultimately just the conversations and how those are evolving given the increased potential competitive backdrop that's out there today?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Dan, that's great. Well, appreciate the question. And I'm going to turn it over to Suzanne Sprague, who will give you those -- that data. Suzanne?"
},
{
"speaker": "Suzanne Sprague",
"content": "Yes. Thanks for the question. So in terms of our portfolio margining program that you mentioned where we offer offsets between interest rate, features an options against interest rate swaps, we continue delivering average daily savings of about $7 billion to clearing members through that program. Most of that is from US dollar swap activity. And then in the cross margining program with FIC, we continue increasing the number of participants in that program. We currently have 12 clearing members participating in that program and have achieved upwards of $1 billion in average daily savings for that program as well. So we are still focused on growing both of those programs and we do continue working with FIC and engaging with the regulators to be able to expand that cross margining program to customers as well."
},
{
"speaker": "Terrence Duffy",
"content": "So our efficiencies, Dan, just to make sure we're perfectly clear, still averages between F&O and portfolio margining of close to $20 billion a day. So we just want to make sure they don't think that's changed one way or another."
},
{
"speaker": "Dan Fannon",
"content": "Understood. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Dan."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Chris Allen with Citi. You may go ahead."
},
{
"speaker": "Chris Allen",
"content": "Yes, good morning, everyone. I wanted to ask about new customer acquisition, which you called out in the deck for the first time. Any color just in terms of how much impact you're seeing in terms of volumes from new customer acquisition and where are these new clients coming from?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks. We appreciate the question. I'm going to turn it over to Ms. Winkler to give you some color on that. But I think one of the things that I just want to highlight is really important is the numbers that came from outside of our US with the record volume. It's a big part of some of the new client acquisition that Julie and her team have been able to do globally. But Julie, I'll turn it to you?"
},
{
"speaker": "Julie Winkler",
"content": "Yes. Thanks for the question, Chris. New client acquisition has certainly been really a core pillar of our commercial model and an area of investment for us over the last few years. We're excited that those efforts are really yielding strong results. And we kind of think about this in two different buckets. One is our retail client base and one is our institutional client base. We are outpacing our 2023 performance by over 3%. And then the new institutional client growth, we're seeing that up almost 40% this year versus our three year average, which is great. So I'd say there's a couple of things behind that. Certainly, we've done a lot to build out a new inside sales team. And they're really a dedicated sales team that is focusing on prospecting, lead qualification and growth around really our medium-sized and high potential accounts. They're leveraging data, they're doing automation and this low touch sales model really is helping us to drive greater efficiency and also scale in that outreach. We have seen a lot of launch of new hedge funds and really the rise of commodity focused strategies that are also helping create some significant opportunities across our client base. CME Direct continues to attract a record number of new option traders. That was up 30% this quarter. And so, we see that all as really critical to the institutional model, as well as a lot of the new products that I'm sure we'll talk about on the call today, whether it's credit or TBAs, those are really powerful opportunities for us to reach new clients and bring them into the CME ecosystem. On the retail side, really what we're focused on less about ADV and more about really how many accounts we're opening and how many new traders we're bringing into CME through our retail channels. In Q3, we welcomed over 176,000 new traders through our retail channels -- sorry, year-to-date and 60,000 in Q3 alone. And so that's a 30% increase year-over-year. That is pretty consistent as you -- among previous quarters, what you see in the data that we released this time is really kind of the spread across regions where we saw 53% of that growth coming from the US and 16% within APAC and our 31% in EMEA. And so, where we're really focused there is on bringing our new to futures brokers into this ecosystem and also our existing partners. And this is a critical part of how we are continuing to drive NCA in this space, working with them on education, on marketing content. And so, where our distribution partners are successful, we have seen that success too, and that's really what's bringing those new traders to CME. They're attracted by the products that we have and we expect that to continue in the year ahead."
},
{
"speaker": "Chris Allen",
"content": "And just a quick follow-up. You noted that plus 500 [indiscernible] surpass expectations and we -- obviously, [Robinhood] (ph) just launched last week on future trading. So when we think about Robinhood's account growth, is there any way to frame out what -- how you would expect penetration of -- I think it's like 23 million accounts they have right now and how they may translate into volumes?"
},
{
"speaker": "Julie Winkler",
"content": "Yes. I mean we're working with all of those firms. I'd say they have their own internal targets about the account openings. And I think with all of this Robinhood in the one -- in the launch last week, they're going to open up access on still a measured basis, right? And some of these are making sure they are testing these products out, they're working on the content. So I don't think we're going to see 23 million accounts trading futures immediately, but we really want to work with them to make sure, right, that the products that we are introducing to them and those clients are ready to be trading futures. And so, what we can see both with plus 500 and [indiscernible] is that adoption rate has happened even faster than what those firms have predicted. And so, I'd say they're very advanced in their customer journey and analytics. And so, that's all providing them, as well as us, information on how we can kind of support the active trader in their journey."
},
{
"speaker": "Terrence Duffy",
"content": "So, Chris, just let me add something to that is one of the things we have said historically since I took CME Public in 2002, it's very difficult to predict future volume. So, when you're looking at new client acquisition and what their behavior may or may not be, it's really difficult to pinpoint what that can transition into. But I do think when you look at the trajectory of our business over the last 20 plus years as being a public company, you could see it's up and to the right growing by customers and of course, the new large open interest holders that I referenced earlier in my comments. So, those are all good factors for new client acquisitions. But again, we can't predict future volumes."
},
{
"speaker": "Chris Allen",
"content": "Thanks. Goodbye."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Chris."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Ben Budish with Barclays. You may go ahead."
},
{
"speaker": "Ben Budish",
"content": "Hi, good morning and thanks for taking the question. I wanted to kind of follow up there. I know it's hard to predict new volumes, but just thinking about like what retail trading activity may look like, can you just talk about the sort of P&L implications? Presumably, we would see a lower rate per contract as people are trading more of like the minis and some of the smaller products. But how do you think about what we might sort of be able to expect there? What are the implications from like an RPC and volume perspective? Again, I know it's hard to predict the volumes themselves, but just how should we think about interpreting results as we start to see a bigger contribution from retail?"
},
{
"speaker": "Terrence Duffy",
"content": "Well, Ben, let me make a couple of comments. Like I said, it is very difficult to predict. And every constituency that we have here is completely different. So when I talked earlier in my comments about the tiered pricing, I don't know that incremental volume drops to the bottom line is a good thing and that does take the RPC down a little bit with those higher tiers. That's still a good thing for us because of the increased volume. So when you're talking about retail in general, you don't automatically have to assume it's going to be a lower rate per contract, because we changed the pricing on some of our products, as you may or may not recall, we didn't price them based off of a notional value in pricing them. So when we did the E-mini or the micro or the mini Bitcoin contract, we didn't take the notional value and decide that's how the price should look. We priced it on the constituency of the client base and what they're getting for their value added that they are receiving from CME Group. So, we look at pricing in many different lenses and it doesn't have to be just the retail client constituency or the size of the contract or the institutional or the size of the contract. So I think it's really important that we keep -- continue to strike that balance with our client base to build the business. But it's hard to say that it will be a lower rate per contract. It's hard to say there'll be a higher rate for contract. So again, I think it all depends on the constituency that we are attracting. And this new retail business, I have said it a million times over the last year or two. I think this is going to become more-and-more blurred as we move forward with other institutional type trading and it's going to be in a very exciting time with the proliferation of artificial intelligence, other technologies, the accessibility into marketplaces, what retail can do. But again, it's really hard to predict what that's going to return to in revenues. Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. I would just add, our focus, Ben is not on growth in RPC. Our focus is on growth in revenue and growth in earnings. So if it's new client acquisition of any type, we're focusing on how we drive that top and bottom line and we're not focused on that RPC line in particular, it's really the overall picture and growth level."
},
{
"speaker": "Terrence Duffy",
"content": "So Ben, I guess I'd like to tell you that we have a special formula, but we don't. And I don't think you would want us to have a special formula, because everybody is different as the market continues to grow. So it's exciting for us. And again, I think the one thing I can truly point to is the pricing change from micros that we did not do based on a notional basis. And that's the trajectory we're going as we look at the constituency."
},
{
"speaker": "Ben Budish",
"content": "Got it. That makes a lot of sense. Maybe one follow up, just something kind of a little bit more nitpicky, but just curious the licensing fees picked up this quarter. And I know you kind of exclude those from your core OpEx guidance for the year, but just any color on what we should expect from that line item, the sort of the drivers of the sequential step up and how we should think about what that looks like over the next couple of quarters?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So we did see a step up in licensing fees, not surprising given the high volume levels and the growth there. As you know, a good portion of that, the majority comes from our equity complex, which had nice growth, 9% up quarter-over-quarter and 17% year-over-year. The other item that you're seeing this quarter is, we do have some existing OTC clearing programs that have been in-place for a number of years, given the strong growth in that business over the last year, it has an off cycle measurement period. So the impact of that was seen in Q3. I would note because we did get a couple of questions this morning. There were no new license fee related programs in our SOFR or treasury complex. Those two main items are going to be the overall growth in the business and that those programs related to OTC clearing, which again have been in place for many years. I don't know. Mike, do you have anything to add on the OTC side?"
},
{
"speaker": "Mike Dennis",
"content": "Yes, just one thing to add on overall futures and option growth continues to bolster our OTC IRS business. We saw double digit volume growth year-over-year in both LatAm and US dollar swap activity. I think the important figure to highlight with Suzanne mentioned already today is that out of the $7 billion to $8 billion in portfolio margin savings that we see in the overall SOFR -- the overall swap complex, over 90% of that is in US dollar swaps. We have about $40 billion in margin collateral for swap activity and 80% of that is being attributed to US dollar swaps. So we've had some considerable buy side clients and bank clients put true risk with the CME in US dollar swaps, hence the over $7 billion a day in portfolio margin savings. I also think it's important to highlight that other CCPs have highlighted their margin and collateral levels. It's important to keep in mind that all of the collateral at other CCPs is not specific to swaps and currencies that will enjoy any material margin savings for SOFR and treasury products. Some of those swaps are related to Swiss yen, Canada, Sterling and Euro."
},
{
"speaker": "Terrence Duffy",
"content": "And for those of you who are wondering who the hell that was, that's Mike Dennis there. He's the new head of our rates franchise. So thank you, Mike."
},
{
"speaker": "Mike Dennis",
"content": "Thanks, Terry."
},
{
"speaker": "Ben Budish",
"content": "All right, guys. Well, thank you so much for the response. Appreciate it."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Ben."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Ken Worthington with J.P. Morgan. You may go ahead."
},
{
"speaker": "Ken Worthington",
"content": "Hi, good morning. I want to ask about the digital business. Can you talk about the launch of Bitcoin and Ethereum ETFs and the impact that they've had on your futures business, they would appear to have helped a good amount. And as you think about the opportunity to further grow the digital platform. The perpetual market still seems to be quite a bit bigger than the calendar market. Does the perpetual market present an opportunity for further growth at CME?"
},
{
"speaker": "Terrence Duffy",
"content": "Tim?"
},
{
"speaker": "Tim McCourt",
"content": "Great. Thanks, Terry and thanks for the question. Certainly the development of the ETFs both in a spot based and futures based ETF structure for Bitcoin and Ether have not only developed the ecosystem further for those products, but also provided an opportunity for the futures complex to grow at CME. Like we see in a lot of asset classes, futures are at the center of these highly related interrelated ecosystems. And when we see the volumes in our crypto complex, the futures ADV was up almost 285% to a record 102,000 contracts. And when we look at the micros, they're up even more up, with Bitcoin up 470% and Ether, Micro Ether up 641%, respectively. This is because our futures not only enable more common ETF strategies such as trading ETFs versus futures or using futures to source inventory for stock loan in the ETF market. It's also our futures often provide a better, more efficient way to create and redeem the ETF is our ability to transact fees against the underlying index close to CME CF Bitcoin reference rate where our reference rates also underlies seven of the 11 Bitcoin spot ETFs. So this is a growing ecosystem. We are certainly at the center of it here at CME and we continue to be a leader in this space offering that regulated, trusted and transparent futurist market. And Ken, going to the perpetual market, it's not necessarily an easy comparison because those perpetual exist on more crypto native platforms that are not regulated outside of the US, but we continue to engage with customers to make sure we're working with them to design all the tools they need to manage risk in these uncertain times, whether that's in cryptocurrencies or other products. We'll continue to engage them to make sure they have all the tools they need, but it is critically important that here at CME and for the marketplace, they can do it in a trusted, transparent and a regulated manner, and that's what we offer with our crypto product here."
},
{
"speaker": "Terrence Duffy",
"content": "That give you some color on that, Ken. Are you good?"
},
{
"speaker": "Ken Worthington",
"content": "Yes, that was great. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Ken."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Patrick Moley with Piper Sandler. You may go ahead."
},
{
"speaker": "Patrick Moley",
"content": "Yes, good morning. Thanks for taking the question. So I had one on the competitive landscape in rates today marks the one month anniversary since FMX launched its SOFR futures contract. Volumes have been modest to say the least. So Terry, I was just hoping to get maybe a state of the union on the competitive landscape and just your updated feelings since this competitor exchange launched?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Patrick. And again, I think you're right, the volumes have been modest, but it's early. So I'm not drawing any conclusions to -- as it relates to any competitor. We will continue to stay focused on the things that we are doing today, a lot of which, Patrick, you've heard us highlight over the last several months and years, and we highlighted again today, which is the efficiencies that we've been able to create for our clients in those asset classes that people are trying to compete with us in. So again, I think that's a -- we feel very good about our strong performance. I think there was some question about the growth of our interest rate products that we had to put incentive plans in. We clearly stated that we did not and still had the growth. So I think that goes to show you that the value of CME's products to its end users. And we also will go to the fact that still the cheapest cost to any participant is the transaction fee, the bid offer is extremely expensive when it gets wider. If you look at some of our competitors and Mike can maybe add some more color to this on the back end of their offering, their spreads are a lot wider than CMEs, which the cost would be dramatically higher than any incentive program they could possibly pay or a transaction fee associated with that. So Mike, you give a little color, then I'll come back and finish up."
},
{
"speaker": "Mike Dennis",
"content": "Yes, sure. And thanks for the question, Patrick. Good morning. What Terry is referencing, it's still early days, but what we see is our bid ask spreads are on average a quarter tick tighter in front month SOFR contracts. Almost a half tick tighter as you move out the SOFR curve. As we all know, half tick equates to $12.50 per contract in SOFR futures, which towards the size of the transaction fee."
},
{
"speaker": "Terrence Duffy",
"content": "Or potentially whatever the incentive is to trade that market."
},
{
"speaker": "Mike Dennis",
"content": "Yes."
},
{
"speaker": "Terrence Duffy",
"content": "So anyway, Patrick, I think that we're keeping a close watch on it, but we're staying really focused on our business and bringing the efficiencies. Suzanne referenced, the $1 billion a day that we're achieving with FICC. We want to make sure we can continue to build and grow on that program. We think it's very beneficial. We got to get more firms signed up. There's a lot on firms plates. So we're hopeful that they get signed up for that and they're starting to see that they don't want to be left out of that potential $1 billion plus on a daily basis with the FICC arrangement. So again, I think that's a -- I like our position there. But I won't comment any further than that if you're referring to some of the local media that's been put out there as it relates to what I have said about treasuries or are you just referring to SOFR? So I know what you're talking about?"
},
{
"speaker": "Patrick Moley",
"content": "Just SOFR, but if there's anything that you have to say on treasuries, I'd be happy to hear --"
},
{
"speaker": "Terrence Duffy",
"content": "I've said it pretty loud and clear publicly about how I feel about this. And I know that I keep getting rebuttals that monies from US participants are held in US banks, which is irrelevant, it could be held in Fort Knox, it wouldn't matter. We are talking about the resolution authority and the authority of who gets to make the decisions over a default and that would be the Bank of England and the FCA, not the United States of America if in fact those contracts were to be cleared there. So that has been our argument and people keep dodging it. I know that they're a duly regulated clearing entity, but that's got nothing to do with our argument. So I think that I've been to as many people as I possibly can, will continue to continue to be loud about this and make sure people understand what could be the detrimental effect of having US Treasuries not only being cleared overseas, but at the same time having the resolution authority being overseen by a foreign regular and not the United States government. So I will wait to see on that, but I'm not backing down from that argument. I think it's very legitimate. And if they want to move into the United States of America and compete with us here under our laws, as I've said, too many of people, I'll pull my chair back and walk out, because my argument is over. But that's not the case."
},
{
"speaker": "Patrick Moley",
"content": "Okay, that's great color. Thanks for that. And then just a follow-up on pricing, specifically in rates. There's been a lot of speculation recently about what you could potentially do in response to FMX launching. People talked about you possibly cutting rates. But given that what you've spoken about on this call and the value that you feel that you've provided your customers, you're coming off -- you're on track for your third consecutive year of record interest rate ADV. I guess the question is, is it misguided for us to assume that rate or possible price increases in the rates complex is off the table at this point? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "I think it's misguided for anyone to assume they know what we're thinking about how we're going to run the business going forward on pricing. As I said, we adjust our tiers all the time. We do a whole host of different things throughout the years. It doesn't have to do anything with competition. It's got all to do with the marketplace. So Patrick, as I said earlier, I clearly stated that we did not put any new incentive plans in place and we've had incremental growth that's a record in this quarter for both SOFR and treasury. So I think that speaks volumes to where we're at today."
},
{
"speaker": "Patrick Moley",
"content": "Okay. Thanks for that, Terry."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Patrick."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from Alex Kramm with UBS. You may go ahead."
},
{
"speaker": "Alex Kramm",
"content": "Yes. Hey, good morning, everyone. Maybe in the context of new customer acquisition and what you focus on a lot, can we, can we maybe go into the energy business in more detail here? I mean, there are clearly a lot of, macro changes, structural changes that quite frankly, from my perspective, seem to be the most interesting asset class in the next couple of years, given energy transition, everything that's going on. So you have a very US focused business, but obviously, some of these changes are global. So just wondering what you're doing to maybe capture some of that structural excitement and what you're seeing in terms of new customer generation maybe around the world and what your customers are doing different already and how you're positioned? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Alex. Thanks for the question. I'm going to turn to Derek, but I think you raised a really good point about what this asset class can mean over the next couple of years as we either transition out of it or continue to build on top of it. So I think there's a lot of verdicts yet to be read yet. So it's interesting with this asset class. So I think you're right to point it out, Derek."
},
{
"speaker": "Derek Sammann",
"content": "Yes, thanks, Alex. I think you're seeing a lot of things that we're seeing right now. And number one, we are putting up a year-to-date record revenues in our energy business. We put together another extremely strong quarter with our volumes up about 21% and actually our options business up 45%. That's a new record for us for the quarter across the energy complex as a whole. You asked a great question. We spent a lot of time digging into where the business growth is coming from. And I'll provide some color as I have on previous calls. When you look at the growth of the business, we look at the record year-to-date results of this business, that business is coming -- we're seeing outsized growth coming from outside the US that's what we're so excited about. We've talked about the new client acquisition story that Julie talked about, boots on the ground, engaging new customers that for the first time with physical flows of WTI and Henry Hub hitting the shores of Europe and Asia, that's bringing new commercial and buy-side customers into our market. When we look at the numbers that underlie that, you look at our buy side business is up 26% this year. Our commercial customer business up 16% this year, our bank business, up 13% this year. When you look at where the growth is coming from a geographical point of view, our European business this year is up 37%, our LATAM business is up 30%. So when we're looking at growth, it shouldn't surprise that when you see physical flows of US benchmarks priced on NYMEX and this is true on the ags and metal side as well. Those physical flows hitting the shores of Europe and Asia, that's driving new customer acquisition for us. They're not necessarily new customers to the energy complex, but there are customers that recently had only traded European or Asian products, they are now adding our global benchmarks that is the import risk they're facing right now. So when you look at the results of the business, we're seeing that the physical flows are driving global participation. So the other couple of pieces I'd point to is that we're seeing growth across not just WTI. We're seeing significant and even faster growth on the natural gas side of the business. When you look at the business this year, we're at a record level of -- almost 780,000 contracts in our nat gas business. That's up 33% this year. This is a market where the US is now producing and exporting record amounts of natural gas priced on Henry Hub, which is the market we own roughly 80% of in a market share perspective, that business is flowing back into CME from European customers adding Henry Hub pricing exposure to their overall portfolios. That's been a big driver of the record activity in our nat gas options growth as well as these markets are extremely difficult to hedge on a flat price basis. So we're seeing increased activity on the option side. So hopefully, that gives you some color from the client perspective, from the regional perspective and from the underlying product perspective. Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. And just to add a little bit to what Derek was saying, we have seen with these new supply lines being drawn, the strong growth in both Europe and Asia in our crude business and Henry Hub. I think what we're also seeing as a longer term trend, one of the limiters on the Henry Hub side is the ability to liquefy the natural gas to then export it internationally. We do expect and we do see the build out in multiple liquefaction facilities that are ongoing. These are multi-year projects, but there are a number that are meant to come online in the next couple of years. So increasing that capacity and that ability to export could also be a tailwind for our business as more international customers would then look to hedge back to that export point."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Lynne. Thanks, Derek. Alex, did that get to your question?"
},
{
"speaker": "Alex Kramm",
"content": "I think it did. Great color. And I'll squeeze in one quick one here on the tax rate. But clearly, you're suggesting the international growth is really helping that one. I mean that's been really a multi-year trend. So if we continue this for 2025, do you think this 20% -- around 23% is a better tax rate to use? Is that in your plans?"
},
{
"speaker": "Terrence Duffy",
"content": "I'm assuming you're referring to energy, Alex again on this --"
},
{
"speaker": "Alex Kramm",
"content": "Sorry, tax rate, the tax."
},
{
"speaker": "Terrence Duffy",
"content": "I'm sorry."
},
{
"speaker": "Alex Kramm",
"content": "Yes."
},
{
"speaker": "Terrence Duffy",
"content": "How about you said -- sorry, we have a bad connection here. It's hard to hear."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, so Alex, we did lower it based on the outsized growth that we are seeing internationally. Certainly, we will provide tax guidance as part of our outlook and guidance for the coming years. We have seen that outsized growth for several years, as you noted. Obviously, there are a number of factors that will be in play, including things like changes in administration, potentially what's going to be the political dynamic and impact on taxes. So it's a little premature for us to take a position on that go forward tax rate at this point, but we'll certainly follow up on that."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Alex. Sorry for the -- you hear you properly on the tax issue."
},
{
"speaker": "Alex Kramm",
"content": "All good."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, bud."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Kyle Voigt with KBW. You may go ahead."
},
{
"speaker": "Kyle Voigt",
"content": "Thanks for taking my question. Maybe just going back to a broader discussion on pricing. Over the past few years, you've announced pricing changes in the fourth quarter that go effective in 1Q for changes that went effective in 2024. I think you guided to 1.5% to 2%, assuming constant volumes of pricing change. And in 2023, I think that was 4% to 5%. Can you just give us an update on how you're thinking about futures pricing over the medium term? And I guess, is there any reason to think that 2024's pricing change levels are not a good baseline assumption for 2025?"
},
{
"speaker": "Terrence Duffy",
"content": "Well, Kyle, I think pricing, we evaluate that throughout the entire year for the next year and there's a lot that goes into it other than just see if we can increase it by 1% or 2%. One of the things I've always said, and I'm sure you've heard me say this is there's got to be a good value add associated to our clients when we change pricing. We invested heavily with our Google transition. We're excited by the future of that, what it means for clients. So that could have an impact on pricing one way or another, maybe to their benefit, obviously. But again, I think when you look at just blanket pricing increases, that's not something that we do. And I know some suggest that was becoming a pattern, but it's because of what we were able to deliver to the marketplace over that time period, we were able to do price increases. But again, we evaluate that pricing throughout the entire year before we make any decisions and bring it to my board. Lynne, do you want to come any further?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. The only thing I would add, Kyle, is that the 1.5% to 2%, you quoted that was on the clearing and transaction fee. Just keep in mind that we do look at different levers as we're thinking about pricing changes. Those could include changes to the fee schedule. It could include things like incentive programs or other agreements there. There is the data component and also things on collateral, so non-cash and cash collateral fees. So we did guide to 1.5% to 2% this year on the clearing and transaction fee. We said 2.5% to 3% on total revenue given some of the changes we made on those other fee lines, and we've been tracking towards that throughout the course of this year."
},
{
"speaker": "Kyle Voigt",
"content": "Great. Thank you. And then maybe a follow up for Lynne on the expense trajectory. I think in 2023, you had $56 million of cloud migration expenses that was expected to grow by $15 million this year. I guess, can you confirm whether that level of migration spend is still on track? And then can you remind us how we should think about the cloud migration expenses into 2025 and 2026? Will there be incremental spend needed in each of those years and maybe address the interplay of that and the trajectory of D&A over that timeframe too?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, sure. So if you look at the migration spend for this year, the total spend is on target for our guidance of $90 million. Now the difference between that and the $15 million increase, you do have some roll off on existing kind of business as usual expenses as we've been migrating to the cloud. So you see about $25 million in costs that are rolling off, which would get you to that differential or that increase of $15 million year-over-year. So we are on track with our guidance on that expenditure. I think what we've also said is that we would expect incremental costs related to our migration for the first four years. We are in year three. So we do expect to still see incremental costs next year related to that migration. I would note that the Google related expenses were included in our overall expense guidance. So that 3.9% implied by our expense guidance did include that Google spend. So that has been trending down as we are starting to see some of the benefits of rolling off that kind of on premises operating expense."
},
{
"speaker": "Kyle Voigt",
"content": "Great. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Kyle."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Brian Bedell with Deutsche Bank. You may go ahead."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thanks. Good morning, folks. Thanks for taking my questions. Maybe just one quick one on -- back to the competitor on SOFR. And Terry, thanks very much for the commentary there, very good and very, very detailed. On the pricing of the SOFR contracts and tiering, is that something you could use in the future? I mean comparative of obviously with the tick size and the wideness of the bid-ask spread dwarfing that, it would seem like you wouldn't need to do that. But is that something that you could do in the future in terms of pricing to certain members or using any incentives on that should the market share increase from the competitor?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes, Brian, appreciate the question. And as you can imagine, I'm not going to comment on that, because there's so many different levers that we have here to bring value to our clients as I continue to say. And I'm not going to predetermine what I should or should not do on this call right now. We have to -- we do a lot of theoretical game planning here at my team and we look at certain things on pricing. We look at certain things on value add. But as I said, we did not increase -- put any incentives in for the last and we had a record quarter. So we're pretty pleased with the way the market has anticipated our offering to date. So it'd be foolish of me to try to suggest that we would do anything different at this moment."
},
{
"speaker": "Brian Bedell",
"content": "Yes, totally clear. And then maybe just Lynne, could you review the collateral balances and the rates paid for the quarter and then I guess, exiting September given we have the rate cut in the month?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Sure. So in Q3, our average cash balances were $72 billion, which was similar to the $73 billion we saw in the prior quarter. Our rates we earned on that remained consistent at 36 basis points. On the non-cash collateral side, we saw a slight increase to $165 billion for the quarter versus $161 billion last quarter, and we continue to earn 10 basis points on that non-cash collateral. So far in October, we've seen slight increases in both of those elements. The US cash balances are averaging $73 billion in months to date and the non-cash collateral is averaging $173 billion."
},
{
"speaker": "Brian Bedell",
"content": "Okay. And is the spread the same given the rate cuts or is that different coming into 3Q?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Continue on the cash collateral, you have the 25 basis points return to clients. The difference between the 36 that we've been earning in the 2025 is our ability to optimize our returns using some other vehicles. And so that did not change during the quarter. If rates continue to decrease and ability to get those outsized returns might be pressured, but the overall rate that we're paying has not changed and it's been at that same 25 basis points for quite a few rate hikes. Yes, it's been since the IRB rate was at 1.65%."
},
{
"speaker": "Brian Bedell",
"content": "Got it. Okay. I'm sorry, so the spread is still 36 basis points. Is that right?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "That is still 25%."
},
{
"speaker": "Terrence Duffy",
"content": "25%."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "We're earning more because we're able to optimize those returns."
},
{
"speaker": "Brian Bedell",
"content": "Yes, I see what you're saying. Okay. Got it. Yes. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Brian. Anything else? Good?"
},
{
"speaker": "Brian Bedell",
"content": "No, yes, totally good. Thank you so much for all the answers."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Brian. Appreciate it."
},
{
"speaker": "Brian Bedell",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Craig Siegenthaler with Bank of America. You may go ahead."
},
{
"speaker": "Craig Siegenthaler",
"content": "Thank you. Good morning, everyone. Most of my questions were asked, but I wanted to try to ask them in a different way. So apologize if any repetition. But first one, we have a follow up on Robinhood's future and index options launched this quarter. I was curious, which products do you expect to see the largest uptick in demand? We're thinking SPY, WTI. And also how do you think SPY will compete against its core competition, including SPX given its tax efficiency and we are curious what insight [indiscernible] launch was able to inform you on this, just given Robinhood's differentiated clientele."
},
{
"speaker": "Terrence Duffy",
"content": "All right. Thanks, Craig. Appreciate the question. On the Robinhood and the product, I'll let Julie take that, on this SPX versus the [indiscernible], I'm going to let Tim talk about that in a moment. So, Julie, why don't you start?"
},
{
"speaker": "Julie Winkler",
"content": "Yes. Thanks for the question, Craig. What we have typically seen in new retail clients coming to trade CME products is the first entry point is within our micro equity suite. These active traders are often using this to hedge existing stock portfolios. They have typical experienced trading cash and cash equity options. And so this is a natural overlay to move into the derivative space in equities first. What we have seen is, as you mentioned, the diversification that we then are quickly able to follow up on is an important part of our product suite for retail, where we are able to then work with our distribution partners to offer them things like WTI and energy as well as our metals complex has continued to see a lot of growth too with our micro gold. So I'll turn things over to Tim, to talk through a little bit of the competition side of things."
},
{
"speaker": "Tim McCourt",
"content": "Great. Thanks, Craig, and appreciate the question. When looking at the S&P 500 ecosystem, it's important to note that these are highly interrelated. But just to clarify that when we look at the futures and options on futures products at CME Group, they are also efficient from a tax perspective. They are also a Section 1256 contract that enjoys the blended 60-40 capital gains tax. That is an index based determination. That is something that we enjoy, other index products are also able to provide that ETFs are not. And when we look at the way that our contracts will be not only distributed through Robinhood, but all of our partners, it continues to be an important tool for traders to manage their risk to access that market. And when we look at how we're doing against ETFs, I'm excited by the fact that more retail distribution partners are coming online because even if we look at Q3, we've had very strong performance in terms of our futures versus ETFs as a product choice. And when we're looking at that, we're at the highest multiple in my 11 years here at CME tracking it with our S&P 500 futures at CME Group are out trading the associated S&P ETS by a factor of 15 to 1 for the -- for the third quarter. So optimistic about what even more distribution platforms offering our products alongside the cash markets and ETFs. We think it will be a great opportunity for the market to take not advantage -- not only advantage of the tax efficiencies, but all the capital efficiencies we offer here at CME Group."
},
{
"speaker": "Craig Siegenthaler",
"content": "Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "[indiscernible]"
},
{
"speaker": "Craig Siegenthaler",
"content": "No, that was great, very comprehensive. Thank you. Just for my follow up, we have a question on event contracts. So a large online broker launched a political election and weather contract platform recently. It's been getting a lot of media attention, as I'm sure you're aware, given the upcoming US election. And this is an example of a broker offering contract, so some vertical integration. I'm wondering if there's an opportunity for CME to play a bigger role in this business. And if you think there is a large TAM for event and political election contracts in the United States."
},
{
"speaker": "Terrence Duffy",
"content": "So Craig, thanks for the question. And I will start and then let Tim go ahead and make a comment or two as well as it relates to that. So that we've been asked if I don't know if your question is being asked in a different way, are we going to list political event contracts? And the answer is at this moment in time, no, but we never forgo any opportunity that we might see in the future. But at this given moment in time, we do not see that as an avenue that CME wants to partake in. I don't see that too dissimilar load to Bitcoin. We did not participate in that for many, many years until we thought it was mature enough for us to list it and make sure that the product was not readily manipulable under the core principles of the CFTC. I'm not suggesting that the product that's being listed today is, but we need to know more about it and watch some cycles before we decide to jump into something like that. So I don't know if your question was, are we going to get into that or not? So I want to make sure that was perfectly clear that at this moment in time, no, but we never forgo potential opportunities if we think that they're right, but timing is always everything for me and my team. So we'll see how that works out. On the other part, I'll let Tim address."
},
{
"speaker": "Tim McCourt",
"content": "Sure. Thanks, Terry. I think the one thing I would say with respect to our offering of event contracts here at CME Group is it's important for us to offer those products to the market in a way that leverage the other futures contracts that we have at CME. So our approach to event contracts are there -- have an underlying associated future that also trades at CME Group, which is a key part to our product offering. We've also look at longer dated year end event contracts on the equity indices. We'll continue to work with market participants to figure out if there are additional types of products that they want in the marketplace. Like I said earlier, that holds true for all of our asset classes, but for event contracts, it's key to us right now to focus on transposing the liquidity we have in their sort of older sibling contracts in a new form, offering more ways to trade those same markets. We'll continue to engage with the market to see what else we should be talking about."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. Thanks. Craig, did that address your questions?"
},
{
"speaker": "Craig Siegenthaler",
"content": "No, that was great. Thank you, guys."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Craig. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Owen Lau with Oppenheimer. You may go ahead."
},
{
"speaker": "Owen Lau",
"content": "Good morning, and thank you for taking my question. So I have a quick question on your expense guidance. If I look at the first three quarters of last year, your comp ratio was about 14% on average. This year for the first three quarters your comp ratio is only about 13.1% based on my math. But your revenue this year is much stronger than last year. So is there any change on your full year comp expense this year versus last year? And should we expect a big true up of your incentive comp in the fourth quarter? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Owen. Lynne."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, so Owen, we do have true ups for our incentive comp throughout the year as we look at incentive based or performance based compensation, that will flow through in the various quarters. So I would say what you're seeing is some of the operating leverage in our business. So to drive that revenue, it's not a direct relation to us adding additional headcount. So I think you're just seeing the benefits of that model rolling through this year."
},
{
"speaker": "Owen Lau",
"content": "So we should expect like a bigger true up in the fourth quarter. Is that what we should think about from a model perspective?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "No. So the true up happens over the course of the year. So if there is any outperformance or underperformance, you will see that in each of the respective quarters. So it's not a large true up on incentive comp in the fourth quarter. And our expectations on compensation are built into our expense guidance for the year."
},
{
"speaker": "Owen Lau",
"content": "Okay. [Multiple Speakers]"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. We're growing revenue with the same amount of people that we have in place with the same cost expense that we have because of the model -- the operating leverage model that we have. [indiscernible]"
},
{
"speaker": "Owen Lau",
"content": "All right, got it. That's it from me. Thanks a lot."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Owen."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from Mike Cyprys with Morgan Stanley. You may go ahead."
},
{
"speaker": "Michael Cyprys",
"content": "Hi, good morning. Thanks for taking the question. Maybe one for you, Terry, just coming back to your earlier comments on treasury futures clearing abroad. Just curious in your conversations with regulators, what level of receptivity are you hearing to your arguments that treasury features should not be cleared abroad? And what actions might we see, if any taken? And then if a competitor were to set up a US clearinghouse to clear treasury futures here in the US, what would be the scope for them to sort of access netting benefits from a related clearinghouse in London?"
},
{
"speaker": "Terrence Duffy",
"content": "That's a great question, Mike. I mean, one of the things that I am going and talking to about treasury futures clearing is and I'm getting some traction on is I don't think people realize the size of the derivatives market that it is today, which is 13% larger than the cash market on an annual basis of notional trade. So you have a new law on cash treasury clearing with the exclusivity of that particular law on cash treasuries being cleared under the guidance of -- and regulation of the SEC, not any joint guidance. I think people start to realize that there are these products, treasury futures, treasury cash, potentially ETFs are a huge part of the ecosystem that make that market work. So I think people are realizing that now. Again, I don't think people realize the size of the derivatives market and the importance there of it, I think everybody understands. So I think people are starting to take notice of it. I cannot predict what the outcome is going to be one way or another, but I will tell you that there's been inquiries coming from the Hill to the regulators. I know there's been responses from the regulator back to the Hill that they're taking this very seriously and they are trying to analyze what it means for a cross border clearinghouse to be clearing foreign sovereign debt in futures. And how does that work as it relates to potentially the MOUs that are under -- they have today, which have been amended, which nobody is talking about either. As you may or may not know, the Bank of England changed their bankruptcy laws and they no longer have -- US participants no longer have protection under the bankruptcy laws of the UK. The UK is now -- the Bank of England is the default for all bankruptcies as it related to systemically important institutions. And that is different from what was in the original MOU with the CFTC when they became a registered in both US and the UK. So I think there's a lot of changes. So people are understanding that. We're explaining that to them the importance of it. And what does it mean if they were to come open up a clearing house in the US as the second part of your question, I believe and they did have that. One LCH under LSE had a US clearing entity, which is now Dormy. I don't believe it's up and running at all for any products. And if in fact, they decided to reconstitute that clearing house here in the US, the offsets would not be what they suspect they would be in London. So they would lose the offsets against the portfolio. So I guess I would have to ask what's the benefit of them doing it and the cost associated for the London Clearing house to reconstitute that clearing house in the United States to do so. So I'll turn it to my colleague, Suzanne Sprague, to clean up anything that I said improperly."
},
{
"speaker": "Suzanne Sprague",
"content": "Yes, just to the second part of your question on the ability to achieve the offset between clearing houses in different geographies. No, it's hard to speculate on how the regulators would look at that today, but our own experience in the past has shown that it is very expensive to do so. So the regulators had basically required the clearing houses to hold capital in the amount equal to the margin savings you give your participants. So the clearing houses basically still have to be fully capitalized in each jurisdiction to recognize the benefit of the margin offsets that you give to customers. And the reason for that really has been back to Terry's point on the resolution regime, given that the domestic regulator would be the one overseeing the resolution of each clearing house, the domestic regulators have wanted to be fully capitalized even in spite of any margin efficiencies that you're able to give between clearing houses. So we hadn't been able to get over that hurdle in the past. I would anticipate that would hold true in the future as well."
},
{
"speaker": "Michael Cyprys",
"content": "Super. Thank you for the comprehensive answer there. Just a follow up, if I could, on interest rate swap clearing, I thought I heard reference to a $40 billion margin of swap collateral. Just curious how much of that was on the US interest rate side and maybe you could just elaborate a bit on what sort of growth you're seeing across your interest-rate swap clearing business? How much that's contributing overall today? It seems like this could be a growth opportunity for you given the larger clearing house overseas. What steps might be able to take to convince customers to move their swap clearing business over to you? How might you increase that appeal and reduce some frictions and make it more seamless for customers to move more activity over?"
},
{
"speaker": "Terrence Duffy",
"content": "Lynne and Mike, you guys want to address that?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, Stuart. Thanks for the question. So in terms of the amount of US dollar swap margin as a percentage of that total, it is the majority that tends to fluctuate, I think, between about 75% and 80% in terms of the amount of total margin requirement that we have coming from the swap activity. I will reemphasize again just the point of the efficiencies that are gained in the portfolio margin program. I think that is a primary driver to the level of activity that we see in our swaps offering. Capital efficiencies in that space have been a large focal point really since the onset of the clearing mandate for swaps clearing, especially because the regulations require a five day margin period of risk for those products. So there is even more focus on being able to offer efficiencies within the swaps complex and across other asset classes or other complexes within the interest rate asset class like features and options. So I'll pass it over to Mike for anything else you wanted to add there on the competitive landscape."
},
{
"speaker": "Mike Dennis",
"content": "Yes, Mike, thanks for the question. Good morning. Yes, for me, being here a short period of time, my first order of business was to meet with all the dealers and kind of talk exactly about what you're highlighting is our margin efficiencies between SOFR futures, treasury futures and our swap portfolio. Obviously, a general theme on the street right now is Basel III Endgame, challenges with capital, tightness of liquidity and how this is all going to impact the balance sheet. So we're definitely in front of clients. We're definitely explaining this value proposition. We've seen a little bit of renewed interest in sending portfolios to us to do some what if scenarios and some portfolio calculations. So we do think, to your point, that it is a good area of growth for us."
},
{
"speaker": "Mike Dennis",
"content": "Great. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from Bill Katz with TD Cowen. You may go ahead."
},
{
"speaker": "Bill Katz",
"content": "Okay. Thank you very much for taking the question this morning. Just maybe on expenses. Just you reiterated your guide of $1.585 billion for the year, which would assume some seasonal, well, pickup into the fourth quarter. So how much of that is seasonal versus more structural? And then as you think about the business conceptually, you're operating at a very high level of profitability, 69% margin. How do we think about that going forward? Is there a natural governor to the margin or would you let that drop to the bottom line? Thank you."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes, Bill, this is Lynne. So on your first question, one thing to keep in mind is we typically have some of our larger marketing events in the fourth quarter. So it is not unusual for us to see an increase in that quarter related to that spend. So you will see if you look back at 2023, the Q3 to Q4 expense growth was $40 million. That is the same growth that would be implied by our guidance of this Q3 to Q4. So the majority of that is going to be that outsized marketing spend. Some of it also will go to things like the joint support for some of the new retail FCMs that have come online. So kind of capitalizing on some of that opportunity for revenue growth. And then you will continue to see some of that ramp up in our cloud migration expense that growth in the technology line. As we've moved more applications to the cloud, you will see that grow and we've seen some of the offsetting declines in depreciation rolling through. But all of that was anticipated in our guidance that as we continue on that migration path, you would see that amount move up. In terms of margin, we don't target an operating margin kind of similar to the question on RPC before. We're focused on how we drive that earnings growth. If there are opportunities for us to invest in new opportunities or new growth initiatives, we certainly are going to do that. Not focusing instead on what our target operating margin would be. We're focusing on driving growth. So obviously, we have enjoyed very nice margins and it relates to the ability of us to return a lot of cash to our shareholders. But that is -- that's part of the beauty of our model and the cash generated -- generative nature of the business, but it's not something where we have a specific target in mind for a margin level."
},
{
"speaker": "Bill Katz",
"content": "Okay. Thank you. And just as a quick follow up, just going back to the rise of the retail opportunity broadly, given that sort of an ongoing opportunity, how do you think about the -- for those clients that may be on the platform already, let's say, a year or so or just whatever the appropriate seasoning point would be, what kind of uplift do you tend to see in terms of that volume growth? And is there any way to sort of think about what that is as a percentage of your total ADV? Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Bill. I'll let Julie touch a little bit on the retail growth and I think you did a lot of it already, but maybe you can just add a little bit more thought."
},
{
"speaker": "Julie Winkler",
"content": "Yes. I mean, as Terry mentioned earlier, difficult to kind of predict revenue. And again, you've got to remember across our distribution partners, they also have slightly different businesses, right? So we have some of our distribution partners that are futures only firms. We have others that have a broad product portfolio and are initially coming to us as existing CFD providers, for example, some of these distribution partners that we're working with in Europe as well as just the account size that each of these different players are targeting as well. And so it's difficult to kind of give a more sweeping or generalized view into what that ADV growth can be, which is really why we're highly focused on bringing net new traders into the marketplace as well as our education and our content opportunities across that. So we work with each of these distribution partners. We have well over 100 of them around the globe and really try to fine tune with each of them, what content is most appealing to them and also what else we can be doing in terms of hosting joint events with them, both online and in person. This still continues to be a great way of how we see acceleration of their revenue growth is to help educate them and bring in other people that are third party influencers that also just talk about what some of their trading strategies are in this space. So it is really I'd say, a multifaceted approach in order to bring volume. And clearly, right when I spoke earlier about their initial interest in equity, they're going to trade what also is moving, right? And so we often are making sure that we are working with our partners to provide product information to those contracts that are at that point in time seen higher volatility and that's where again our diverse product portfolio really plays into that where if equity vol is down, we can very much switch to talking to them about WTI and Micro Gold, which is really what we saw with micro volume up right 35% year-on-year already. So this is part of really our strong offering and continuing to look at some other new product opportunities in the retail space with our partners for next year too. So we're excited about that."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Julie. Thanks, Bill. And just to add to what Julie said, the beauty of this quarter, again, as in the last one, all six of our asset classes were up. It wasn't just one that was moving. All six were up at the same time, which is really amazing for us. So thanks for your question, Bill."
},
{
"speaker": "Bill Katz",
"content": "Thank you all."
},
{
"speaker": "Operator",
"content": "Thank you. And that was our last question. I'll now turn the call back over to management for any closing remarks."
},
{
"speaker": "Terrence Duffy",
"content": "We thank you all for joining us this morning. Appreciate it very much. Look forward to communicating with you throughout the quarter and talking to you again next quarter. So thank you. All be safe."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's conference. Thank you all for participating. You may disconnect at this time."
}
] |
cme | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Welcome to the CME Group Second Quarter 2024 Earnings Call. At this time I would like to inform all participants that your lines have been placed on a listen-only mode until the question-and-answer session of today's conference. I would now like to turn the call over to Adam Minick. Please go ahead."
},
{
"speaker": "Adam Minick",
"content": "Good morning. I hope you're all doing well today. We released our executive commentary earlier this morning, which provides extensive details on the second quarter 2024, which we will be discussing on this call. I'll start with the Safe Harbor language and then I'll turn it over to Terry. Statements made on this call and in the other reference documents on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance. They involve risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statement. Detailed information about factors that may affect our performance can be found in the filings with the SEC, which are on our website. Lastly, on the final page of the earnings release, you will see a reconciliation between GAAP and non-GAAP measures. With that, I'll turn the call over to Terry."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you, Adam, and thank you all for joining us this morning. I'm going to make a few brief comments about the quarter and the overall environment. Following that, Lynne will provide an overview of our second quarter financial results. In addition to Lynne, we have other members of our management team present to answer questions after the prepared remarks. Our strong second quarter results again reinforced how the need for risk management continues to grow. And CME Group is where market participants turn to manage their risk across the most diverse set of benchmark products. We delivered record quarterly revenue, driven by year-over-year growth in both average daily volume and open interest across every single asset class. This is the first quarter with this broad base growth since 2010. Second quarter average daily volume of 25.9 million contracts increased 14% and represented the highest Q2 ADV in our history, including a quarterly record for non-US average daily volume of 7.8 million contracts or up 23% year-over-year. This robust activity drove record adjusted quarterly earnings which Lynne will detail shortly. We delivered 16% year-over-year ADV growth across all our physical commodity products to 5.2 million contracts, which included double-digit year-over-year growth for both energy and metals products at 16% and 42% growth respectively. Importantly, our overall Commodities portfolio has generated record revenue year-to-date in 2024, up 16% versus the first half last year to over $836 million, representing 34% of our clearing and transaction fees revenue in the first half of the year. Turning to our financials, total ADV across the complex increased 13% from Q2 last year, including record Treasury ADV of 8.2 million contracts or up 36%. Our US Treasuries set a new daily volume record of 34.4 million contracts during the quarter on May 28th. The continuing high levels of issuance and deficit financing are tailwinds even in the absence of Fed rate changes. Also, Foreign Exchange second quarter ADV grew 20% versus Q2 last year. In addition to our impressive quarterly volume results, we continue to provide unmatched, and I’d say it again, unmatched capital efficiencies for our customers. Within interest rates alone, these efficiencies result in margin savings of nearly $20 billion per day for our clients through the unique combination of offsets within our rates futures and options franchise. Our one pot margining with CME cleared swaps and cross margin offsets versus cash treasuries, offers clients the efficiencies which no one else has the regulatory approval to provide. Coupled with the 13 million interest rate futures and options traded at our exchanges on a daily basis, the liquidity depth of book and capital savings in our interest rates complex is unparalleled. While we are pleased with our record results and our ability to consistently deliver quarterly earnings growth, we continue to innovate with an eye towards the long-term needs of our customers. Near the end of the quarter, we were particularly excited to announce a significant step forward in our partnership with Google Cloud. I have Ken Vroman in the room with me who will provide more detail during the Q&A period on the integration. We plan to build a new private Google Cloud region, and a co-location facility in Aurora, Illinois, designed to support global trading of our futures and options markets in the cloud with next-generation cloud technology, ultra-low latency networking and high-performance computing. This next generation platform will build on the benefits we provide our clients today through a broader range of connectivity options and faster product development. In addition to our state of the art trading infrastructure, our clients will also be able to utilize Google’s artificial intelligence and data capabilities to help develop, test and implement trading strategies to manage their risk more efficiently. Finally, as we begin the second half of the year, looking at the uncertainty around the US political landscape with the disparity of opinions and policies, the need to mitigate and manage risk has never been more paramount. On top of that, the ongoing uncertainty in the Middle East, coupled with the unrest between Russia and Ukraine are continuing issues with no end in sight, that markets need to manage. These are just a few of the geopolitical events that highlight the need for our risk management products. We look forward to working with our clients to make sure they have the most liquid and efficient markets to manage these issues, and all the others we encounter in this world. I’ll now turn the call over to Lynne to review our Q2 financial results."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thanks Terry and thank you all for joining us this morning. CME Group delivered the strongest earnings in our history this quarter. Starting with the highest ever quarterly revenue at over $1.5 billion, up 13% from the second quarter in 2023. Quarterly revenue for our physical commodities asset classes grew 17% year-over-year and represented over one-third of clearing and transaction fees in the quarter at $444 million. Market data revenue of $175 million increased 7% from the same quarter last year and other revenue increased over 35% to $107 million. Continued strong cost discipline led to adjusted expenses of $474 million for the quarter and $388 million excluding license fees. Our adjusted operating margin was 69.1%, up from 66.8% in the same period last year. CME Group had an adjusted effective tax rate of 23.1%. Driven by the robust demand for our risk management products, we delivered the highest quarterly adjusted net income and earnings per share in our history at $932 million and $2.56 per share both up 11% from the second quarter last year. This represents an adjusted net income margin for the quarter of 61%. Capital expenditures for the second quarter were approximately $17 million and cash at the end of the period was approximately $2 billion. CME Group paid dividends during the quarter of $419 million, and we have returned over $25 billion to shareholders in the form of dividends since implementing the variable dividend policy in early 2012. A consistent, higher level of demand for our products continued in the second quarter, evidenced by 52% of our trading days being above 25 million contracts in the first half of this year, compared to 34% in the first half of 2023. In addition, four of the first six months this year set all time volume records including all three months this quarter. We are very proud of the team for their efforts to efficiently run the business, driving earnings growth for our shareholders, while also focusing on the future and providing our clients with the risk management products and capital efficiencies they need as our industry continues to evolve. We’d now like to open the call for your questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin our question-and-answer session. [Operator Instructions] Our first question comes from Patrick Moley with Piper Sandler. Your line is open."
},
{
"speaker": "Patrick Moley",
"content": "Yes, good morning. Thanks for taking the question. So I think it was the first time today that you disclosed that aggregate amount of daily margin savings of $20 billion. Can you maybe just elaborate or provide a breakout of how that splits between the buckets or the margin buckets, cross-margining, portfolio margining? And then could you also maybe just help investors understand how that compares to what the competitor is offering and what type of moat that provides you when we think about your customers potentially looking elsewhere. Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Patrick. Thank you for your question. Sunil Cutinho is going to answer the first part, as Suzanne Sprague is out sick today. So Suzanne -- or Sunil as you know, headed up our Clearinghouse for many, many years, who is very informed on that question. I will answer the latter part of that question as it relates to the competitor and what they offer, because it will be a short one. But go ahead, Sunil."
},
{
"speaker": "Sunil Cutinho",
"content": "You know, the same clients trade both futures, options, swaps, and cash products. So the rough split is around $12 billion for futures and options, $7 billion for swaps with futures and options, and then $1 billion including the cash."
},
{
"speaker": "Terrence Duffy",
"content": "Patrick, if you're referring to a competitor such as people who have announced they're going to compete with us, their efficiencies are exactly zero. They don't have any futures’ business so they can't have any efficiencies to-date. So I don't know what you want me to do, speculate on what you think they are going to get or not get, but the answer to your question, they have zero efficiencies. Sunil?"
},
{
"speaker": "Sunil Cutinho",
"content": "The only other, an additional thing I would add is our competition cannot provide any efficiencies relative to options either."
},
{
"speaker": "Terrence Duffy",
"content": "Correct."
},
{
"speaker": "Sunil Cutinho",
"content": "It's very unique to see [anything] (ph)."
},
{
"speaker": "Patrick Moley",
"content": "Okay great and maybe just one on the pricing increases you announced at the beginning of the year. I think you said you expected market data revenues to increase by 3% to 5% and then 1.5% to 2% bump in futures revenues. Could you maybe just update us on how you're feeling about, how you're tracking towards that? And, with half the year behind us, you have a sense of where you could maybe come in directionally within those ranges. Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Patrick. Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yeah, so thanks, Patrick. So far in the first half, we are very consistent with the guidance. So we said 1.5% to 2% on the clearing and transaction fees, 3% to 5% on the various data products, and then getting to a total revenue impact of somewhere between 2.5% to 3%. And I would say that we're tracking very well on each of those line items through the first half."
},
{
"speaker": "Patrick Moley",
"content": "Okay, great. Thanks for that. I'll hop back in the queue."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Ben Budish with Barclays. Your line is open."
},
{
"speaker": "Benjamin Budish",
"content": "Hi. Good morning and thanks for taking the question. Maybe just following up on Patrick's first question, can you give us an update on where you are with the DTCC cross-margining program? How are efficiencies looking there versus what you've kind of been signaling and where are you in the process of getting to where you think you'll be getting to."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Ben. Again, I'm going to turn it to Sunil with that answer. Sunil?"
},
{
"speaker": "Sunil Cutinho",
"content": "We have 10 clearing participants taking advantage of it. We have a few more in the pipeline that will be onboarded shortly. And as I mentioned before, we have grown to about $1 billion in savings and we'll continue to grow that. We are also working on trying to provide efficiencies all the way to indirect participants, but that would require an approval with the RESI."
},
{
"speaker": "Terrence Duffy",
"content": "So the savings then has gone up exponentially since we last reported out last quarter. So that number hitting a high watermark of near $1 billion is a record for us."
},
{
"speaker": "Benjamin Budish",
"content": "Okay, that's very helpful. And maybe just a follow-up on the energy side. You published a white paper recently talking about the increasing use of WTI and setting the price of Brent and how you were seeing, I think an increasing amount of WTI trading happening during European hours. Could you just unpack that a little bit? Are you seeing new customers joining the platform? Is it taking share from existing customers that may have been previously trading on other exchanges? Any other color there would be helpful. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Ben. Derek."
},
{
"speaker": "Derek Sammann",
"content": "Yeah, thanks, Ben. As you heard Terry mention at the top of the call, we set a record revenue this year for the first half in the commodity side. Energy is a big part of that. Our overall energy volumes are up 16% this year to 2.4 million contracts. We've also seen our [open interest] (ph) grow 20% as well. When you look at our WTI business, as we've said with record amounts of US Crude oil out in the market, both in production side and export side, that's creating net new exposures for non-US customers on the WTI side. When you look at where those growth is coming from in our WTI complex, we actually see that our energy volume across EMEA is up 53%. So European volumes from European customers up 53% this year. Just on the WTI future side, that's up 42% from European customer base. So as we expected, as physical US oil hits the global market, we are expecting to see customers that were not directly exposed to US crude oil imports in Europe, now using WTI products to manage that risk. We're seeing that most acutely on the option side as well where WTI options is up 23% this year. As it relates to kind of the share and where that's coming from, we are seeing net new customer growth on the WTI side in Europe, but we're also seeing shares between our WTI and the competitors WTI basically flat, going back seven months now to December of last year. And actually in options, we are seeing our share increase to 89% and 86%. So we are growing in absolute terms, we're growing in relative terms, and we continue to see that growing."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Derek. Thanks, Ben."
},
{
"speaker": "Benjamin Budish",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Simon Clinch with Redburn Atlantic. Your line is open."
},
{
"speaker": "Simon Clinch",
"content": "Hi. Thanks for taking my question. I was wondering if you could circle back to the process of competition here. And I was wondering if you could expand on the levers you would consider pulling. And what kind of signals you would be looking to as you respond to competitive FX going forward? Just maybe you can reference how that's been done historically because this has always been a competitive environment. Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Simon, is your question is what we are going to do if they actually launch and what are we going to do if they actually get business? I'm confused what you're asking."
},
{
"speaker": "Simon Clinch",
"content": "No, it is more a case of what would you be looking for? And in terms of what they might do and how you might think about responding to those signals. Not that a will necessarily happen, but --."
},
{
"speaker": "Terrence Duffy",
"content": "I made it perfectly clear on the last call that we have done a number of things over the last eight years to 10 years to put ourselves in the strongest position possible. I could not cite the numbers of $20 billion if we didn't make the investments we have made over a long period of time to create the efficiencies for our client base. And that is something that is unparalleled as I've said, in the industry. We are in a very strong position today. So to walk away from a potential $20 billion of margin savings on a daily basis to go to an unproven model seems to be a bit of a fiduciary stretch for people to direct business in that venue. So we’re in a strong position today to compete with anybody, including the announced competitors. And so this is something that we've always been prepared for. We always are preferred -- prepared for. And I do believe competition always makes everybody better. So I take everything seriously. And that's the reason why we've made the investments we have for our clients along the way. That's what we've done and that is what we'll continue to do. First part of this question -- those are an additional steps. I have to wait and see what they are going to offer here. Let me be clear. There is no approval for anybody to list in the United States, foreign sovereign debt and clear that US foreign sovereign debt in another legal jurisdiction outside of the United States. There is $27 trillion of outstanding debt in treasuries that the US Treasury in the United States government depends on to run this country, under the rules of the United States, not under the rules of the United Kingdom or the Bank of England. So we will wait and see how that proceeds if that offering goes anywhere. I think there is a lot of concern about giving up jurisdiction to a nation the size of Great Britain with some of the track records they've had with LME and some of the other issues they've gone forward with. So we will have to wait and see Simon. So I don't want to put the cart in front of the horse, but I think there is a long way to go before that's even been decided what you can and cannot do. That's why the efficiencies are zero, and they'll stay zero."
},
{
"speaker": "Simon Clinch",
"content": "I appreciate that. Thanks very much Terry. Just as a follow-up question. Just going back to the pricing dynamics in futures and options. Could you just expand on what's really going on from a mix perspective from -- in RPC, particularly in rates? I just noticed that we are back to sort of year-on-year declines and despite what should ultimately be a positive mix shift towards the long-term rates within that franchise. And I'm just trying to piece that together. Thanks."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "I'll take the price increase. So Simon, you are looking at the year-over-year rate RPC in total. That's your question."
},
{
"speaker": "Simon Clinch",
"content": "Yes and the [inside the] (ph) and impact from rates as well with."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So if you look at rates on a year-over-year basis, they were up 14% volume-wise. So you are going to see some pressure -- downward pressure from the increased volume tiering. You also have a higher contribution of treasuries, which is a positive but you do have higher members this quarter, and you do have a decrease in some of the block volume that we saw last year. So there is a number of factors at play there. I would say the most impactful is probably that a 14% uplift in volume, which is going to have that downward pressure on the RPC, but still a strong revenue growth number for the rates complex, given that volume growth."
},
{
"speaker": "Simon Clinch",
"content": "Okay, that's very useful. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Dan Fannon with Jefferies. Your line is open."
},
{
"speaker": "Dan Fannon",
"content": "Thanks, good morning. Was hoping Lynne, just to talk about expenses for a bit. First half run rate is tracking well below the guidance, typical seasonality of that building in the second half. So hoping you could flush out a bit of what you are spending on? And then also the new colocation facility that you announced in partnership with Google, just thinking about that in terms of what that means from an expense and/or investment perspective and versus the guidance that you've kind of talked about in terms of that Google partnership over time?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Sure, Dan. Happy to. So yes the guidance, we’re still comfortable with the full year guidance that would imply about a $60 million increase in the back half of the year versus what we saw in the first half, there is a few things to keep in mind. You mentioned the typical uplift in our marketing and event spend in the fourth quarter, that is going to continue, but you also have other items where we are spending more on things like some retail marketing as we are supporting some new brokers that are coming into that space. Another piece of that increase is going to be around the Google migration. So some of the cloud consumption you will see increases in our technology line item. You are starting to see that in the past few quarters, you will continue to see that as we go through the balance of the year. As we move more applications into the cloud, you will see more of that consumption spend. Remember the offset is we are spending less on CapEx, and you are seeing that come out of depreciation as well. The other things to keep in mind are some of the project-based work on things like the treasury clearing project that we've announced and the balance of that increase is going to be in compensation. So we remain comfortable with that increase, and it is a number of factors beyond just the typical marketing spend in the fourth quarter that we've seen in the past."
},
{
"speaker": "Terrence Duffy",
"content": "Jim, do you want to talk more about the market and the second part [you] (ph)?"
},
{
"speaker": "Adam Minick",
"content": "You mean, Ken?"
},
{
"speaker": "Terrence Duffy",
"content": "Ken, I'm sorry."
},
{
"speaker": "Kendal Vroman",
"content": "Yes. Maybe -- thanks, Terry. This is Ken Vroman. Maybe just a little bit of context on what's next with respect to Google. We are very excited about what we announced and Terry alluded to this a one-of-a-kind purpose-built for CME facility that will provide scale and resiliency to our customer base. At the same time, allowing markets to operate in the cloud, not next to the cloud, in the cloud. And we think there is an innovative amount of engineering that went into delivering ultra-low latency capabilities in the cloud that will allow our customers to take advantage of that for both scale, efficiency, new products and new services. So with respect to that, we are very excited about that. We've extended our relationship with Google that goes out as far as 2037 to ensure that we have plenty of time to burn in this capability. So for next for us, we are in a process. We are now reaching out and working with our customers to drive that iteration and make sure that we get the technology and the ecosystem correct as we build the facility out in Aurora. At the same time, in parallel to that and related to some of the things Lynne's talking about, we are migrating our core business, our regular non-ultra-low latency business to the cloud, we received approval from the CFTC to run clearing in the cloud. We expect to be running cycles shortly in the cloud with respect to our business and other non ultra-low latency applications will go there. We are about two-thirds of the way through that migration and continue to make great progress with respect to it."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "And just to finish, Dan on the expense piece of that, it doesn't have an impact on the current guidance, and we will layer in any impact in the out years, as we give the guidance going forward. So no impact yet on our financial guidance from the Co-lo facility."
},
{
"speaker": "Dan Fannon",
"content": "Great. Thanks for taking my question."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks Dan."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Owen Lau with Oppenheimer. Your line is open."
},
{
"speaker": "Owen Lau",
"content": "Hi, good morning. And thank you for taking my question. So it's a broad question and go back to Terry's comment about the upcoming election. I know you have many different asset classes, but I'm interested to hear more about how does the upcoming election and potential change in administration could impact CME over the next 12 months to 24 months. Is it mainly because of volatility? Or there is some potential secular trend that we may not fully appreciate? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Owen again, this is speculation. So we have to be very careful here. Depending on who assumes the White House, is it the same policies that we've seen over the last several years? Or is it a new administration with President Trump coming back in and putting his agenda in place. You know what his agenda is, is for less regulation, less taxes, things of that nature, more security for the country, more domestic pay attention to more domestic issues to try to eliminate those. So the question will be what does that have to do with markets. I think regardless of who sits in the White House, the uncertainty as I said in my opening comments, is there and markets are going to need to manage that risk because no matter what people say on the campaign trail and what they do once they assume office are normally two different things. And if you look at history that will -- you'll find that to be a fact. It is very difficult to follow through with some of the rhetoric that you say on the campaign trail. So markets get very skittish one way or another, get excited one day, not so excited as the next is President Trump going to sit on the Fed or make fun of the Fed like you did prior, the -- to tried to get them to take rates down? Or does the Fed stay independent like he has which I think he’s done a great job of doing. So there is a lot out there about pressure in rhetoric. So we are going to have to wait and see. We've had a man. If he does have a change of administration, had four years in the office. And if he does reassume that office, I think he will have a whole new cabinet and obviously a new cabinet with new people around him that could the advice might be completely different than the first four. And if, in fact the current Vice President assumes the office, we know where the administration has been. And so I don't think there is any surprises there. So that's the best way I can look at it, and say that, I think overall, the volatility issue with the markets because the US is the dog that wags the tail around the world is going to be very important. We saw what happened in France, a little a bit of a surprise. We saw what happened in the UK, a little bit of a surprise, markets need to pay attention to this because it has long-term effects on it. So again, we've got to get rid of the rhetoric, see who wins and then we'll move forward, but that's how the markets seem to manage it. Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. And Owen I would just add that regardless of that dynamic, we are seeing a lot of this volatility play-through in our markets today. So we talked about the records in the quarter, the fact that all six asset of the classes were up in both volume and open interest. If you look on a year-to-date basis, we have that same trend. So July has continued to be strong, running 20% ahead of last July, trending towards an all-time record if these levels hold and we are continuing to see that year-to-date across all six asset classes, the volumes are up and the open interest is up, and that's something that's fairly unusual. Typically it won't be such a broad-based use of our product, but we are seeing that people need this risk management in this current environment across all of the offerings that we have."
},
{
"speaker": "Owen Lau",
"content": "Got it. That's helpful. And then my follow-up about -- maybe about the stock. I mean the company continues to have record quarter, but the stock has been under pressure this year because of the interest rate and competition narrative. Do we change how you approach your capital allocation priority and acquisition strategy if the situation persists or not at all? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "I think we got your question. It came through a little bit scrambled. But your question was about, I think capital return. And then your question was the pressure on the market? Is it due to announced competition? Or is it due to Fed policy. Is that fair?"
},
{
"speaker": "Owen Lau",
"content": "I would say the stock has been under pressure even though you continue to achieve record quarter, because of the company's narrative. How does that dynamic change -- how you approach your capital allocation priority. I think that's the question. Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Okay. So Lynne is going to go head start, and then I'll jump in."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So certainly, we have seen the disconnect between the record performance and the stock price. And certainly we continue to do what we can on the performance side to help that equation. On the capital return policy, it's something that we consistently look at. It is something we are undergoing a new review on again. It is something that we do periodically as good stewards of the capital to make sure we're returning that capital to shareholders in the most effective manner. So we'll be continuing to go through that process. And should anything change, we'll certainly communicate with both shareholders and the analyst community."
},
{
"speaker": "Owen Lau",
"content": "Got it. Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks Owen."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Chris Allen with Citi. Your line is open."
},
{
"speaker": "Chris Allen",
"content": "Good morning everyone. Thanks for taking the question. I wanted to talk through some of the structural growth opportunities, specifically in energy around natural gas, expect there to be a material impact from AI-driven data center demand on natural gas over the next, call it, five years to 10 years. I wonder if you could help us frame out the opportunities you see it what potential impact you could see on volumes? And any color just on whether data centers currently hedge energy exposure? And if not any thoughts on why?"
},
{
"speaker": "Terrence Duffy",
"content": "So before Derek answers on the natural gas, which we have a good story to talk about with natural gas and he will so. Are you suggesting that because of AI and the compute that it will take to run AI that natural gas will be more in favor or out of favor? I'm trying to understand your question. Is that your question?"
},
{
"speaker": "Chris Allen",
"content": "Yes. Our energy team here has done work around the incremental demand -- energy demand from data centers driven by AI. And 50% is expected to be filled by natural gas, a pretty material increase. So I see it as a positive catalyst. Just wondering how you guys are framing that out."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you. I just want to make sure we understood your question."
},
{
"speaker": "Derek Sammann",
"content": "Yes. Chris, I think that they don't disagree with the premise that there’s going to be increased demand for natural gas and AI. But frankly, that's just the energy transition story. So I mean, you're just seeing natgas replace all other, I mean we're seeing coal reduced eliminated. We are seeing not a real adoption of nuclear. So natural gas is that solution. We are already seeing that in the record results in our natural gas business now. When you look at the year we put up already this year, we set multiple records on a year-to-date basis and quarterly basis for both futures and options with natgas up 29%, more important natgas options up 54%. This is a global story as much as a domestic story because we are seeing our fastest growth in our Henry Hub Compact coming from outside the US. So when you look at the EMEA business growth right now, we are seeing our 2024 year-to-date consumption of Henry Hub, up 78% year-on-year. We're setting records in terms of participation, globalization and options are a big part of that as well. So we see this as a broader story, not limited to energy being consumed by AI, but natgas being not just a transition fuel, but a fuel for future. And that is a position that we are in -- we're 80% market share of that natural gas futures business, and we've increased our shared of Henry Hub options business as well to about 69%. So we feel good about that. We agree with the premise that we'll see natural gas be a bigger source of energy consumption over time, and we like our global position in Henry Hub there."
},
{
"speaker": "Terrence Duffy",
"content": "And Chris, just to follow up on that. I think you guys are right. The question is to Derek's point, I don't know if I would just use AI as your story. When you look at the grid system in the United States of America, the grids are down significantly and to continue to power them up, which you know as well as anybody, the grids today are powered by nuclear and fossil fuels and a handful of what they would call green energy, but that's 2% or 3%. So natural gas needs to play a bigger role because we are running out of power in parts of the world today. We don't have the -- so not only computing AI, how about lighting our homes and powering our country. So there's a lot -- it's a lot bigger story than just AI, but we agree with your premise."
},
{
"speaker": "Chris Allen",
"content": "Thanks. And just for a follow-up, wanted to dig a little bit on dealer relationships. I'm just wondering what areas there are ways to improve relationships with dealers. I would imagine price is always going to be top of their list. But I'm just wondering what other areas would dealers be asking for in terms of rooms for improvement in how they view the CME?"
},
{
"speaker": "Terrence Duffy",
"content": "I think that the relationships are good Chris and maybe you heard something I didn't. But we worked very closely with them. I work with not only the CEOs of all the dealers, but up and down the street with the people who run the FCMs, as does my team. And I think the way the relationships are always enhanced is by giving them return for their trading. And when you can invest over the years, like I hate to keep Harper on this, but give them basically $20 billion of savings on a daily basis in the capital-constrained world, you got to imagine that crosses a lot of bridges for them and makes them very pleased with what we are doing. So I think the relationships are good. The dealer community does have a tendency to turn over a little bit more than the exchange community. So we are constantly working to bolster those relationships. But I don't see them as fractured in any way, shape or form. And I think that the guy that's out there promoting his 10 friends is trying to promote that there is a fracture in there because of pricing and other things. What you got to remember, and I think Chris, you're smart enough to understand this, that the smallest cost of any transaction is the transaction cost. The spreads are what really affected the dealers and affected participants, and they know that. So the cost is not the issue. We bring a lot of value to it, and that $20 billion goes a long way on a daily basis."
},
{
"speaker": "Chris Allen",
"content": "Thanks guys."
},
{
"speaker": "Terrence Duffy",
"content": "Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Craig Siegenthaler with Bank of America. Your line is open. Craig your line is open. You need to unmute yourself."
},
{
"speaker": "Craig Siegenthaler",
"content": "Hi, good morning. Can you guys hear me okay?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes, Craig. Go ahead. We got you now."
},
{
"speaker": "Craig Siegenthaler",
"content": "All right. Perfect. Good morning everyone. So we had a follow-up on the rates capital efficiency topic. So in the quarter, you held a call and disclosed that the capital efficiency of cross-margining CME futures with CME interest rate swaps was 20% to 25% less than CME future to future clearing. But given that your rate swaps business is heavily skewed towards Latin America would it that actually reduce the capital efficiency versus a business that was mostly SOFR-based?"
},
{
"speaker": "Terrence Duffy",
"content": "I'm not sure we're calling you on, Craig. We didn't say that. So -- that is not true, and we are happy to have a follow-up as Sunil can walk you through it right now, but we did not say that."
},
{
"speaker": "Sunil Cutinho",
"content": "We have deep and rich liquidity across all of our rates products. You are rightfully pointing out that we have significant market share in Latin American currencies, but our dollar market is very strong. And we’re the only clearing house that provides capital efficiencies between futures, options, cash and swaps or dollar rate. So the growth has been very strong. The capital efficiencies in and of themselves are a function of the structure of the portfolio and the open interest. And as Lynne pointed out, the open interest has grown as well."
},
{
"speaker": "Terrence Duffy",
"content": "So Craig, I think what we were probably pointing out, maybe what you've heard is we are dominant in some of those Latin American rates swaps business clearing, but if you look at the swaps clearing against our future portfolio today, I assure you if anybody was giving up on portfolio margining, they would move their swaps to CME to get those offsets today. So everybody that's trying to achieve offsets is to bring this business to CME and that's the reason we got the $20 billion. So I think we were pointing out the dominance we have in the Latin American nations of their swaps clearing out. Is that fair, Sunil?"
},
{
"speaker": "Sunil Cutinho",
"content": "That's fair. And then the most important metric here is we have over 3,300 large open interest holders. So they are ones who are carrying inventory every day. And as Terry pointed out, they have to fund those positions every day. So this $20 billion in capital efficiencies is material."
},
{
"speaker": "Terrence Duffy",
"content": "And that's an important number, Craig and for the rest of the call, that 3,300 large open interest holders, they direct where they their trade to go because they are the ones driving the benefits of the $20 billion. So that's a lot of people to convince, it is not convincing 10 people, two of which are proprietary trading firms."
},
{
"speaker": "Craig Siegenthaler",
"content": "Got it. I guess our worry was that CME may not have enough SOFR initial margin balance to provide total savings and that the portfolio margin benefit between US rates futures and last in interest rate swaps might not be as efficient as US rate futures to US rate swaps. So I don't know if you can provide any kind of high-level commentary efficiency between the two, but that would be helpful."
},
{
"speaker": "Terrence Duffy",
"content": "All right. Tim?"
},
{
"speaker": "Tim McCourt",
"content": "Hi, Craig. Yes, I think what's interesting -- I think what you are trying to get at is there is various permutations and calculations of how those capital efficiencies can be extracted across the various product types. I think what the main takeaway should think about SOFR is right now, we have 100% of the SOFR open interest across futures and options. So we are the only ones who can actually afford that as a mechanic or a part of the calculation to unlock that saving. So SOFR could be used against OIS swaps on the cleared swap -- side that can be used against treasury futures. SOFR futures can be used against, SOFR options and with the improvements we made in January that can now be used against cash positions at FICC with the enhanced gross margin. So the real takeaway here is not necessarily just a mathematical result. You have to look at the gravity of the risk pool that is here at CME with the large open interest holders, the growing open records across the rate complex, those are the more important things because that was the cornerstone of how clients access the capital efficiencies, not just the individual computation by any sort of one possible trade combination."
},
{
"speaker": "Terrence Duffy",
"content": "Does that help -- does that give more color for you Craig?"
},
{
"speaker": "Craig Siegenthaler",
"content": "No, that's helpful. Thank you guys."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Kyle Voigt with KBW. Your line is open."
},
{
"speaker": "Kyle Voigt",
"content": "Hi, good morning. Maybe just a follow-up on the cloud announcement. I'm just wondering if you could expand a bit on how that might work in practice in terms of clients potentially migrating towards a Google infrastructure as a service offering versus utilizing a self-managed infrastructure. And more specifically, I'm wondering if rolling out the new co-location facility and matching engine and the subsequent client migration will have any material impact, whether positive or negative on CME's connectivity, co-location or low latency data feed revenue?"
},
{
"speaker": "Terrence Duffy",
"content": "I'm going to let Ken answer that for you Kyle, but I'm going to make one comment because I think it's important. We listen to our clients who use that facility. And one of their main concerns when we announced this deal in 2021 of where that cloud could potentially be where would that data center be? How disruptive would it be? We've announced that, that cloud data facility is across the street. So there is no disruption from the client perspective. So we heard them loud and clear and we worked with our partners at Google for them to build a one-of-a-kind bespoke facility for CME's clients. Ken, I'll turn it to you."
},
{
"speaker": "Kendal Vroman",
"content": "Yes. One of the things just to build on that, a number of us were around for this, but when Globex was first developed, it wasn't as a replacement for the floor. It was put alongside the floor to enable new strategies, new business models, new products and services. We think about this as the migration to cloud very similarly. We allowed our customers to choose and migrate over time. So today, as we move forward with the cloud, our customers, because of what Terry said, because of the location, they will have the ability to choose. They can continue to do what they do today and manage their own gear or they can migrate into the Google managed solution and take advantage of the various capabilities there. But ultimately, it was important for us to allow the migration to happen based on the pull of the value proposition, not us pushing it in a certain direction. So the facility out there in Aurora allows it to leverage the infrastructure they have today, leverage the infrastructure we are building for tomorrow and that migration will happen in a seamless manner because of that. And so we can be both intentional and careful with our customer interest as we do that. And again, as I said earlier we are in a process now where we are iterating on a daily basis with our customers' input to make sure that we get all that right."
},
{
"speaker": "Terrence Duffy",
"content": "So let me just clarify one thing my colleague said because it is important, Globex was not a floor product. Globex was a product -- that was an electronic product that was distributed outside of the trading floor, so it's not a floor-based product. Just want to make sure that, that's clear for all the lawyers that are listening."
},
{
"speaker": "Kyle Voigt",
"content": "Just to clarify one point there, though -- but when the migration does happen or that pull does happen for those clients and they elect to migrate to the Google infrastructure. From a CME revenue perspective, is that a net positive or net negative or net neutral when you look at the connectivity colo and kind of low latency data feed revenue bucket?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. Kyle, there is a lot of moving pieces in that at this point. So once we get closer to that, we probably will have more guidance, but there is going to be a number of ways that you can access the facility. There's going to be a number of ways that you can excess data, so there's going to be potentially new streams changes to existing streams. It is just too early to comment on that at this point."
},
{
"speaker": "Kyle Voigt",
"content": "Okay. And then just if I could just follow up on the discussion around just competition. Obviously, we saw the announcements on the bank and market maker partners from FMX in 2Q. But I guess my question is more so on the client side. CME has a large sales force, you are in constant communication with your end-users of your futures products. I'm just wondering, at this point, if your sales team has been fielding more or any questions from kind of the end users, hedge funds, CTAs, asset managers, other buy-side firms about this FMX platform or any of the value proposition?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. So Julie, you want to -- I'll let Julie Winkler, our Chief Commercial Officer, who deals with most of the end user clients, I want the rest of us answer that."
},
{
"speaker": "Julie Winkler",
"content": "Yes. No, thanks for the question. And certainly this has been a great opportunity for our sales force to continue to engage with our customers, which is part of what we're doing each and every day. Our rates business is just continuing to demonstrate strength and resilience. This 15% surge in volume and record treasury futures ADV, it's giving us a lot to talk about with our customers. And the feedback, we are -- a key part of what we do is listen to our customers. And as Terry pointed out earlier, transaction fees are one very small piece of the value proposition that is being offered. And so what we are really trying to do is make sure we understand the dynamics of what they are hearing but also being very focused on highlighting the key aspects of our value proposition, which is our deep liquidity, the capital efficiencies that we talked a lot about on this call today and making sure that across our offering, both with BrokerTech and with our treasury futures complex as well as SOFR futures and options that people are well aware of all of those dynamics that we have, and that has been the focus of our conversation. So we are not assessing or hearing anything that's from those constituents that you spoke to earlier that would concern us that people are extremely happy and have shown that with their trading volume on our exchange over the past quarter."
},
{
"speaker": "Terrence Duffy",
"content": "In the calls that I feel that are call me Kyle, have been more of the business side of what we can do more together to continue to create these efficiencies. Those are the calls that I'm feeling, I'm not feeling anything about any other offering. So they are calling me about more efficiencies. Talking more about Basel III. What does that mean for the bottom-line? How can we work together to continue to build their business and CME's business together. That's the calls that I'm talking to from the real business rating community."
},
{
"speaker": "Kyle Voigt",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Michael Cyprus with Morgan Stanley. Your line is open."
},
{
"speaker": "Michael Cyprys",
"content": "Hi, good morning. Thanks for taking my question. Just wanted to ask on the rates franchise as the Fed begins to cut rates expected in a couple of months. Just how do you anticipate that impacting the types of instruments that customers will trade as well as the level of activity. And then specifically, how might it impact the capture rate if investors for example maybe extend duration or even shift from options to future? Just how do we think about any sort of impact to the capture? Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Michael. Tim?"
},
{
"speaker": "Tim McCourt",
"content": "Yes. Thanks, Michael. I think what's interesting is when we look at the backdrop that our rate conflict continues to serve the needs of our clients in, as Terry said, the uncertainty is only increasing over the both near-term and long-term horizon. So the one thing that is important is that we have all those tools at CME to trade, whether you want to use SOFR on the short end of the curve or the treasury complex on the long-end of the curve. We've already seen a tremendous amount of difference of expressions or reviews on what the Fed will do by the end of the year. We've gone from expecting six rate cuts across 2024 to maybe one now sort of the market is pricing maybe two by the end of the year, and we are well positioned to take advantage of that from both a product innovation perspective, where we've introduced things like T-bills on the short end of the curve. We are continuing to invest and add expiries to our SOFR complex and the option side. We are also continuing, as Terry said to figure out ways to unlock additional capital efficiencies around that. And how that sort of manifests into the capture rate or the RPC for the complex, that's tough to predict. As Lynne said earlier, the mix between [stories and lectures] (ph) is one element of the impact on RPC. It also is a function of what is being done on Globex versus ExPIT or in the block trade, also as well as member and non-members. So the fact that we have a very diversified healthy and robust community of traders as Sunil and Terry said earlier, over -- with a recent large open interest holder record of 3,370 large traders in that complex, that complex is growing. So we also need to factor in the growth rate of additional non-members coming online, additional increase in [biocide] (ph) participation, asset managers, insurance companies, all of these participants coming in. It is hard to forecast that it is important just to note that there is a difference, but it is more than just the volume itself, if the member, non-member and participant mix that will also increase or impact the RPC going forward."
},
{
"speaker": "Michael Cyprys",
"content": "Great. And just a follow-up. Yes. Can you guys hear me?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Go ahead, Michael."
},
{
"speaker": "Michael Cyprys",
"content": "Just a follow-up question, Terry to your point on the phone calls you're getting from customers asking for more efficiencies. Just curious how you are thinking about that, where there might be opportunities to bolster efficiencies for customers in the near-term and also the longer term, what steps might be able to take there? And are there any ways for maybe any strategic actions to help with that? Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Well, I'll be careful talking about strategic action, but there are some conversations going on as it relates to that, how we could be more strategic. I think when you look at what Sunil pointed out earlier with $1 billion with the offsets against FICC, which is growing exponentially, bringing in new -- bringing in more and more clients into that is something that is very exciting for them. These banks, these dealers need to continually look at ways to free up some of their balance sheet, so they can continue on with their other activities. And this is just another way of continuing to do it. So our conversations are more focused on that. There are some strategic conversations going on with some of the dealer communities that I've had and with other entities. So I think it is around efficiencies. Let me be clear about that. They are mostly dealing with efficiencies and what we can or cannot do together. So it is a pretty exciting time for the marketplace and we'll have more to report as we continue to have conversations. But at the moment, that's where I can go with Michael."
},
{
"speaker": "Michael Cyprys",
"content": "Great. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Alex Blostein with Goldman Sachs. Your line is open."
},
{
"speaker": "Alex Blostein",
"content": "Hi, everybody. Good morning thanks for the question as well. One slightly bigger picture question around the firm's kind of longer-term revenue growth algorithm that I was hoping to get your thoughts on. So -- over the years, CME rigs pricing across various parts of the business by call it, low single digits, maybe 2% to 3%. And as you think and kind of thinking forward, whether it is due to competition or feedback you are getting from the market, is that sort of 2% to 3% still reasonable? And what part of the model do you think pricing increases can become more challenged? And kind of how are you thinking about offsetting that? Thanks."
},
{
"speaker": "Terrence Duffy",
"content": "So first of all Alex, we look at price increases all the time and how we do them and we don't believe in just raising prices because you can strategy. We do it because of value-add strategy. And I think that's what's long-term and more lasting for our shareholders. So working with our market participants bringing them value strategically, we are thinking about different opportunities, different risk management tools. I can't emphasize enough what this Google AI can do for our clients going into test environments about what they can do to enhance their own books, as it relates to risk and other opportunities for them that nobody else will be able to effectuate in such a quick way. This is an exciting time for our market participants. So we look at those value-added proposals that we have with all of our clients across the spectrum, we don't just raise prices because of inflation or because you [can’t] (ph) strategy. That's a bad strategy in my mind. So that's not what we do. We do it because of value. I'll let Lynne comment further."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. I think Terry covered it. I mean it's always a bottoms-up approach. It's market by market, looking at customer health, market health, and where we've created value. So I think that strategy is still intact and it's something that we'll continue to do as we think about making any changes."
},
{
"speaker": "Alex Blostein",
"content": "Okay, thanks."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thank you Alex."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Brian Bedell with Deutsche Bank. Your line is open."
},
{
"speaker": "Brian Bedell",
"content": "Great. Thanks good morning – thanks for taking my question. Maybe just back on the Google Cloud. Maybe just if you can talk about the timing of when the new platform will become available? And any early expectations about how much faster it could be versus Globex and views on what portion of the client base would be migrating on that over time? And maybe when you think -- most people would migrate over to that new platform if it was superior."
},
{
"speaker": "Terrence Duffy",
"content": "Great question Brian and there is some information that we don't have fully baked yet. I'm going to let Ken give you as much as he possibly can right now to give you some color as it relates to the transition into the cloud as we move forward."
},
{
"speaker": "Kendal Vroman",
"content": "Brian, as you can imagine, we are actually building a physical building now. So that takes a little bit of time. And one of the things that's nice is that there is capability in Dallas. So you also heard us announce that our disaster recovery site will be in Dallas. And we will have our customers up in testing and playing around in that environment in early 2026. What we said about the longer time frame is more about making sure our customers and our ecosystem is prepared. And so we tend to talk that when we have more specifics about bringing the market migration online, we are going to give 18 months' notice at a minimum in order -- before we start migrating our markets. So that's really what we've said about timing. And then as it relates to which customers will take advantage of which venue and how long that will take. Those are very early days in that process. And as I said before, we are providing choice and optionality to our customers. And as we get further iterating with them and they understand the value proposition and the things that are available and their ability to do, they will make individual decisions about their business models and what makes the most sense for them. So I think it would be premature to speculate on who's going to do what. But I will say that we are very excited about the engineering that has gone into this capability. We think it is innovative. We think it is differentiating and we think it will be enabling for our customers. And so we are excited about that, but a little too soon to give specifics."
},
{
"speaker": "Terrence Duffy",
"content": "And just to add on to what Ken said Brian, when you referenced the latency or the speed to how you set it. As I've said since 2021, we will not go into the cloud, if in fact, Google does not put forth a platform that is as good or faster than what we have today, and that has not changed one bit. So we still have to make sure we see that platform before that ultimate decision can be made. We think they will get there, but the exciting part is what Ken said and the functionality associated with that speed. I don't know where markets are ultimately going to go on the speed. We're pretty much at that point right now where it's kind of hard to continually to make it any faster than it is. But what I think is impressive and important is the distribution, the functionality and the tools associated with Google Cloud that others will not be able to replicate."
},
{
"speaker": "Brian Bedell",
"content": "That's great color. And maybe I could just follow up with Lynne on the collateral balances in terms of the rates that you are paying and the spreads you are getting exiting the second quarter coming into third quarter, both on the non-op line and the other fee line?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So for the second quarter cash balances averaged $73 billion and the non-cash balances averaged $161 billion. Both of those fairly similar to what we saw in Q1. So far in July, we've seen the total collateral is down a bit and we've seen both of those lines come down a little bit. So, so far in July, the average cash balance is $69 billion, and the average non-cash is $159 billion."
},
{
"speaker": "Brian Bedell",
"content": "And the rates that you are paying out on this?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "It was 36 basis points on the cash was our portion. And then we are paying out fee on the non-cash is 10 basis points, rather 36 basis points on the cash, 10 on the non-cash."
},
{
"speaker": "Brian Bedell",
"content": "Okay. Too early to say when the Fed cuts where you might go to at this stage? Or do you think you might be able to maintain the spread?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. It is a bit early to say, but I would keep in mind that the spread that we are actually charging it's 25 basis points less than the IORB rate, and it is been at that level since last June. So it stayed at a consistent level since the IORB was at 165, if that's helpful."
},
{
"speaker": "Brian Bedell",
"content": "Yeah, absolutely. Yeah, okay. Great. Thank you very much."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks Brian."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Ken Worthington with JPMorgan. Your line is open."
},
{
"speaker": "Ken Worthington",
"content": "Hi, good morning. And thanks for taking the question. I wanted to dig into CME's treasury clearing plans. Can you give us a more detailed picture of what you're planning to offer, what needs to be built out still and when it might be ready for launch? And are there any regulatory approvals that you'll need to get this up and running?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes, yes and yes there Ken. A treasury clearing proposal we've announced, we are working with the SEC now. I did a call with the Chair and staff with -- my staff again on Friday, we feel very confident that all the information will be in the SEC by mid-September and then it will be in the hands of the SEC. They do need to go through, to deem it complete and approve and they have an approval process which is public. So you'll see that, Ken. As far as our plans, what products -- I'm assuming what you're asking, will launch?"
},
{
"speaker": "Ken Worthington",
"content": "Please."
},
{
"speaker": "Terrence Duffy",
"content": "Yes. And I'll let Tim go ahead and reference that. But again, I think we are really focused on getting our approval and getting the structure of the new clearing facility up and going. And I think what's even more important is, I've said this publicly before, and I will say it again, that the FICC offering today is a dominant offering. They are the incumbent. We don't know where the world is going to be come 2026, when the mandate kicks into place. So we will be prepared and ready if, in fact we need to. But at the moment, I got to be honest with you. When you just take your savings with FICC up to $1 billion in a very short period of time with those offsets, that's a very powerful tool to offer your clients today. So again, we'll be prepared, but I don't want to be dismissive of my colleagues over at DTCC and the FICC offering because they've done a good job, and we'll see how they progress as long as side-by-side with us. Tim?"
},
{
"speaker": "Tim McCourt",
"content": "Yes. Thanks, Terry. Again, just to reinforce, Terry is absolutely right. We have a long-standing partnership with FICC that unlocks a tremendous amount of savings to – [for our] (ph) clients and market participants. And when we are looking at our offering that we will be building, part of it is to satisfy the mandate both with respect to the US active treasuries as well as repo clearing. But when we are engaging with clients, we want to make sure that we are looking at this from a complementary fashion, how can we work with market participants to not only bring the service to market, but in a way that deals with some of the issues presented whether it's on done away trade or how is it additive to some of the activity and services are providing. It's also important when we look at it, we know notice and partnership with our clients is going to be of the utmost important as we look to bring the solution to market. As Terry said, we are working towards the approval time line for this year, and we are looking to be ready to test in the second half of next year, such that we can meet the January '26 deadline for US Actives and the June '26 deadline for Repo. Stay tuned for that, but that's the broad strokes we've provided for [that] (ph)."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks Tim."
},
{
"speaker": "Ken Worthington",
"content": "Okay, great. Thank you. Yes. And just on the Google facility, do you have a dollar cost of the investment? Like is this all being paid for by you? Is it be paying for Google? And what's sort of the payback you would expect on your investment?"
},
{
"speaker": "Terrence Duffy",
"content": "Are you referring to the facility itself Ken? Are you referring to the commercial arrangements we have at Google, what are you referring to?"
},
{
"speaker": "Ken Worthington",
"content": "The facility itself, the new announcement, I guess today with the co-location facility in Illinois."
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Yes. I want to make sure we're fair on that, Lynne."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So we won't own the facility and we won't be building it. So there will be some costs associated down the road for our usage, but it's not a build that we are undertaking."
},
{
"speaker": "Terrence Duffy",
"content": "They are paying for the building to put it more clear."
},
{
"speaker": "Ken Worthington",
"content": "Perfect. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from Craig Siegenthaler with Bank of America. Your line is open."
},
{
"speaker": "Eli Abboud",
"content": "Good morning. This is Eli Abboud from Craig’s team. Thanks for taking the question. You onboarded the -- yes, can you hear me?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Go ahead, Eli."
},
{
"speaker": "Eli Abboud",
"content": "Okay. You onboarded a couple of large retail brokers earlier this year. Can you share any details around the incremental volume you're seeing from these clients? I know you said some records in certain micro contracts this quarter. To what extent would you attribute this to these new clients?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Eli. It's a great question. I'll let Julie and then if Derrick wants to jump on as well with some of the contracts, but Julie."
},
{
"speaker": "Julie Winkler",
"content": "Yes. I mean -- thanks for the question Eli. Certainly, Q2 was a really strong quarter for our retail business. We saw growth in both number of retail participants as well as revenue. Those are -- this growth was really kind of driven by a few factors. One of them was the one that you mentioned, and that is the focus that we've had on these new to futures channel partners that are distributing CME futures for the first time. We saw a lot of strong client interest in our dollar-denominated equity index offerings and also just the fact that we have a very diverse product offering and a really strong quarter for metals as well as options. So as we looked at the new brokers that are offering our products, really what we've seen is the support from both our marketing and an education partnerships, they have delivered a number of significant new clients in Q2, they are experiencing that success with our educational content that they are able to deliver on their website and also have told us about the strong customer engagement that they are seeing. So we'd say definitely early success, and we believe that, that is promising for the future growth and really sets a blueprint for some additional brokers that we hope to bring online in the second part of this year. In terms of the second one and the APAC retail clients, again I think this is one where there seems to be a lot of interest in dollar-denominated Equity Index complex, which we are extremely strong. So that resulted in a big uptake over 20% in our mini and micro NASDAQ suites. And this is where we were able to outpace our competitors in terms of ETFs and other products out there. This is even with low volatility. So I think it speaks to the power of our complex, as well as the investments that CME has made in long-term access to that intellectual property. And then just the last point, when volatility is up where gold futures prices were at record levels, we saw some really great results, I’d say, in metals activity among our retail client base. Revenue there up significantly in Q2, and as well as some good penetration, I would say, in getting brokers, particularly internationally, having options access for the first time ever to our retail clients. So I think it was a combination of all of those factors that is certainly setting us up in a strong way for future growth. So we are excited about those new brokers that we brought on and also the additional ones that we expect to come online this year."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Julie. Derek, do you want to wrap it up."
},
{
"speaker": "Derek Sammann",
"content": "Yes. Just very quickly on the gold side as Julie touched on, we saw significant growth in participation on the gold market this year. When you look at our Q2 volume in metals overall at 42%, retail in the second quarter is at 70%. This is a function of having the right product size for the right participants in the right risk appetite. So when we look at that growth, we saw records with both micro copper, micro silver and micro gold, and we saw as prices pushed up, we have the right products for those customers. So this is a function of serving customer needs for intermediaries and users, and that's led to a growth not just in the volume but open interest and a broad main set of market participants as well."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks Derek, thanks Julie. Thanks Eli."
},
{
"speaker": "Eli Abboud",
"content": "Thanks. If I could squeeze in a follow-up. You mentioned you'll be giving clients access to Google's AI capabilities. I was just wondering if you could give us any more details on what use cases you are envisioning? And which market participants you would be targeting? Is this for your buy side, FCMs, market makers?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. We'll be careful on disclosing what market participants we always are on that more -- but Ken can give a little bit more color as it relates to that."
},
{
"speaker": "Kendal Vroman",
"content": "Yes. I think AI is just one piece of it. Certainly, we are focused on data and analytics capabilities. And as AI relates to that, I think some of the things that will be working with our customers on and unveiling over the coming years will be very interesting to them and hopefully enable both their risk management and their trading strategies. So Beyond that, I think it'd be a little bit premature to talk about too much more depth about which clients would do what with AI, is they are all figuring it out on their own, in their own ways, frankly. Okay, Eli."
},
{
"speaker": "Eli Abboud",
"content": "Got it. Thank you."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you. All right."
},
{
"speaker": "Operator",
"content": "Thank you. And we have no further questions at this time. I'd like to hand the call back to management for closing remarks."
},
{
"speaker": "Terrence Duffy",
"content": "Well, we want to thank you all for joining us for today’s call. We’re very thrilled about our record results. We are going to continue to work hard to bring efficiencies to the marketplace and bring value to our shareholders. So thank you very much for joining us. We look forward to following up with you."
},
{
"speaker": "Operator",
"content": "Thank you. That concludes today's conference. Thank you for participating. You may disconnect at this time."
}
] |
cme | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Welcome to the CME Group First Quarter 2024 Earnings Call. [Operator Instructions]"
},
{
"speaker": "",
"content": "I'll now turn the conference over to Adam Minick. Please go ahead."
},
{
"speaker": "Adam Minick",
"content": "Good morning, and I hope you're all doing well today. We released our executive commentary earlier this morning, which provides extensive details on the first quarter 2024, which we will be discussing on this call. I'll start with the safe harbor language, and then I'll turn it over to Terry."
},
{
"speaker": "",
"content": "Statements made on this call and in the other reference documents on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance. They involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any statement."
},
{
"speaker": "",
"content": "Detailed information about factors that may affect our performance can be found in the filings with the SEC which are on our website. Lastly on the final page of the earnings release, you will see a reconciliation between GAAP and non-GAAP measures. With that, I'll turn the call over to Terry."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Adam, and thank you all for joining us this morning. I'm going to make a few brief comments about the quarter and the overall environment. Following that, Lynne will provide an overview of our first quarter financial results. In addition to Lynne, we have other members of our management team present to answer questions after the prepared remarks."
},
{
"speaker": "",
"content": "Our performance in the first quarter was strong evidence of the ever-growing need for risk management globally. First quarter average daily volume of 26.4 million contracts was the third highest quarterly ADV in CME Group's history. The only higher quarters were first quarter 2020 at the onset of the pandemic and the first quarter last year, which was impacted by the significant bank turmoil in March and created the much tougher comparison for March 2024."
},
{
"speaker": "",
"content": "Despite no specific macro event or change in Federal Reserve rates occurring in Q1, we had the highest January ADV to date, up 16% year-over-year, and a February that included the highest monthly interest rate ADV in our history of 17.2 million contracts, or up 6%. We achieved quarterly ADV records for both treasuries of 7.8 million contracts, and the overall options of 5.9 million contracts. Both equity index and energy options reached all-time high levels."
},
{
"speaker": "",
"content": "Our non-U.S. ADV also reached a record level of 7.4 million contracts. This is driven largely by 38% growth in energy, 29% in ag products, and 7% in metals. In total, we delivered 14% ADV growth across our physical commodity products to 4.7 million average daily volume, which included 16% year-over-year growth for both energy and ag products. This strong first quarter activity across our business lines helped generate record-adjusted quarterly financial results, which Lynne will detail in just a moment."
},
{
"speaker": "",
"content": "Activity so far in April has continued to build on many of these trends. Following the strong first quarter of our physical commodity asset classes, they are up 26% to date in April as of April 22. Metals ADV specifically is up 76%, and the complex reached its highest daily volume in history at 1.7 million contracts on April 12."
},
{
"speaker": "",
"content": "On the financials side of the business, the CPI released on April 10 was a great example of how important every data point is for the market to adjust positions to manage risk. We reached nearly 44 million contracts traded that day, and the wide range of views around the health of the global economy and the nuance related to interpreting the many different economic indicators continues. As a result of the strong market dynamics, year-to-date through April 22, our ADV is up 4%, including year-over-year growth in all 6 of our asset classes."
},
{
"speaker": "",
"content": "CME Group continues to provide deep liquid markets across global benchmarks to deliver the most operational and capital efficiencies to market participants. CME Group's multi-asset class offering is in higher demand today than ever. I'm now going to turn the call over to Lynne to review our financial results."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Thanks, Terry, and thank you for joining us this morning. During the first quarter, CME generated nearly $1.5 billion in revenue, up 3% from a very strong first quarter in 2023. Within the physical commodities asset classes, quarterly revenue was up 14% year-over-year and represented approximately 1/3 of clearing and transaction fees in the quarter. Market Data revenue reached a record level, up 6% to $175 million. Other revenue increased 37% to $104 million, largely due to the increased noncash collateral fee implemented in January."
},
{
"speaker": "",
"content": "Continued strong cost discipline led to adjusted expenses of $462 million for the quarter and $374 million, excluding license fees. Our adjusted operating margin for the quarter was 68.9%, up from 68.2% in the same period last year. CME Group had an adjusted effective tax rate of 23%. Driven by the strong demand for our risk management products, we delivered the highest quarterly adjusted net income and earnings per share in our history at $911 million and $2.50 per share, respectively, both up 3% from the first quarter last year. This represents an adjusted net income margin for the quarter of over 61%."
},
{
"speaker": "",
"content": "Capital expenditures for the first quarter were approximately $16 million and cash at the end of the period was approximately $1.7 billion. CME Group paid dividends during the quarter of approximately $2.3 billion, and we have returned nearly $25 billion to shareholders in the form of dividends since implementing the variable dividend policy in early 2012. We're very proud to deliver the best adjusted quarterly earnings in our history and are pleased to see this strong start continue into the second quarter."
},
{
"speaker": "",
"content": "Year-to-date through April 22, 42, or more than half, of our trading days have been over 25 million contracts versus 28 days last year demonstrating more consistent, higher demand for our products. At CME Group, we continue to focus on providing the risk management products needed by our clients and driving earnings growth for our shareholders. We'd now like to open up the call for your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question in the queue is from Chris Allen with Citi."
},
{
"speaker": "Christopher Allen",
"content": "I wanted to focus on the U.S. Treasury complex record activity in the quarter. Obviously, there was a lot of chatter out there where maybe somewhere peak rate activity does not seem to be the case. But maybe how you're thinking about the U.S. Treasury complex? What's driving it? Any color on the impact from the CME DTCC cross margining? And then also U.S. Treasury clearing, which you applied to clear cash U.S. Treasury. How are you thinking about that from a structural impact perspective, but also if there's any revenue opportunities around that? Sorry for the multipart question."
},
{
"speaker": "Terrence Duffy",
"content": "No problem, Chris. Again, we'll unpack that a little bit, and I'm going to ask Tim probably Suzanne and myself, will all kind of answer the 3 different parts of it. So let's just talk about -- I think first part of your question was around is it the peak activity around treasuries? I think that would be really difficult to draw that conclusion in lieu what's going on fundamentally around the world and in the United States."
},
{
"speaker": "",
"content": "So I just don't see anybody can draw a conclusion that this is the peak of that activity. Activity should generate more if, in fact, the Fed does cut so that would generate more activity. It doesn't need to just go up in order to generate activity, as you know, Chris. So I would say that a far away of saying that we are not near a peak as it relates to activity in the treasury market. As far as the DTCC and the clearing, I'll let Tim and Suzanne respond to that, respectively."
},
{
"speaker": "Suzanne Sprague",
"content": "Yes. Thank you very much, Terry, and thank you for the question. We do continue seeing increased participations in the cross margin program between ourselves and the fixed income clearing corporations. Some of those clearing members are seeing upwards of 75% to 80% in margin savings. And that's in addition to the portfolio margining program that we offer within CME between our interest rate futures, options and swaps, which in the first quarter of 2024, continued delivering average daily savings of about $7 billion."
},
{
"speaker": "",
"content": "So holistically, those capital efficiency solutions, I think, have been a great story for market participants in achieving record savings over time and continued consistent savings for the first quarter of this year."
},
{
"speaker": "Terrence Duffy",
"content": "Tim, do you have anything to add?"
},
{
"speaker": "Tim McCourt",
"content": "Chris, I think maybe just one thing to add on the treasury complex is when we look at the long-term growth of that complex, the volume and open interest continue to grow with the stock of outstanding treasuries. And over the last 10 years, the stock of that treasury has roughly doubled. And when we look out the congressional budget office also is forecasting it to double over the next 10 years."
},
{
"speaker": "",
"content": "So when we look to where the total net issuance is currently occurring in Q1, while it was little changed from Q4 in terms of the net issuance, it was much more coupon heavy than previous quarters, and when we look at the treasury ramps up the notes and bonds to issue the finance these growing budget deficits, that plays very well into the complex of the products that we offer."
},
{
"speaker": "",
"content": "And as Terry said in his remarks, furthering the growth that we've seen where the treasury complex had a record Q1 of 7.8 million contracts across futures and options and we expect the general issuance backdrop to continue to be a tailwind for that [indiscernible]."
},
{
"speaker": "Terrence Duffy",
"content": "And Chris, let me just add to one thing that I was going to say at the beginning. But on the treasury complex to say that as it peaked, you know and everybody on the call knows that the different amount of opinions that's out there is related to what the Fed is going to do or not do is all over the map. And everybody has been absolutely for the most part wrong. So you had anywhere from 6 rate cuts predicted 6 months ago coming into '24 to 3 that was advertised by the Fed."
},
{
"speaker": "",
"content": "Now people are going anywhere between 0, none and somewhere in between that. I have no idea what's going to happen, but there's a big difference of opinions out there, which had also generated a tremendous amount of activity. One of the things we don't talk about, and we haven't talked about since SVB failed, was their duration risk. And I'm not suggesting others are going to fall into this. But the longer that rates are higher, you have to think that others are watching this and need to make sure they manage that risk on duration."
},
{
"speaker": "",
"content": "So I think that's an equation that most people that are sitting on these treasuries was not put accounting for, say, just as little as 3 to 6 months ago."
},
{
"speaker": "Christopher Allen",
"content": "Appreciate the color. Anything on U.S. Treasury clearing?"
},
{
"speaker": "Terrence Duffy",
"content": "On the U.S. Treasury clearing, I will say that we -- I made the announcement that we are going to file an application, as it relates to this. We are in the very early stages of completing that application it will -- I think we've said publicly that we'll probably look in sometime in the fourth quarter before we can have that being viewed by the SEC, and then we'll go from there. But again, I think from our standpoint, the mandate doesn't kick in until sometime in '26 and we'll be prepared either way to go forward with it if it's in the best interest of CME and its participants."
},
{
"speaker": "Operator",
"content": "The next question in the queue is from Dan Fannon with Jefferies."
},
{
"speaker": "Daniel Fannon",
"content": "I was hoping to get a little more color on some of the activity in the commodities and metals markets. Maybe talk about the health of the customer, given the robust increase in volumes, has there been any change in position limits or other things that might potentially curtail some of the activity that's been happening?"
},
{
"speaker": "Terrence Duffy",
"content": "Derek?"
},
{
"speaker": "Derek Sammann",
"content": "Yes, I think it's -- we've seen a really spectacular rise in our metals activity. And then, as you know, our metals activity is made both with the precious metal side and the base metal side. Q1 was a little bit quiet. Volumes up for the first quarter were 4%. What you've seen is a significant move and change in expectations around the role that gold is playing in the market. I think a lot of us scratched our heads over the last few years about why gold was sort of stuck below [ $2,000. ]"
},
{
"speaker": "",
"content": "We saw a significant run-up in participation and growth, and we've actually seen very healthy activity and participation across each of our client segments. When you look at kind of the spread of activity in that market, it's a market that has very healthy participation across not just the commercial participants but buy side as well. And you've seen that activity increase and accelerate."
},
{
"speaker": "",
"content": "In Q1, we saw really nice growth on the base metal side of the business, up 15%. There's a lot of questions there about global growth, questions around China and electrification generally of the grid globally that's typically really good for markets like copper and aluminum, where we're seeing records in the early stages of our aluminum growth there. So when you look at the growth of the activity, we see it healthy across client segments, we're seeing significant growth across regions and our options business, as Terry said earlier, set records, not just for options, but the full complex in April."
},
{
"speaker": "",
"content": "So very happy with the client growth, very happy with the product growth across asset classes and across regions as well."
},
{
"speaker": "Terrence Duffy",
"content": "And Dan, let me just add to what Derek said because I think it's really important. We talked a moment ago in our prepared remarks about how all 6 asset classes are achieving the levels that they are doing. I've talked to several people just recently as the metals run-up has happened, who I thought never traded metals anymore because of the price action, but are back in the marketplace now. So you asked, I think specifically about the customer is the customer healthy, I don't know how you phrased it, but I will tell you that it's amazing, and this is a story that we've been telling for 22 years is when one asset class might quiet down, they go to another one."
},
{
"speaker": "",
"content": "We're seeing a big divergence into these metals from people that used to participate that have gone other places. That's really fascinating for us to continue to see. But the bigger part of the picture is all 6 asset classes are humming along. So I think it's really healthy for a client across CME."
},
{
"speaker": "Operator",
"content": "The next question, the queue is from Patrick Moley with Piper Sandler."
},
{
"speaker": "Patrick Moley",
"content": "So Terry, for a few quarters now, you've expressed an openness to potential M&A as an avenue of future growth. So we're just hoping to get your updated thoughts on M&A and kind of the areas and asset classes that you're focused on when it comes to potential M&A opportunities."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Patrick. I don't know if I've been open to discussing that. I think that I have said that with CME is in a strong position, if, in fact, the right transaction was to come along, and made sense for our shareholders and our clients. And so I'm not out looking for particular deals. I just said that we are in a strong position to do so if it were to arise."
},
{
"speaker": "",
"content": "And again, that mindset has not changed. One of the things that we are obviously excited about is what I just said, all 6 asset classes is going at the same time that may open up different opportunities as it relates to some potential M&A activity if we see something. But again, we're not out shopping at the moment or anything, but we are always open to looking at something that's of value to our clients and shareholders. And what was the other part of your question, Patrick?"
},
{
"speaker": "Patrick Moley",
"content": "No, you hit on all of them. That was great."
},
{
"speaker": "Operator",
"content": "The next question in the queue is from Alex Kramm with UBS."
},
{
"speaker": "Alex Kramm",
"content": "Just a quick one on market data. You pointed out some kind of like onetime-ish episodic revenues here. I think one was audit, and I get that but the other one was on derived data, and that was a bigger number. So maybe you can just remind us why that comes with sometimes episodic revenue. But then bigger picture, I think a few years ago, derived data was a big new initiative."
},
{
"speaker": "",
"content": "And we would hope that there's maybe a little bit more of a stable revenue source at this point. So maybe you can just give us an update where we stand in particular, as it also pertains to what you're doing with Google on the market data side."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Alex. I'll turn it over to Julie Winkler and I don't know if Sunil wants to chime in as it relates [indiscernible] Julie."
},
{
"speaker": "Julie Winkler",
"content": "Yes. Thanks for the question, Alex. I mean the data services business, obviously, in general, had a great quarter, $175 million revenue, up another 6%. This is on the back of a record year from last year. And the key growth part of that is certainly with our professional subscriber revenue. That is our core revenue base that is coming and delivering over 80% of that revenue."
},
{
"speaker": "",
"content": "As it relates back to those more episodic and sporadic revenues last quarter, right? Certainly, we've talked a lot about the unpredictable nature of the audit. And if you think about derived that there's 2 pieces of derived data revenue that typically an annual component of that as well as a variable component. And so there were some true-ups that we saw, it does bring up, I'd say, consistent revenue and these are contracts that are up for renewal."
},
{
"speaker": "",
"content": "So I think we do see some -- certainly some repeatability with the subscription and the nature of those agreements but because of those 2 different components. There is some spikes to them occasionally, and we did see that happen in this particular quarter. And I'd say as it relates back to commercialization more broadly, definitely continuing to work with Google in our initiatives there. We've been very clear for the onset that our data business is a priority as we think about trying to deliver our data in new ways and new solutions with them."
},
{
"speaker": "",
"content": "And that work has tied throughout the quarter. And so I think in one particular example, right, we've talked about the transaction cost analysis and TCA work. That is in production today and is being used by our business teams and with our clients to make better business decisions, the broker tech [indiscernible] change that we're having in the 7-year coming up just a couple of weeks with specifically developed as a result of being able to leverage this tool."
},
{
"speaker": "",
"content": "So we're working to be able to share that directly with clients. But for now, I think that is a good example of the innovation that we're driving with our partners at Google. Over to Sunil."
},
{
"speaker": "Sunil Cutinho",
"content": "The only thing I'll add is we have plans to add more data sets [indiscernible] more data sets available as risk management becomes a priority, as Terry has pointed out. So we'll be working with our clients on stress scenarios, historical scenarios, so they could use that [indiscernible]."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Julie. Thanks, Sunil. Thanks, Alex."
},
{
"speaker": "",
"content": "Craig, we have you listed as the next speaker. Are you there? Any of us or any out there, can hear us. We're having a little trouble hearing the other side come in. So we're not hearing anything. [Technical Difficulty] Bear with us for one second to see..."
},
{
"speaker": "Operator",
"content": "Craig line is open."
},
{
"speaker": "Craig Siegenthaler",
"content": "Terry, can you hear me?"
},
{
"speaker": "Terrence Duffy",
"content": "I can now Craig. Thank you. I apologize for the delay."
},
{
"speaker": "Craig Siegenthaler",
"content": "No worries. I was trying before, but nobody could hear me. So listen, guys, I know you planned to launch credit futures in June. There is an attractive capital efficiency component here with the margin offsets, especially against the rate product. How do you size up the TAM for this new segment? And how quickly do you expect volumes to ramp just given your conversations with key participants?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Good question, Craig. And I don't know if we can answer it fully because we haven't got the contract out yet, but that's always the multimillion dollar question, as I say. But let me turn it over to Tim to talk a little bit about the market and the potential opportunity and what it might mean for not only for the credit market, but for markets that are correlated associated with it that she merely has today. Tim."
},
{
"speaker": "Tim McCourt",
"content": "Great. Thanks. And Craig, I really appreciate the question. Ourselves and our clients are excited about the launch of credit futures on June 17, which will be index futures on the Bloomberg corporate bond indices and I think CME is uniquely positioned given our strength both in the interest rate and equity complex. Credit tends to be at a nice intersection of those other asset classes, but also offers a unique distinct market where when you look at the recent growth in credit markets, that has an addressable market of about 90 billion average daily volume in terms of notional across the fixed income ETFs, the CDX, the cash bond."
},
{
"speaker": "",
"content": "And even the underlying market is becoming more and more electronic. So we think that the velocity of this market will continue, the needs to hedge this market will continue as people become increasingly aware of managing their credit risk and to your point, Craig, we expect to offer margin efficiencies, introducing capital efficiencies to enable our clients to manage their risk is something that is tried and true here at CME and early indications, which are always subject to change, we think there will be a 70% margin offset between the U.S. Treasury futures and the investment-grade credit future and 50% offsets against our E-mini equity benchmarks for high yield."
},
{
"speaker": "",
"content": "Lack of the margin efficiencies in prior products and prior offerings is something that we believe and what we're hearing from customers was a key hurdle for some of the other offerings to become successful. So to Terry's point, while we can't necessarily predict the future, we are optimistic, we're hearing great things from clients given our ability to offer offsets against our asset classes in the base F&O fund and our unique leadership positions in the price formation of the associated asset classes, we certainly like to see what we can do with that coming June when this contract goes [indiscernible]."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. Thanks, Craig, for the question. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question is from Kyle Voigt with KBW."
},
{
"speaker": "Kyle Voigt",
"content": "Maybe a question for Lynne. I noticed that $750 million of debt moved into the short-term bucket this quarter due to the expiration coming in early in 2025. You're below your historical target leverage level of 1x. And I think you could even issue $1 billion of additional debt from current levels and still be below that threshold. I guess, would you consider increasing gross debt levels with upcoming refinancing to include that cash as part of the annual variable next year?"
},
{
"speaker": "",
"content": "Or should we think about the debt simply being refinanced at current levels? And sorry to squeeze the second part of this question in, but could you also remind us how you think about maximum leverage in a -- if the right M&A opportunity were to present itself?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. Thanks, Kyle. So we do have our next maturity coming up in March of 2025. So it's certainly something we will be looking at over the course of this year. As you know, we don't have a strong need for debt financing, but we do try and keep some bonds out in the market just to keep our name in front of the investors and keep that credit work fresh."
},
{
"speaker": "",
"content": "So we'll certainly be evaluating our approach for those bonds as we go through the course of the year. Certainly rates are higher now than when we did that issuance. So we will take that into account, but we haven't made any decisions on level of refinancing or how we will do that at this point. In terms of the maximum target for M&A, we do value our strong investment-grade rating. So that's where we came out with that 1x target. Certainly, there is flex up in an M&A context, given the fact that we do generate a lot of cash and would be able to pay down that debt relatively quickly."
},
{
"speaker": "",
"content": "I think it would all depend on the circumstance and the transaction if we were to execute how far we would go on the leverage. So I don't have an exact target for you, but it's something that we do try and balance the use of debt and equity in our transactions as you've seen historically."
},
{
"speaker": "Operator",
"content": "Our next question Brian Bedell with Deutsche Bank."
},
{
"speaker": "Brian Bedell",
"content": "Maybe just come back to the treasury futures complex. To what extent is the portfolio margining in agreement with D2C contributing to the strong volume growth? Or is it just more of a side share relative to the other market dynamics? And then from the -- I appreciate it's very early [indiscernible] for this treasury dynamic but would that potentially change the gross margining agreement with DTC?"
},
{
"speaker": "",
"content": "And if I could just squeeze in one more. I didn't see the revenue for EBS and BrokerTec for quarterly summary. I don't know if you can comment on those for 1Q."
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Brian, we're going to have to kind of win this one a little bit because I think we heard about every third word that you said for some reason. I don't know what's going on in the line, but you kind of tapped out a few different times there. So can I just break this down? You asked about our treasury business, and you asked about DTCC and the offsets. Is that correct? And you asked about -- just give me the headline of the other things."
},
{
"speaker": "Brian Bedell",
"content": "Yes. Yes. Maybe this is clear. I was on my headset. Basically the contribution from the portfolio margining in your treasury volumes. Just to sort of categorically is it really helping? Or is it really more of the market dynamics? And then the back to the treasury clearing question, maybe it's early days, but does your application complicate things with the DTC agreement?"
},
{
"speaker": "Terrence Duffy",
"content": "That's the part I missed. That's the part I missed. We got it. So I'm going to let -- I'm going to take your last question. But the first couple, I'm going to have Suzanne Sprague, who heads up our clearing and risk, deal with those. Suzanne?"
},
{
"speaker": "Suzanne Sprague",
"content": "Yes. Thanks very much for the question. So just on the participation in the existing programs, we have seen some new clearing members take direct membership to be able to take advantage of the cross margin program that is currently in place for health accounts between ourselves and the Fixed Income Clearing Corporation. I think it's hard to quantify how much of that would be new activity versus activity that may have been cleared as clients through existing clearing numbers prior to that."
},
{
"speaker": "",
"content": "Tim McCourt may be able to chime in a little bit on his thoughts there about the growth in that activity. But generally, our focus with the DTCC continues to be growing the participation in that program as well as extending that program to customers. So it's something that we've been working very closely as partners on and it's still important to us and thinking about the clearing mandate and bringing to market more efficiencies for those end clients that could be impacted by the current mandate as well."
},
{
"speaker": "Terrence Duffy",
"content": "Okay. Tim, you have anything to add?"
},
{
"speaker": "Tim McCourt",
"content": "I think I mean, I'll talk about the relationship with DTCC. I think the one thing I would add is when we looked at the additive value of the CME one-pot portfolio margin where we have the futures against -- the futures and options against the swaps, is that has grown significantly over the years while it's hard to exactly draw a strict relationship that, as Suzanne said, those margin savings have grown to $7 billion to $8 billion last year per day, about $7 billion per day this year."
},
{
"speaker": "",
"content": "Along that, our interest rate complex has doubled in sort of volume and open interest. And that is the testament to believe if we focus on unlocking capital efficiencies for our clients, enabling them to more efficiently manage their risk, we would expect any further capital savings to have similar effects, but hard to say sort of what that coefficient of growth might be but we think it is a tailwind for our complex and the more we can do to unlock those savings, the better we will do on the transaction side for futures, options and [indiscernible] at CME."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. I think that's really important. And let me just add, Brian, that on the relationship with DTCC as it relates to our treasury and clearing application, I have spoken to those folks before I said anything publicly about this. And what I also said publicly when we announced this is I do believe that DTCC has the most efficient offering in clearing of these products today."
},
{
"speaker": "",
"content": "We didn't create the mandate that's coming at us in 2026. We have an obligation, as I've told my friends at DTCC that we have to go through with this application. We don't know what's going to happen in 2026 when the mandate kicks in, what the market structure is going to look like? Is it going to change? It couldn't be the same? But I can't wait until 2026 to file an application. So that's why we're doing it now."
},
{
"speaker": "",
"content": "We are being prepared. And if we are going to use it, we'll use it and if it's not necessary because the better offering comes out of DTCC, with the efficiencies for the clients, we will stay with DTCC. So that's really where we stand on the relationship and the application if that makes sense to you."
},
{
"speaker": "Brian Bedell",
"content": "It's a great answer."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "And then Brian, you just asked on the data point on the cash market -- yes. The total trading revenue for the quarter was $69 million, similar to Q4 and the total revenue from cash markets, including data and some of the connectivity was also consistent with Q4 at $92 million."
},
{
"speaker": "Brian Bedell",
"content": "Right. Okay. And between EBS and BrokerTec were similar to Q4?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So if you break that out, BrokerTec was at $38 million in line with Q4 and EBS was at 31. That's just creating [indiscernible]."
},
{
"speaker": "Operator",
"content": "Our next question now is from Alex Blostein with Goldman Sachs."
},
{
"speaker": "Alexander Blostein",
"content": "Question on the energy markets for you guys again. Definitely good to see momentum in overall volumes picking up here in April and over the course of the first quarter, but it looks like the market share trends between you guys and ICE and WTI continue to kind of move a little bit more towards ICE or those share gains have been relatively sticky."
},
{
"speaker": "",
"content": "You gave us a bit of an update, I think, last quarter on like the underlying composition of the mix kind of what's been driving that. So hoping you can update that and give us a sense of whether or not you're seeing any shift in the kind of underlying producers, consumers, more kind of core user base there. And if CME's working on anything to kind of call some of the market share back."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Alex. And let me just touch on the first point on the first quarter, especially as it relates to energy on the market share. The market share did not shift from Q3 into -- or Q4 into Q1 as it relates to market share. So I'm -- they're not continuing to supposedly take market share."
},
{
"speaker": "",
"content": "And again, the way we count market share is all of our different products that we have, including our Gulf Coast contracts that we did not maybe point out is clearly over the last several years, so I don't see the market share that you're referring to in Q1. As it relates to the other part of your question, I'm going to ask Derek to answer."
},
{
"speaker": "Derek Sammann",
"content": "Yes. Appreciate the question, Alex. So as Terry mentioned at the top of the call, the breadth and the scale, the diversity of the franchise here is, I think, yielding benefits for shareholders and certainly providing multiple ways that customers use us to manage risk. Energy delivered strong results in the first quarter this year, up 16%. When you look at the significant participants of where that business is growing, we saw the fastest growth of our biostatic commercial customers, and we saw record options level at the overall level as well."
},
{
"speaker": "",
"content": "When you look at energy being a key contributor to our non-U.S. growth, our non-U.S. growth in energy was up 38% this year as well as our record options volume up almost 60% and that's helping to drive a strong RPC of a little over $1.33 in the energy business. When you look at the core benchmark products, and I'll come back to the point Terry just made, when you compare our WTI contracts to ICE WTI contracts, our market share in Q1 was flat with Q4 about 74%."
},
{
"speaker": "",
"content": "When you look at our WTI options against ICE WTI options, we actually saw an increase in market share to 89% from 86%. So where we compete directly with ICE, we are either maintaining or growing that market share. So but let me talk a little bit about what's actually going on. When the U.S. is actually producing and exporting crude oil at record levels, follow that physical flow. And what does that mean? That means we have new and record amounts of non-U.S. customers that have exposure to U.S. crude and also Henry Hub to the same degree."
},
{
"speaker": "",
"content": "So that's an increasing set of customer participants that we have not seen before, which is why when you look at where the growth is happening, in our WTI complex, particularly, we're seeing our non-U.S. WTI growth of up 30% and our commercial customer is up 21%. So the very customers, whether it's the buy side or the commercial customers that are looking for that open interest and looking for the best exposure for the energy markets are coming to [indiscernible] WTI to manage that risk."
},
{
"speaker": "",
"content": "The other parts of the franchise that Terry talked about, our WTI franchise isn't just our WTI futures and options. It's our grades contracts, which continues to grow. We actually just exceeded our open interest in our grades contracts exceeding 600,000 contracts that's up almost 50% year-on-year to a new record. And Alex, that's important because 80% of that open interest holding is with commercial customers to have exposure to the global export market out of the U.S. and into Europe and Asia."
},
{
"speaker": "",
"content": "So when we think about that growth in the client segments and the regional growth, it's reflective of the physical flows going out into the rest of the world. Pivoting over to the benchmark Henry Hub side of the market, I'll say similar things to what Terry just talked about. When we look at our Henry Hub franchise, compare that to ICE's Henry Hub franchise, you actually see that not only have we set a record total Henry Hub volume for futures and options in first quarter of this year, but we've also hit records of underlying options as well."
},
{
"speaker": "",
"content": "From a competitive perspective, we actually grew our market share to 81% versus 80% last year, and that's up from 77% in 2022. And our options business was actually up as well. I think we're up at 66% market share, up from 59% market share last year. So we want to be clear, and I think Terry laid this out well, in the markets where we have competitive dynamics, where we have our Henry Hub contracts against listed elsewhere, our WTI contracts against listed elsewhere. We're maintaining stable share and we're growing the OI. So with that, I'll pass it back to you."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Derek. Again, Alex, hopefully that gives you some clarity."
},
{
"speaker": "Operator",
"content": "Our next question now from Ken Worthington with JPMC."
},
{
"speaker": "Kenneth Worthington",
"content": "I wanted to extend the competitive landscape question to rates, FMX is launching later this summer, do you see merits to the FMX value proposition? If so, which customer segments might FMX be best positioned to pursue and given that all have tried to compete with CME and rates in the past and have failed, what would you need to see to conclude that FMX might be different?"
},
{
"speaker": "Terrence Duffy",
"content": "Ken, let me answer this in this way. First of all, I have sat here for 22 years as the Chairman and CEO of this company since we went public, and I've seen nothing but competition in my entire career. So this is no different. I take every single bit of competition seriously as I'm sure others do about CME as we continue to move our business forward."
},
{
"speaker": "",
"content": "We have about as much information as everybody else does and what their offering is, which is 0. I don't know what their offering is. And I won't say that the party, but Tim just referenced our one pop margining that saves an additional $7 billion to $8 billion a day. We also have an additional offset with FICC, which we just got approved which we have multiple clients using today that are exceeding 80% efficiencies using that service that we offer today. So we think we have a really strong offering going forward against whoever wants to compete in this product or any of our other asset classes."
},
{
"speaker": "",
"content": "So we feel like we're in a good position. We believe that capital efficiencies are the name of the game and you have to have them. And if you want to just do a me-too strategy, then people will do that. It's a very attractive business. I get it. But again, I think you have to have the capital efficiencies. It's hard to walk away from $7 billion to $8 billion a day in efficiencies, and it's hard to walk away from an additional 80 plus percent that they are receiving associated with FICC now and our new offering that we just accomplished in the last several months. So I think that's very powerful, and that's all I'll say about what they're doing."
},
{
"speaker": "Operator",
"content": "Our next question from Owen Lau with Oppenheimer."
},
{
"speaker": "Kwun Sum Lau",
"content": "So just a quick one on the expense guidance. First quarter adjusted expense was lower than our expectation but you maintained the full year guidance. Is there any investment that you paused in the first quarter that you expect to incur over the next few quarters? Or there is some conservatism picking here?"
},
{
"speaker": "Julie Winkler",
"content": "Thanks, Owen, for the question. So we do have some project-based work that we do expect to ramp up over the course of the year for things like the Google migration, securities clearing that we've mentioned on the call previously. You'll also see a ramp-up in terms of the consumption. So in the technology line as we're moving more into the cloud, we will see that grow over the course of the year."
},
{
"speaker": "",
"content": "So we do see some of those items growing as we move forward. And then we do typically see that higher spend related to marketing events in the fourth quarter. So there wasn't a particular pause. I just think it's timing on some of these project-based spend that we still expect to come through in the course of the year, making us comfortable with our guidance."
},
{
"speaker": "Operator",
"content": "Our next question from Michael Cyprys Morgan Stanley."
},
{
"speaker": "Michael Cyprys",
"content": "Just wanted to ask a question on the cash rate, BrokerTec business and interest rate swaps. Both of those have seen a bit more limited growth. I was just hoping you could unpack some of the drivers moving pieces there that you're seeing maybe you could touch upon the competitive landscape, how you see that evolving? And what sort of potential uplift could we see to the BrokerTec business and interest rate swaps business from the cross margining benefits that you have noted here on the call?"
},
{
"speaker": "",
"content": "And then maybe you could speak to some other initiatives that can help accelerate growth as you look out over the next year or two."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Michael. I'm going to ask Tim to start, and I might join in as well and see where he goes. Tim."
},
{
"speaker": "Tim McCourt",
"content": "Great. Thanks, Terry. Thanks, Michael. Certainly, when we look at our BrokerTec business, volatility has come in since the start of the year and that tends to favor the internalization of flow with less being sent to our club. And that's what we've seen in Q1. So not necessarily surprising in that regard."
},
{
"speaker": "",
"content": "We still do get some of the risk layoff and the risk recycling into the club. So given the backdrop, not surprising where we are, but it's important to note that when we look at the U.S. Active club, that's only one part of the story for BrokerTec. U.S. repo had a strong quarter where that year-to-date ADV is just about $300 billion per day. That's up 5% year-over-year. And also the value prop of the BrokerTec platform remains extraordinary."
},
{
"speaker": "",
"content": "It's important that we focus on the totality of the risk management capabilities, myself and the team look forward to engaging with all of you in the other parts of our business to better understand and showcase things like repo and BrokerTec quote, which is now up to an impressive $45 billion to $50 billion per day. When we look at the interest rate swap business here at CME, still having a very strong quarter here in Q1, so seeing all sort of near record levels in the major 3 Latin American currencies that we clear. That is a growth story, but it's really important to Terry's earlier comments, these are all pieces of how we approach the totality of managing risk for the interest rate complex and the needs of our clients."
},
{
"speaker": "",
"content": "These things go together. It's important that when we look at what we've been able to achieve in OTC markets, what we've been able to do in providing continued risk management for BrokerTec, that's alongside record futurization in the treasury complex where our futures and options at CME remain the leading center of price discovery and risk management."
},
{
"speaker": "",
"content": "The treasury future is now at a record 113% of the cash market in terms of the value being traded every day. So you really have to look at all of the pieces of the puzzle together to understand the breadth of the offering here at CME..."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. You said what I was going to say. So that was very good. Not all, but I didn't have all. Michael, hopefully, that addressed your question as it relates to BrokerTec and what we're doing and where we look at from the percentages with others."
},
{
"speaker": "Operator",
"content": "Our next question now is from Simon Clinch with Redburn Atlantic."
},
{
"speaker": "Simon Alistair Clinch",
"content": "I mean most of my questions have been answered already, but I was wondering if you could just walk through sort of where we are in the long-term progress with the Google Cloud migration. And I'm curious as to -- if you could talk about the sort of innovations that you are coming up within partnership with Google to sort of deal with the back-end aims of that migration in terms of moving the rest of the business to the cloud, dealing with your co-location clients and things like that. So it's quite longer-term stuff, but interesting numbers."
},
{
"speaker": "Terrence Duffy",
"content": "So I'm going to turn it to Sunil, Simon, but on the back end of your question, we are obviously and I've said this from the beginning, we will wait until the work is completed. I'm assuming in the back end, you're referring to the markets going into the cloud. Is that where you were going?"
},
{
"speaker": "Simon Alistair Clinch",
"content": "Yes, that's right."
},
{
"speaker": "Terrence Duffy",
"content": "So again, that is yet to be finalized and the data centers are yet to be finalized. We're working on all those things. But again, as I've said from the very beginning of this transaction, I will not put CME's markets into the cloud or any other platform unless it's better than, more efficient than what CME offers today to its clients."
},
{
"speaker": "",
"content": "So -- and when we get that, we'll make that final decision. But we have not seen that product yet. So it's -- they're working on it. And Sunil and his team are working on it. So we can't answer the back part of that question just yet. But Sunil can answer the beginning part."
},
{
"speaker": "Sunil Cutinho",
"content": "I'll answer 2 aspects of that question. One is related to migration of the nonmarket workloads. And there, we are making very good progress. We intend to migrate our clearing regulatory services and business intelligence services this year subject to regulatory approval, of course. And then the second aspect of it is the data platform. We spoke a little bit about it. What we've done is we stood up our data platform."
},
{
"speaker": "",
"content": "We have over 26 petabytes of rich historical information that includes our market data, instantaneous order book. So this information will be available for monetization in the future. We are adding to it risk information as we are migrating our clearing workloads and the risk information will be risk scenarios. And I spoke to that later as far as monetization of those in future cycles."
},
{
"speaker": "Terrence Duffy",
"content": "Does that answer your question, Simon? Okay. I think we lost Simon. But Simon, thank you very much for your question."
},
{
"speaker": "Operator",
"content": "Our next question is from Benjamin Budish with Barclays."
},
{
"speaker": "Benjamin Budish",
"content": "Maybe just following up on the last point on the market data side. Can you maybe talk about how you think about the longer-term growth potential of that offering? So it sounds like there's plenty of other opportunities to kind of increasingly add value to the package there. What about in terms of the client base? How do you think about the penetration of potential subscribers versus opportunities to kind of enhance what you're adding?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Ben. Good question. I'll turn it over to Ms. Winkler for a response."
},
{
"speaker": "Julie Winkler",
"content": "I think I will start where Sunil was talking. I mean I think as it relates to being able to have our consolidated data sets for cloud [indiscernible]. So as we think about easing onboarding to those tools and [indiscernible] to analytics, able to offer these guys. These are new opportunities that we otherwise did not have. And I think the ability to really facilitate access to customers more data. We're seeing a lot of interest in customers as well [indiscernible], more explainability or market model and this supports our business."
},
{
"speaker": "",
"content": "We're here to manage risk and our ability to be able to provide them data and insight much faster, we believe we match to help our data business, but also be additive to [indiscernible]. We continue to see strong demand on the professional subscriber side, drive data, as we talked about earlier, putting those onetime activity aside from [indiscernible] Q1 and we're still seeing strong plan and that is really a product [indiscernible] benchmark and that price discovery that we're [indiscernible]."
},
{
"speaker": "",
"content": "I'd say the participation regionally has also been extremely strong. And I think, selectively, we [indiscernible] just we have to continue to provide data set offering and to access to it but how are we leveraging our [indiscernible] that more attractive as part of the package? We had record cross-sell across [indiscernible] last couple of years to really making sure we are selling data and those services alongside our existing relatable products [indiscernible]."
},
{
"speaker": "Operator",
"content": "We now have a question from Alex Kramm with UBS."
},
{
"speaker": "Alex Kramm",
"content": "Just I wanted to pop back in for a model cleanup. Can you just, unless I missed it, give us an update on cash and noncash collateral rates you've realized, et cetera, stuff that I often ask anyways?"
},
{
"speaker": "Sunil Cutinho",
"content": "Lynne?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Sure, Alex. So for the quarter, we averaged U.S. cash balances of about $76 billion, and we earned about 36 basis points on that cash. On the noncash, the average balances for the quarter were about $159 billion, earning 10 basis points."
},
{
"speaker": "Alex Kramm",
"content": "Any update how that's trending? I think cash seems to be trending a little bit softer, but maybe a quick update. I know it's only been 3 weeks."
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. So far in April, our average U.S. dollar cash balance is about $73 billion and the noncash is averaging $160 billion -- $163 billion, so similar to what we saw in Q4 -- Q1, excuse me."
},
{
"speaker": "Operator",
"content": "Our next question from Eli Abboud with Bank of America."
},
{
"speaker": "Elias Abboud",
"content": "This is Eli Abboud from Craig's team. Given the prospect of new competition, I was hoping you could speak to the size of your network and interest rate futures. And maybe more specifically, how many unique firms are providing liquidity in rates futures on a daily basis? And when you look at the top handful of market makers, what proportion of liquidity provision are they accounting for?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Thanks, Eli. We don't -- I let Tim go ahead and answer it, and I'll jump in as well."
},
{
"speaker": "Tim McCourt",
"content": "Yes. Thanks, Eli. As you can understand, we don't comment on the number of exact firms providing liquidity in a given market or at a given time or who's in what provision program or what certain subset of participants might be doing. The anonymity of the cloud is an important part of the efficacy and efficiency of risk transfer and price discovery process here at CME but what I can tell you is that our network is strong for interest rate futures."
},
{
"speaker": "",
"content": "And to your question, while liquidity providers are an important part of this ecosystem, they are not the only part. We have a mix of customers percentage with different trading and risk management needs that leads to the efficient transfer of risk when the market and our participants needed most. If we look to the growing and record-setting ADVs in our complex or treasury futures and options, as Terry said, almost nearly 8 million contracts per day, we have record daily open interest levels in our combined futures complex -- sorry, combined rate futures complex of over 33 million large open interest holders topped a new record of 3,300 large traders just earlier this month."
},
{
"speaker": "",
"content": "And again, the capital efficiencies we've talked about at length on this call. When you combine all of these things, it's fair to say our network is immensely strong global in nature and is vital to allow our participants to continue to manage their risk."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. Thanks, Eli. I appreciate your question."
},
{
"speaker": "Operator",
"content": "Our next question from Brian Bedell with Deutsche Bank."
},
{
"speaker": "Brian Bedell",
"content": "My name is on the cash collateral, but I will squeeze one more in on rates, if I can. The basis trading, just if you want to -- if you can comment on your view on how that component of trading may continue to progress through the year. Clearly, there's a lot of value in the arbitrage process there. And of course, Tradeweb has made an acquisition of a systematic trade rates in."
},
{
"speaker": "",
"content": "Do you see that as expanding the activity in basis trading or the other way around?"
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Brian. Tim, do you want to continue?"
},
{
"speaker": "Tim McCourt",
"content": "Sure, Brian. I think certainly, when we look at the basis trading, it's a trade that has persisted in the market now for several years. When we look at the combination of trading futures alongside cash, that's certainly something CME is uniquely positioned in our ability to help facilitate that. But it is important to note that basis trading does change some of the characteristics of how participants may be trading or the size they may be trading in and the different modalities they use."
},
{
"speaker": "",
"content": "So it's important for us to make sure we're working with all of the participants, whether they're banks, hedge funds, market makers or even other providers such as Tradeweb that you mentioned, they're all connecting to see me on the future side of the transaction so that's something that when we combine these assets together for BrokerTec and CME, that's a very hard thing for the marketplace to replicate."
},
{
"speaker": "",
"content": "So it's an important trade. It's continuing, and it's something with the rate environment we're in, we do expect it to continue, but hard to say if it will continue to grow or shrink from here. The important part is when clients need to manage that risk, we have both tools here at CME for them to be able to keep up."
},
{
"speaker": "Terrence Duffy",
"content": "Thanks, Tim. Thanks, Brian. Appreciate the question."
},
{
"speaker": "Operator",
"content": "Our next question from Owen Lau with Oppenheimer."
},
{
"speaker": "Kwun Sum Lau",
"content": "I know it's not material to your financials, but it's getting much attention recently. If the [ SEC ] were to defer security, how would CME respond to it?"
},
{
"speaker": "Terrence Duffy",
"content": "Yes. Thanks, Owen. On the crypto, Tim?"
},
{
"speaker": "Tim McCourt",
"content": "Thanks, Owen. It's certainly something that we've heard customers talk about markets whether or not either will become security. However, it's important to note our primary regulator, the CFTC as said unequivocally that either is a commodity. Based on that clarity, we have listed this product for years under the [ CDC's ] exclusive jurisdiction. The SEC did not have [indiscernible] when we listed the contract, but that will be the path we take forward until we learn otherwise with respect to our other futures and options here at CME Group."
},
{
"speaker": "Terrence Duffy",
"content": "But the way you asked your question is correct. This is not that material to CME. We are in this asset class, but we are not all in on this asset class. I think that's important. We're in the [indiscernible]."
},
{
"speaker": "Operator",
"content": "Our last question today from Michael Cyprys with Morgan Stanley."
},
{
"speaker": "Michael Cyprys",
"content": "I wanted to circle back on the Google Cloud migration and your migration of clearing services and market data to the cloud. Just curious how you think about new services that you could provide customers over time as well as new revenue monetization opportunities over time. And if you look out 5 to 10 years, I guess how do you see the evolution of your business as more of it over time will be moving to the cloud?"
},
{
"speaker": "Sunil Cutinho",
"content": "I will answer the capabilities and then Julie Winkler will talk a little bit about the commercialization of them. So what we've done over the last 2 years is we've made margin calculation services available on the cloud. There are 2 types. One is your current margin calculation that was the first to be released following that we allowed clients to actually calculate historical calculations. Now we are allowing our clients to actually compute margin intraday so as you can see, we are progressing to give clients increased visibility into risk in a highly scalable way in far more real time."
},
{
"speaker": "",
"content": "The next thing we are going to introduce for our clients is optimization. We've talked a lot about portfolio margining. We've talked a lot about portfolio margining with multiple risk pools. Optimization is the ability to give clients the tools to move positions between these risk pools to get the best margin treatment. And we are speaking in that way. We're one of the clearing houses that provide fee services. So we are making that available on Google Cloud as well towards the end of this year as we migrate [indiscernible] Following that, we are releasing a few APIs to some of our services that can be accessed by our clients, our FedWatch API, which gives clients ability to participate in Fed actions that in our markets is now available. We have clients taking advantage of that. So I'm going to forward that now to Julie to talk a little bit about [indiscernible]..."
},
{
"speaker": "Julie Winkler",
"content": "I mean I think Sunil touched on a few of the items that we have in process. There's certainly a distribution component to this, right? We have an extremely large market data distribution network today and being able to offer our data in the cloud gives us another avenue to do that. And it also allows us to do different data packaging than what we do today."
},
{
"speaker": "",
"content": "Our -- we can provide much more customization. For example, with the offering that we have today been live for a number of years [indiscernible] with Google. Customers can come to us if they just want say crypto data as one particular example. So it's a lot more flexibility, I would say, in the data packaging and the offering and the distribution. It allows us to also package that data in a way that it's much more consumable to our clients."
},
{
"speaker": "",
"content": "And we're working with our technology piece also find ways where we can create cloud environments where customers are taking the data for many different sources. So can we create, say, secure environments where they can bring in CME data and use it alongside their existing data, and we believe there's some commercialization opportunities among that as well."
},
{
"speaker": "",
"content": "And as I mentioned earlier, if you think about analytics and APIs, there will be commercial opportunities there. Some of that building on analytics that we already offer, but also how we're going to look to build new things that is going to take a little bit of time. And so I think I would think about that more of a slow burn as we set up those commercialization opportunities."
},
{
"speaker": "",
"content": "And ultimately, right, it's about how we have this data reinforce both the [indiscernible] that we're providing to our customers and also our transaction-based businesses."
},
{
"speaker": "Terrence Duffy",
"content": "Lynne, do you want to add?"
},
{
"speaker": "Lynne Fitzpatrick",
"content": "Yes. Just one thing to add there, Michael. How we commercialize these opportunities is still to be determined. These may be tools that we want to get in the hands of as many people as we can because they might lead to more growth and trading opportunities and just overall scalability of access to our market. So we could see benefits of this coming through trading and clearing fees. We could see specific products that we want to monetize through subscription-type fees. But that's to be determined where you will see that incremental revenue."
},
{
"speaker": "Terrence Duffy",
"content": "Michael that gives you some clarity [indiscernible]."
},
{
"speaker": "Operator",
"content": "This is the operator. I apologize for the technical difficulties experienced. Thank you very much for your patience. Now I'll hand it back to management for closing remarks."
},
{
"speaker": "Terrence Duffy",
"content": "Thank you. I appreciate that. And let me just say, I appreciate everybody that participated in today's call and those that can't, we look forward to continually communicating with you. I want to say one thing before we close, I think it's really interesting to look at CME. We've talked about all 6 of our asset class being up in Q1. That is a great sign. We've got a question about the health of the client."
},
{
"speaker": "",
"content": "I think that points to the health of the client and the expansion of the client and Julie Winkler and her sales team are out there creating new [indiscernible] and people are managing the risk. And we're saying that because open interest year-to-date is also up across all 6 asset classes. This is exactly what we've been talking about over the last 1.5 years as we talk about risk and needing to manage that risk. They're doing it across the board and new participants are coming in. That's a very expected [indiscernible] CME group. That being said, I want to thank each and every one of you for participating again today, and be safe."
},
{
"speaker": "Operator",
"content": "As we are concluded, again, thank you for your participation. Please disconnect at this time."
}
] |
cmg | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day and welcome to the Chipotle Mexican Grill Fourth Quarter 2024 Results Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note, today's event is being recorded. I would now like to turn the conference over to Cindy Olsen, Head of Investor Relations and Strategy. Please go ahead."
},
{
"speaker": "Cindy Olsen",
"content": "Hello, everyone, and welcome to our fourth quarter and full year fiscal 2024 earnings call. By now, you should have access to our earnings press release. If not, it may be found on the Investor Relations website at ir.chipotle.com. I will begin by reminding you that certain statements and projections made in this presentation about our future business and financial results constitute forward-looking statements. These statements are based on management's current business and market expectations, and our actual results could differ materially from those projected in the forward-looking statements. Please see the risk factors contained in our annual report on Form 10-K and in our Form 10-Qs for a discussion of risks that may cause our actual results to vary from these forward-looking statements. Our discussion today will include non-GAAP financial measures. A reconciliation to GAAP measures can be found via the link included on the presentation page within the Investor Relations section of our website. We will start today's call with prepared remarks from Scott Boatwright, Chief Executive Officer, and Adam Rymer, Chief Financial Officer, after which we will take your questions. Our entire executive leadership team is available during the Q&A session. And with that, I will turn the call over to Scott."
},
{
"speaker": "Scott Boatwright",
"content": "Thanks, Cindy, and good afternoon, everyone. I speak on behalf of everyone at Chipotle when I say that we are deeply saddened by the devastation caused by the recent wildfires in Southern California. The safety of our restaurant teams and guests is a top priority. And fortunately, I'm pleased to report that our team members are safe and the impact of our business has been minimal. In response to this tragedy, Chipotle has provided thousands of burritos to firefighters and first responders, committed $1 million in free meals to those impacted, as well as made donations through our Cultivate Foundation to charitable organizations, aiding in the relief efforts. We also featured the American Red Cross in our app to provide our guests a way to donate by rounding up their change. I want to thank our employees and our guests for helping to support the recovery efforts in the affected communities. Now turning to our business update, Chipotle had another outstanding year, delivering strong transaction-driven comps each quarter, expanding margins, opening over 300 restaurants, gaining momentum in key industry-leading brand metrics, making progress on many back-of-house initiatives, and building our footprint internationally. For the fiscal year 2024, sales grew about 15% to reach $11.3 billion, driven by a 7.4% comp, including over 5% transaction growth. Digital sales of $3.9 billion represented 35% of sales. AUVs increased to $3.2 million. Restaurant-level margin was 26.7%, an increase of 50 basis points year-over-year. Adjusted diluted EPS was $1.12, representing 24% growth over last year. And we opened a record 304 new restaurants, including 257 Chipotle lanes. Our fourth quarter results were also impressive, especially considering that we are lapping the very successful Carne asada limited-time offer from last year. Additionally, we experienced some volatility around the December holidays, which we believe was impacted by the calendar shifts this year. Despite this, we were able to grow transactions by 4% in the quarter, driven by continued improvement in throughput, as well as the successful rollout of Brisket as a limited-time offer. For the fourth quarter, sales grew over 13% to reach $2.8 billion, driven by a 5.4% comp. Digital sales were 34% of sales. Restaurant-level margin was 24.8%, a decline of 60 basis points year-over-year. Adjusted diluted EPS was $0.25, representing 19% growth over last year. And we opened 119 restaurants, including 95 Chipotle lanes. Considering our underlying trends, as well as our incremental throughput opportunity and strong marketing plan, we believe we can continue to drive positive transaction comps in 2025 and anticipate annual comps to be in the low- to mid-single-digit range. Adam will provide more details on this in just a few minutes. Now, before I dive into an update on our strategies, I want to take a minute to share a key takeaway from our leadership summit we held in November. An important theme we are prioritizing is to be guest-obsessed. I want to make sure that as we continue to scale Chipotle, everything we do is in service of our guests or those who serve our guests. This will require an understanding and a focus on how each role in the organization matters up to making the experience in our restaurants better every day. A guest-obsessed mindset is crucial to ensuring that we continue to deliver against our five key strategies that help us win today while we grow the future. And these strategies include running successful restaurants with a people accountable culture that provides great food with integrity while delivering exceptional in-restaurant and digital experiences, amplifying technology and innovation to drive growth and productivity at our restaurants, support centers, and in our supply chain, making the brand visible, relevant, and loved to acquire new guests and improve overall guest engagement, sustaining world-class people leadership by developing and retaining top talent at every level, and expanding access and convenience by accelerating our restaurant openings in North America and internationally. I will start with our operations and our focus on throughput. One key driver of running successful restaurants is an experienced general manager who understands the importance of throughput and can train and develop the crew to execute the four pillars consistently every day. The good news is our GM turnover continued to improve in 2024 and is among the lowest levels in the company's history. More stability among our GMs results in more stability in our restaurants, and stability coupled with consistent training and reps has been a big driver of the progress we have seen. In 2024, throughput improved by about two entrees in the peak 15-minute period, and we achieved our near-term goal to reach the mid-20s. Our support centers and restaurant leadership teams continue to find ways to improve our ability to execute the four pillars. For example, our weekly throughput reviews conducted across our restaurant support centers help to keep us top of mind and give our restaurant leaders information to provide coaching and feedback to drive improvement as well as celebrate excellence. We also made the decision last quarter to have the manager on duty responsible for the expo position, and this helped to improve the percentage of restaurants with an expo in place to over 60%. While I'm thrilled to see the progress we are making, we still have work to do and throughput remains one of our biggest priorities and opportunities in 2025. One of the important unlocks this year will be our focus on modernizing the back of house to improve the team member experience and the speed and simplicity of prep while maintaining our high culinary standards. This will ensure more restaurants complete prep on time, which will enable better execution of the four pillars during peak periods, and this brings me to amplifying technology. We have several innovative tools that we are testing to improve the prep process. As we mentioned last quarter, we are currently in the middle of rolling out the produce slicers to all restaurants and expect the rollout to be complete by this summer. Fresh chopped produce in our restaurants each day is key to maintaining our high culinary standards. But it's also one of the most time-consuming tasks. The slicer improves the experience for our team members by reducing the time to chop produce and improve the culinary by ensuring consistent cut sizes. As we have mentioned in the past, some of the efficiencies from the produce slicer will help offset the investment we made last year, ensuring generous portion sizes. Over the last several months, we also began a new initiative in a patch of restaurants to better understand the synergistic benefits of installing the produce slicer, the dual-sided plancha, the three-pan rice cooker, and the dual-vat fryer in the same restaurant. As a reminder, the dual-sided plancha cooks the chicken and steak in under half the time it takes on the traditional plancha with the same sear and char and better consistency and juiciness. The new rice cooker eliminates the large rice pots and cooks the rice in the pans that you see on the line, which creates more consistent quality and streamlines the rice cooking process. And the dual-vat fryer doubles the capacity for frying our chips, resulting in better quality and reducing the time it takes while ensuring consistent availability. Based on the initial results, we have decided to roll out all four pieces of equipment to new restaurant openings beginning later this year. And as we gain more data and insights into this initiative, we will determine if and how we roll out more broadly to existing restaurants. This is a great example of how we're beginning to look at our tools and processes and conventions holistically rather than as bolt-on additions. The end goal is to improve the experience for our teams by making tasks easier to execute, more efficient, faster, and more consistent while maintaining our high culinary standards. We are also pursuing long-term innovations through our stage gate process, including avocado, our device that cuts cores and scoops avocados, and our augmented digital make line, both of which are being evaluated on a test basis. While it is early in our learnings on these opportunities, we are making progress and remain optimistic about each of these innovative tools. When we improve the experience for our restaurant teams, it ladders to a better guest experience. Exceptional in-restaurant and digital experiences coupled with our powerful marketing strategy to make the brand more visible, more relevant, and more loved, builds the brand momentum and results in year after year of transaction growth. Our marketing strategy in 2024 was nothing short of exceptional with a strong brand campaign and two very successful limited-time offers, including Chicken Al Pastor and Brisket, both of which surpassed our expectations and drove incremental transactions and spend. This helped to further strengthen our brand as we ended the year leading and gaining momentum in important categories like high-quality ingredients, value for the money, healthy and nutritious, good amount of food for the money, and brand I love. And we have a strong plan for 2025 to keep the momentum going. We started off the year by putting a spotlight on our lifestyle goals and to encourage and reward healthy habits among our guests in North America and Europe, and our second partnership with Strava, the app for active people with over 135 million users in more than 190 countries. With health and wellness top of mind for our guests, this is a great way to show how the Chipotle ingredients can be customized to fit and fuel any dietary restrictions or lifestyle routines. Additionally, I think it's no secret that our Chipotle Honey Chicken Pilot was a success. It was our best performing limited-time offer, both in early sensory testing as well as the broader to market tests, and you'll see it in our restaurants in the near future. We will also continue to reinforce our brand story of high-quality, responsibly sourced ingredients made fresh every day through our behind-the-foil advertising campaign. This campaign, which features our real teams preparing our delicious food, has certainly resonated with our guests who are not just buying our brand, but buying into our brand and our purpose to cultivate a better world. Speaking of our teams, last year was another tremendous year of opportunities and growth with over 23,000 people promoted, of which over 85% of all restaurant management roles were internal promotions. We also promoted three regional Vice Presidents who started as crew members, and now five of our 11 Regional Vice Presidents started as crew and worked their way up to the highest level of operations, managing a region of the country with sales over $1 billion. Collectively, these five RVPs have over 100 years of experience at Chipotle. To be promoted to an RVP, not only did they need to run a successful sub-region, but they also needed to show the ability to develop and grow future leaders, and these five have developed and promoted over 30 Team Directors, nearly 100 Field Leaders, and hundreds of General Managers. These are life-changing careers for the RVPs, as well as the leaders they are developing along the way. I think this is a testament to our leadership development capabilities as an organization, which I couldn't be prouder of. At the end of the day, our business wins when we lean into the growth and development of all Chipotle team members. Finally, moving to expanding access. 2024 was another outstanding year with 304 new restaurant openings, including 257 Chipotle lanes, making it a second year in a row of record openings. We continue to anticipate between 315 and 345 new openings in 2025, with at least 80% including a Chipotle lane. I'm excited to share that we recently surpassed our 1,000th Chipotle lane, and now this drive-through format makes up over 25% of our restaurants. On average, the Chipotle lane takes less than 30 seconds to complete the order pickup process. The added convenience has been incremental, as Chipotle lanes continue to generate better revenues, margins, and returns than non-Chipotle lanes opened at the same time. It can also be seen in the mix of business as Chipotle lanes have a larger pickup mix, mostly offset by a lower delivery mix. Shifting to outside the U.S., we now have 85 international restaurants. Including 55 in Canada, 27 in Europe, and three in the Middle East. As we mentioned last quarter, we're proving that Chipotle resonates across geographies, and we will accelerate growth in Canada and the Middle East in 2025. We will also continue to make progress on proving out the economic model in Europe and begin to build a pipeline for growth. To conclude, 2024 was another year of milestones, including growing transactions over 5% and surpassing $3.2 million in AUV. Reaching 1,000 Chipotle lanes, opening our first restaurants in the Middle East, and making tremendous progress in Europe. I want to thank our 130,000 employees for your hard work last year. The amount of talent and passion we have is more than most businesses could ever hope for. I don't take that for granted, and I'm proud to be a part of this great organization that prioritizes our people and their growth. And we continue to have so much growth in front of us as we aim to reach 7,000 restaurants in North America, grow our AUVs beyond $4 million, expand margins, and make progress toward becoming a global iconic brand. This will require exceptional people, exceptional food, and exceptional throughput, and a commitment to being guest-obsessed. I'm confident that we have the right team to achieve these ambitious goals, and that the best is yet to come. With that, I'll turn it over to Adam."
},
{
"speaker": "Adam Rymer",
"content": "Thanks, Scott, and good afternoon, everyone. Sales in the fourth quarter grew over 13% year-over-year to reach $2.8 billion, as comp sales grew 5.4%, driven by 4% transaction growth. Our comp included a negative 20 basis point true-up related to our loyalty program. As a reminder, in Q4 of each year, we reevaluate the estimated breakage for loyalty points that will expire, and this year we decreased our estimate due to higher member engagement. Restaurant-level margin of 24.8% declined about 60 basis points compared to last year. Earnings per share was $0.24 cents on a GAAP basis and $0.25 on a non-GAAP basis, adjusted for unusual items, representing 19% year-over-year growth. During the quarter, transaction comps were positive in all months, driven by the launch of Brisket and continued improvement in throughput. As Scott mentioned, we experienced softer trends around the holidays in late December, which we believe was due to Christmas and New Year's falling in the middle of each week. Comps have been volatile so far in 2025, with weather having a larger impact on our sales than what we experienced last year. While we believe underlying transaction trends are healthy and we have a strong plan for the year, we do compare against progressively tougher comps in the first half of the year, and therefore are guiding to a low- to mid-single-digit comp for the full year. There are also a couple of factors to keep in mind when you think about the full year. In the second quarter, we will be rolling off about 90 basis points of pricing in April when we lap the pricing we took last year in California to offset the step-up in wages. And Easter will fall back into the second quarter this year, which will negatively impact Q2 comps by about 100 basis points, with no net benefit in the first quarter because of leap day in the prior year. I will now go through the key P&L line items, beginning with cost of sales. Cost of sales in the quarter were 30.4%, an increase of about 70 basis points from last year. The benefit of our menu price increase was more than offset by higher usage, as we focused on ensuring consistent and generous portions, as well as the mix impact from our premium smoked brisket LTO and inflation across several items, most notably avocados and dairy. Relative to our guidance, avocados were favorable, as the year-over-year step-up was less than we anticipated. For Q1, we expect our cost of sales to be in the high 29% range, as pricing leverage and the benefit from brisket ramping down will be partially offset by higher costs across several items, most notably avocados and chicken. Our guidance does not include the impact of the new tariffs on items imported from Mexico, Canada, and China. We source about 2% of our sales from Mexico, which includes avocados, tomatoes, limes, and peppers, and less than 0.5% of our sales from Canada and China. If the recently announced tariffs go into full effect, it would have an ongoing impact of about 60 basis points on our cost of sales. Also, we remain confident that we can offset the 60-basis point portion investment we made in 2024. Recently, we have started to see the impact ease slightly, as we expected, and we will offset the remainder through efficiencies we have identified within our supply chain, as well as several in-restaurant initiatives, including the produce slicers. While we expect to realize some of the benefit in the first half of the year, we don't anticipate a full offset until the second half of 2025. Finally, underlying cost of sales inflation is expected to be in the low single-digit range for the first quarter and for the full year, which excludes the normalization of avocado prices, the mixed impact from LTOs, the portion investment, and any impact from tariffs. Labor costs for the quarter were 25.2%, an increase of about 20 basis points from last year, as the benefit from sales leverage was offset by wage inflation. For Q1, we expect our labor costs to be in the high 24% range, with wage inflation in the mid single-digit range. We anticipate wage inflation will step down to the low single-digit range in Q2 and for the remainder of the year, when we lap the nearly 20% step-up in wages in California that went into effect in April of last year. Other operating costs for the quarter were 14.5%, a decrease of about 20 basis points from last year. The decrease was driven by sales leverage and a lower delivery mix, partially offset by a true-up in insurance reserves. Marketing and promo costs were 3% of sales in Q4, a decrease of about 10 basis points from last year. In Q1, we expect marketing costs to be in the low 3% range, with the full year to come in the mid 2% range. In Q1, other operating costs are expected to be in the low 14% range. G&A for the quarter was $191 million on a GAAP basis or $175 million on a non-GAAP basis, excluding about $12 million related to equity awards granted for retention of key executives and a $4 million increase in legal reserves. G&A also included $133 million in underlying G&A, $32 million related to non-cash stock compensation, $8 million related to higher bonus accruals and payroll taxes on equity vesting and exercises, and $2 million related to our upcoming field leadership conference, which is scheduled in Q1 for this year. We expect our underlying G&A to be around $135 million in Q1, and we'll step up each quarter as we make investments in people and technology to support ongoing growth. We anticipate first quarter G&A will also include around $33 million in stock-based compensation, although this amount could move up or down based off our actual performance and is subject to the final 2025 grants, which are issued in Q1, around $8 million related to employer taxes associated with shares that vest during the quarter, and $3 million for costs associated with our biannual field leadership conference in March, bringing our anticipated total G&A in Q1 to around $179 million. Depreciation for the quarter was $84 million, or 2.9% of sales. For 2025, we expect it to remain around 3% of sales. Our effective tax rate for Q4 was 24.4% for GAAP and 24.6% for non-GAAP, and benefited from a reduction in non-deductible expenses. For 2025, we estimate our underlying effective tax rate will be in the 25% to 27% range, though it may vary based on discrete items. Our balance sheet remained strong, and we ended the quarter with $2.3 billion in cash, restricted cash and investments, and no debt. During the fourth quarter, we purchased $331 million of our stock at an average price of $59.83. For the full year, we purchased nearly $1 billion at an average price of $57.21 and going forward, we will continue to opportunistically purchase our stock. During the quarter, the Board authorized an additional $300 million to our share purchase authorization, and at the end of the quarter, we have just over $1 billion remaining. To close, I want to thank our 130,000 employees for all your hard work and dedication in delivering an exceptional experience for our guests each and every day. This powers our strong economic model that we continue to protect and grow and allows us to invest back into Chipotle by growing our footprint and furthering our purpose of cultivating a better world. We have a strong plan for 2025, and we look forward to sharing our progress with you in the coming quarters. And with that, let's open it up for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions]. Today's first question comes from Sara Senatore with Bank of America. Please go ahead."
},
{
"speaker": "Sara Senatore",
"content": "Just a quick housekeeping and then a question about the food line. So just on the housekeeping, you talked about positive transactions in 2025, so I think you mentioned 90 basis points of price rolling off. If you don't take any additional price, what does that look like for the full year? I think you would still have some. And then the question about food costs is better than we expected, given all the headwinds you highlighted in terms of inflation and portion investments. I guess to the extent that it was better than you thought, what was the impact? Was it the pricing? Was it benefits from supply chain earlier than you expected? And have you contemplated tariffs as you think about it going forward? Thanks."
},
{
"speaker": "Adam Rymer",
"content": "Thanks, Sara. So on your first question, we believe pricing will be somewhere around 2% in 2025, and so that assumes no additional price. Because if you think about it, we just took about 2% in December. That will carry through December of this year. And then we roll off the roughly 1% national impact from the Fast Act pricing in April. So that comes to be around 2% for the full year. And then on your second question, you're right. We came in a little bit better than we guided in Q4 on cost of sales, and that was mostly because the step-up in avocado prices was a little bit less than we anticipated. It's still happening. It just is more of a timing issue."
},
{
"speaker": "Scott Boatwright",
"content": "Sorry, this is Scott. Sara, did you have a question around tariffs?"
},
{
"speaker": "Sara Senatore",
"content": "Yes, just anything. I know it's obviously in flux, but to the extent that avocados have been a swing factor, if you wouldn't mind touching on that. Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes. I'll take this one if you don't mind, Sara. So our supply chain team has done a remarkable job over the last couple of years with vendor diversification and moving some country of origins out of Mexico proper. Today we source from both Colombia, Peru, as well as the Dominican Republic. Only about 50% of our avocado supply today is coming out of Mexico. And I think we said earlier in the prepared remarks, it's about a 60 basis points impact if it is something that sustains for the year."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from David Tarantino with Baird. Please go ahead."
},
{
"speaker": "David Tarantino",
"content": "My question is on the comps guidance for the year. I think, Adam, you mentioned a few issues related to the first half. I was just hoping that maybe you could elaborate on how you're thinking the comp trajectory could play out as the year goes on. And I have a follow-up."
},
{
"speaker": "Adam Rymer",
"content": "Thanks, David. I'll start talking about really January. So if you look at January from a transactions comp standpoint, we ran about a negative 2, and that included a pretty sizable impact from weather as well as the calendar shift, which kind of had, people going back to work and to school a little bit later with the New Year's Day falling in the middle of the week, and then a very small impact from the wildfires in L.A. All of that was about a 400 basis point impact on our comps in January. And so the underlying trend there is closer to about a plus 2. And so if you push that plus 2 forward for the rest of Q1, we believe that Q1 will come somewhere around flattish on comps. And the reason for that is really when you're looking at February, we're going to be comping over a really successful braised beef barbacoa campaign that we did last year. And that one, the amazing thing about that is we really saw a nice uplift not only in transactions but also in mix that caused a really nice lift in check, a lot of that sustained. And so we don't believe it will hit quite the same way this year because of how much of it sustained. So that's going to be a bit of a tougher comp as well as the second iteration of Chicken Al Pastor hitting in March. It was really pent up demand from the first time that it was in restaurants. And so when that going up as much as it did, that's going to be a really tough, tough comp going into March. And then Easter is also kind of a delay. And so Easter, being a few weeks later is going to cause a little bit of a loss in sales in the sense of Easter tends to really spring our burrito season or beginning of kind of that spring step-ups that we see. So the fact that that's happening several weeks later makes us believe that all of those things will lead to kind of a flat transaction comp in the first quarter. And then when you go into the second quarter, really strong comps from the year before. So I think that'll be kind of a low point for us in terms of the comparison for the full year. And then we'll step up in Q3 and Q4 from there to get to that low to mid-single digit guide that we have for the full year."
},
{
"speaker": "Scott Boatwright",
"content": "I just want to say, David, I apologize. I think Adam said that, the comp would be flat for the quarter. He meant that transactions [indiscernible]. I want to make sure we cleared that up."
},
{
"speaker": "David Tarantino",
"content": "Yes. Thanks for that clarification. I guess, are you assuming a big lift from, you mentioned honey chicken would be coming pretty soon. Is that embedded in your guidance? Are you assuming something similar out of honey chicken, as you thought it Chicken Al Pastor? I guess, how should we think about potentially the upcoming launch of that, that you signaled?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. Hi, David, Scott here. That is not included in the guidance that Adam just gave you. And we typically launch our LTOs around mid to late March. We do intend to launch a product around that timeframe. And we're excited about the marketing calendar for the year. I think Chris and team have done a really nice job of setting up the year to drive positive transactions. And we're excited about the LTO we're going to launch in the spring."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from David Palmer at Evercore ISI. Please go ahead."
},
{
"speaker": "David Palmer",
"content": "As a follow-up on that commentary about the LTO with honey chicken, lapping chicken al pastor, to some degree, I feel like we all focus on these LTOs as the big driver for comps. It's obviously easy for us to focus on these innovations. But when you think about real comp drivers for the year, I'm wondering what other things you're really thinking about that will give you momentum as you go through the year. You mentioned throughput. Do you think that will be as much of a lift this year or maybe even bigger than last year? And maybe you're contemplating certain things that you can do seasonally, maybe personalized marketing initiatives or anything beyond these LTOs that you might be thinking about in terms of a sales driver. Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, David, you've heard us talk about this idea of having a flywheel really generating outsized performance and the flywheel being inclusive of great operations, great marketing, and a great digital strategy. I'll start with operations. I'll tell you, our ops teams have never been on better footing as they stand today with regard to staffing, app model, the best retention numbers we have experienced in my years with the brand. Culture is really strong in the organization today. And we're set up for what could be an extraordinary year around this idea of improving this guest experience, the total guest experience. We spent a lot of time over the past many years really getting to the heart of extraordinary culinary. Speed down the line has been a key focus. There's more work to do there, David. And I think the unlock for step change improvement there is grounded in this idea of what I'm talking about as modernization of the back of house at Chipotle, which drives efficiency, allows us to be better prepared for the peak period at lunch and dinner, and also allows us to continue to scale this great brand as we endeavor to go to 7,000 restaurants in North America alone. That said, operationally, I feel like we've never been on better footing. I will continue to lean into, obviously, the throughput strategies we've deployed in the past and a couple of new ideas we have for this year. As it relates to the marketing calendar, as I said earlier, Chris and team have come forward with a marketing plan that is really extraordinary and probably the best plan we've seen in the branches I've been here as well. We have incremental spend, as you know, year-over-year. We have more linear TV this year than last. The LTOs this year are going to be really strong. We have some new things we're going to test and learn on as it relates to summer months. More on that at a later date. And then with regard to digital, the team is really working on this idea of leaning into the AI assistant to help with customer journeys. I'll give you an example of what that looks like. It's a new pre-defection journey. When the model detects that a customer's behavior is changing in a particular way that would signal a propensity for churn, we will take them on a new journey with personalized extras and offers to encourage them to reengage. And so I think those things are going to drive meaningful difference within the digital channel. And so that total flywheel gives me a lot of confidence this year that we'll have positive transactions and continue to move the business forward."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Lauren Sullivan with Deutsche Bank. Please go ahead."
},
{
"speaker": "Lauren Silberman",
"content": "I wanted to follow up on the traffic commentary. Underlying traffic in January up to, it's a [de-sell] [ph] from what you've been seeing in recent quarters, as you assess the underlying business and understand there's a lot of noise, any more color on what you're seeing from the consumer, any shifts that you're seeing across cohorts, just trying to understand how we go from, I guess, what underlying is plus two, but we're at a down two to back up to positive as we move through the year. Thank you."
},
{
"speaker": "Adam Rymer",
"content": "Yes, no, nothing really to report from an income cohort standpoint. I mean, they're all contributing to the comp very nicely, and we saw this throughout Q4, and that really hasn't changed going into January. So nothing to report on that side. And I would just say, as we turn the year and we look at what we're comping over last year, I mean, keep in mind that we're comping over a roughly, what, 5.3% trans comp from the year before. And so I think that's probably what you're seeing with some of that step down in terms of the absolute comp."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Dennis Geiger with UBS. Please go ahead."
},
{
"speaker": "Dennis Geiger",
"content": "Great. Thanks, guys. Another one on the comp outlook, if I could, sort of bigger picture, cutting through some of the weather noise, the comparisons. Do you guys generally look at the business a little bit longer term as sort of mid-single digit from a same-store sales algorithm perspective, pick your price to understand the positive traffic? Is that still the right way to think about the business longer term or kind of underlying trajectory? Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, I'll start, and I'll flip it over to Adam. Yes, absolutely. Mid-single digits is right where we should be as an organization. We'll continue to put forward strategies that will keep us on that pace in the years to come. I think we've demonstrated over the past many years that we can continue to push forward long-standing, durable earnings and have done a remarkable job with it over the past many years. This year, unfortunately, is off to a rough start, and some of that stuff is largely out of our control. But we have, what we believe to be a great plan for the year, and guiding the low to mid makes more sense to us, based on where we sit today. Hence the guidance. But, Adam, anything you would add to that?"
},
{
"speaker": "Adam Rymer",
"content": "No, that's perfect. Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Christine Zhao with Goldman Sachs. Please go ahead."
},
{
"speaker": "Christine Zhao",
"content": "So, Adam, you still seem to be pretty cautious about taking additional pricing this year. I just want to understand whether this is a reflection of consumer price sensitivity rising or competitive pressure on value, or do you think there would still be a runway for incremental pricing if it becomes necessary throughout the year? And, secondly, just also if you had any thoughts on the mixed component this year. Thank you."
},
{
"speaker": "Adam Rymer",
"content": "Sure. So when it comes to pricing, we are comfortable with the level of pricing we're running right now for the inflation that we're seeing in the business. Because, as you know, we like to utilize price only to offset inflation, and we want to grow our margins through incremental transactions. And so if there were something that came up throughout the year that would be a permanent hit to the business in the form of inflation, we would consider taking price. But at this point, we feel we're well covered based off of what we're projecting. And then your question about mix. So the mixed drag in Q4 was about 70 basis points. Keep in mind 20 basis points of that is related to the loyalty adjustment that we took, which was a multi-period adjustment. So it's really, outside of that, the underlying mixed drag was about 50 basis points. And when you're looking at that a little bit closer, it's still driven by a decline in group size. And a big component of that decline in group size that we saw in Q4 really happened in those last couple of weeks of December, as it relates to that calendar shift. And then we're continuing it. And there was also a benefit. So when you think about the offset or sorry, the offset to that group size decline, benefits really came from brisket being a premium priced item, especially compared to Carne asada in the year before. And then I'm happy to report we're continuing to see strength in size. And this is coming from queso. This is coming from extra meat and chips. You probably remember us talking about this for several quarters in a row now. And so that did not change in the fourth quarter. And so those are the main components of that mix."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from John Ivankoe with JPMorgan. Please go ahead."
},
{
"speaker": "John Ivankoe",
"content": "The question is on the labor market for you, and obviously the entire industry. As we went through the end of '24 and into early '25, wage rates have actually been fairly cooperative, maybe outside of California, but fairly cooperative. And turnover levels across the industry have been fairly low relative to historic averages. So can you comment, I guess, so why you think that may have happened, at this point in the economy and are you looking for any kind of signs of change? Maybe there's some certain pockets of change of either strengthening or weakening, in the labor market and various points of the country that maybe you're paying attention to that could potentially be a forward indicator. Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "It's a great question. And one, it's hard to answer as you think about why, why all of a sudden retention across the industry has improved. I think ours is probably improved at a quicker rate than many others in the industry. And I attribute that largely to our, what I believe to be best in class wages, best in class benefits, and a great culture. And so, as I said earlier, we're at all time highs on staffing as a brand today, as we sit here, we've never been stronger and retention has never been lower. I attribute that success to our operations leadership out in the field, really doing a remarkable job, creating the right experiences, the right environment that people feel heard, and that they are able to continue to develop and grow and hit their long-term career goals for. As it relates to our peer group, I really can't speak to what's happening there. Is there a canary in the coal mine? I haven't seen one. I think we still continue to see strength in the brand, even in the face of extraordinary value wars and value wars, meaning value as a price point with some of the big QSR players, we continue to take share consistently throughout the year, throughout 2024. We continue to see that trend move forward as well. I think that's built on the fact that we create extraordinary value and keep, we're still a 30% discount on average to our peer group, and the consumer still sees value at Chipotle as benefit over price."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Andrew Charles at TD Cowen. Please go ahead."
},
{
"speaker": "Andrew Charles",
"content": "Two questions for me. Scott, in light of the external environment that's presenting some challenges to start the year, can you talk about the decision to keep March at the time to launch this upcoming chicken promotion when it possibly could have been accelerated to help make up for some of the shortfall the external environment caused to start the year?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. We considered that, absolutely thought about it, you know, toward the end of last year. Can you pull that up? Can you make it, pull it forward? To be quite frank, there were two things that went into the decision. Number one is we had a lot of confidence in Braised Beef Barbacoa, even the second time through, we think will be a meaningful launch in February. We really want to target that March timeframe as it relates to linear TV specifically, because we know that our reach and frequency is much stronger in that March, April timeframe. And so it's kind of, it's fishing when the fish are biting, if you will, and putting all of our marbles in one hat. Hopefully that's helpful."
},
{
"speaker": "Andrew Charles",
"content": "Okay. Yep. That's great clarity. Thanks. And then my second question was around, I think in the past you talked about the addition of the expedited position, helps drive around five incremental transactions during that peak 15-minute window. So I'm curious, what is the gaining factor to getting that staffing of that position from 60% to closer to a 100%?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. Believe me, it's something we continue to lean into every single day. I think there are restaurants today that are challenged with getting all the prep items done prior to peak getting breaks deployed so that we are set and ready for peak rush. Oftentimes what we find when we don't have the expo in position, there are people that are out of position, either on breaks at the dish sink, washing the enormous amount of wares we use on a given day or still involved in prep activity. We fervently believe that the back of house innovation, the equipment that we are leaning into through our stage gate process will help us drive greater efficiency at the AM morning prep cycle. That'll allow us to hit those targets more consistently as an organization and create a step change and improvement in throughput."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Danilo Gargiulo with Bernstein. Please go ahead."
},
{
"speaker": "Danilo Gargiulo",
"content": "I actually have two questions on potential future unlocks. The first one is if you're looking at international markets, I mean with nearly one year of new leadership team in the U.K., what are now the restaurant level margins in their region and how have they improved over time? And maybe, Scott, what other initiatives are you expecting to close the gap on margins versus the U.S.?"
},
{
"speaker": "Scott Boatwright",
"content": "Hi Dino. Thanks for the question. I'll tell you they've improved measurably so much so that we have decided to go ahead and start looking at site development in specific areas of Western Europe to begin to build the pipeline to grow again. And so we have a lot of confidence in the team. We have confidence in the progress. They continue to make month-over-month progress. And we know that we have, we can drive or create a viable business in the Western Europe markets we operate in today with hundreds of restaurants and potentially thousands of restaurants in other markets, adjacent markets that we can bring in."
},
{
"speaker": "Danilo Gargiulo",
"content": "Thank you. And then, another source of opportunity for you is probably the Chipotle lane. And you mentioned that you're still seeing a lot of success in this Chipotle lane, generating higher sales, higher margins. What is your aspirational opportunity to maybe retrofit the stores with more Chipotle lanes given that they've been a success?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. So we take a hard look at those, Dino. So the legacy restaurants, we take a hard look at which ones where it makes sense to convert, where we can do it and still see a nice return on the investment. And we will make those strategic decisions throughout the year on which ones we do convert. It's just a hard decision. You've got to understand, how much lease term do I have? Do I have space on the lot? Will the traffic flow work? Will permitting allow it? Obviously so many variables that go into that decision. But where we can, Dino, we will make the investment because we know there's a return."
},
{
"speaker": "Operator",
"content": "And our next question comes from Jon Tower at Citi. Please go ahead."
},
{
"speaker": "Jon Tower",
"content": "Hopefully you can hear me okay."
},
{
"speaker": "Scott Boatwright",
"content": "Yes."
},
{
"speaker": "Jon Tower",
"content": "Great. Awesome. Maybe first on unit growth, you've got another year here in '24 where you hit the effectively smack dab in the middle of your guidance range. And I'm just curious if you can offer any insights to what might prevent you from getting to that higher end of the range in fiscal '25. Are you still dealing with local government, permitting issues as kind of a governor there?"
},
{
"speaker": "Scott Boatwright",
"content": "Jon, some of it's permitting. We're going to hit somewhere in the 9% to 9.5% range this year. And we'll continue to drive the team as it relates to performance for SARs development. Those are the site acceptance requests for new restaurants, obviously 21 months out. And so we feel like the pipeline for '25 was really strong. We'll continue to grow that pipeline and ensure that we have a really successful '26 and hopefully get closer to that 10% mark. But as I said on the last earnings call, we feel really comfortable and confident that we can grow this business in that 8% to 10% range and continue to drive what we believe to be best in class return on investment."
},
{
"speaker": "Jon Tower",
"content": "Okay. Maybe switching gears to the marketing front. This will be another year or '24 was another year where your marketing spend as a percentage sales is, is roughly in that 2.5% range. I think you're speaking to a similar level in '25. And when looking back, historically you guys had been in that 3% range and I'm just curious. I know the dollars have grown, but why kind of take that percentage down rather than keep it there and maybe hit different mediums or use it in a different manner?"
},
{
"speaker": "Adam Rymer",
"content": "Yes. I mean, what you're seeing with that, and we guided for the full year, somewhere in that mid 2% range, what you're seeing there is we're asking for some leverage over the last several years, especially during COVID when we took some outsized price increases to offset inflation and labor and some of the other areas. And so we didn't feel like that should be passed all the way down on the marketing side. And so that's why we're showing a little bit of leverage compared to that historically. However, it is still like, did a very big step up year-over-year, something around 8%, 8.5%. But it's something that we can continue to pull that lever. So if there's good areas that we can invest in, that we think we can get a good return, we'll absolutely pull that lever when those opportunities come up."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Brian Harbour with Morgan Stanley. Please go ahead."
},
{
"speaker": "Brian Harbour",
"content": "Yes, thanks. Good afternoon, guys. How would you sort of contextualize the performance of brisket this time relative to, the past iteration of that and other LTOs. And was there anything different just about timing? Like, for example, was it sort of a stronger start, and did it trail off at the end or was it pretty strong throughout?"
},
{
"speaker": "Adam Rymer",
"content": "Yes. I'll start and then Scott, feel free to add it. And so we felt like, brisket, this was the first time they'd been back in quite some time because as you know, it's a very difficult item to procure. And especially for us to last several months in the amount of restaurants that we have and things like that. And we were very, very excited about the performance. It hit really high in terms of transactions, as well as those that are switching, from all, all across proteins, not just, steak and barbacoa, but also chicken as well. And so it performed really, really well at the onset and then continued through the end of the year and into January. So we're happy with the fact that a lot of our existing customers switched over to brisket. It drove a lot of new customers to the brand. And that it sustained really nicely. And so we're really happy with the results of brisket as well as the hype because like, as you know, it took a couple of years to get it back into our restaurants. And I think that built up some of that hype."
},
{
"speaker": "Scott Boatwright",
"content": "Yes. I would tell you it's an extraordinary product and hopefully the folks on the call have tried it many times throughout the promotional window. I know I probably ate it once a week throughout the entire season. The teams in the restaurant did a really remarkable job delivering that experience with excellence this time around and the consumers voted with their wallets and the incidents remained strong throughout the entire promotion. It's something we would probably do annually, maybe even permanently if you could find adequate supply, but unfortunately that's not the case. So hopefully we can bring it back as a future LTO as an arrow in the quiver in the years to come, but we'll see."
},
{
"speaker": "Brian Harbour",
"content": "Okay, great. Thanks. Just on the equipment discussion. So the produce slicer, I guess my question there was, once you roll that out, does that actually change? I knew you could redeploy some of that labor, but does it actually sort of like change labor hours needed? If people can, I don't know, show up an hour later, for example. And then, Scott, you talked about sort of that new suite of equipment that you're, you're testing, but if you were to sort of put that in more existing locations or try to roll that out faster, is there, you know, any obstacle to doing so besides just kind of securing supply of equipment?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. So the produce slicer will save labor. We plan to redeploy some of that labor and capture part of the labor. How much we have is, is undecided at present. The other piece of equipment are also pieces of equipment that will drive efficiency in the restaurant, better team member experience, better culinary, but it'll also allow us to redeploy or take labor as margin as well. One of those examples is the dual vat fryer. Dual vat fryer, obviously, allows us to cook chips and less than half the time it takes today, freeing up that individual to do other tasks in the restaurant to better prepare for throughput. The dual sided plancha, we've talked about quite a bit over the years. We think it's a better product coming off the plancha, reduces the complexity of one of the most complex jobs at Chipotle today, which is the grill operation. And the rice cooker is far more efficient for the team members, gets them away from those big pans of rice that are just hard to work with and hard to mix and makes that easy, that process much more efficient. Those four pieces of equipment will go into all new restaurant openings at the back end of this year, and will be a part of the new restaurant opening package. We are looking to retrofit a handful of restaurants today. We're calling the high efficiency equipment package. We'll walk that through stage gate and if successful, we're seeing the returns we were looking for. Then we'll do, we'll work through how we retrofit the existing fleet of restaurants today."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Sharon Zackfia with William Blair. Please go ahead."
},
{
"speaker": "Sharon Zackfia",
"content": "I guess there are a lot of moving parts and restaurant level margin this year. And I just wanted to maybe touch on your thoughts on full year restaurant level margin and your ability to spend that. It feels like it might be a tale of two halves where down in the first half, maybe up in the back half. I'm wondering if that's correct. And then secondarily, in terms of the opportunities to mitigate those portion investments, is there any opportunity to accelerate the harvesting of those efficiencies? Thanks."
},
{
"speaker": "Adam Rymer",
"content": "Yes. Hi, Sharon. So you're right in the sense of, I think it is kind of a first half second half type of story. And a lot of that has to do with the portion investment and the fact that we believe that we can offset that investment in the second half of the year. And so that'll cause a little bit of pressure on the first half and then a little bit of relief in the second half. But in general, as you're looking at it from, you know, 10,000 feet, our goal this year is to drive positive transactions and flow that through to where we would see incremental restaurant level margin. So it's really highly dependent on our ability to drive transactions and our ability to flow that through. But that's the ultimate goal. And then in terms of your second question, I believe it was the offset on the portion investment. Is that correct? And the details around that?"
},
{
"speaker": "Sharon Zackfia",
"content": "Yes. Thanks."
},
{
"speaker": "Adam Rymer",
"content": "Yes. And so with that portion investment, you'll notice in the prepared comments, I talked about how a little bit of that 60 basis points is starting to come back, especially through some of our teams and outlier management. That's going to be basis points, at most, maybe 10 basis points. So that'll leave about 50 basis points left in that investment. And we believe that the produce slicers that Scott just talked about will offset a little less than call it half of that. And then you'll get the rest of it a little more than half some from some efficiencies that we've already identified within the supply chain that we're going to start to chip away at here in Q1 and in Q2. And so we'll slowly start to offset that investment. But until those produce slicers come in, you won't see that full offset until the second half of next year."
},
{
"speaker": "Operator",
"content": "And our next question comes from Brian Bittner with Oppenheimer & Co. Please go ahead."
},
{
"speaker": "Brian Bittner",
"content": "All my questions have been answered. So I'll just zoom out for you, Scott. you were named permanent CEO in November. And I know on the last call you talked a lot about how the strategy isn't changing. And I think that makes a lot of sense. But now that you're taking on the permanent role of CEO, are there any differences between you and Brian and how you look at the business that's maybe worth pointing out on this call? Or perhaps maybe there's opportunities where you see you could lean in more. I mean, I think it's anticipated that everything stays the same for the most part, but just wanted to give you the opportunity to suggest any differences."
},
{
"speaker": "Scott Boatwright",
"content": "I really appreciate that. I don't know there are a ton of differences. Here's what I would tell you is there are three core things that we have the organization focused on for the year. And I talked about this differently in the last earnings call when I talked about a more connected organization. And what I endeavor to do in this leadership endeavors to do is be more connected to the guest and around this idea of guest obsession. And if you're in a support center role, your guests are the folks out in the field that are doing the work in our restaurants every day. And I need us to obsess over those individuals. At the restaurant level, we have to do a better job of creating a better experience consistently for all guests that come into our restaurants, whether that's clean dining rooms, smiles down the line or better guest recovery. We have opportunity there. We're really strong with culinary today. We're really strong with speed down the line. We have best in class team members in every single restaurant. We can do a better job of creating a really unique experience as it relates to guest obsession. That's number one. Number two, I keep talking about this, it's a critical one, is modernization of the back of house. And I own that one because I've been reluctant for many, many years as a Chief Operating Officer to make any wholesale changes to how we deliver the experience. And it's taken me a long time to get comfortable with equipment innovations that will come into the back of house and modify, if you will, the knife and cutting board process that we have today. I've gotten comfortable because we still need the knife and cutting boards and we create a better consistent cut size, which ladders to a better consistent recipe and taste profile. So if we can generate that experience and be more efficient and have better culinary, I am all in. So we are bought into this idea of modernization of back of house. And the last thing is around this idea of growth. And growth, not only in organic growth, new restaurant growth, growth around the globe, if you will, as we move into other countries like the Middle East. We're taking a look at a couple of other partnerships as we speak today around the world. But growth with people and growth in from our restaurants all the way up to this executive team. How do we think about development? How do we continue to lean in on growth for individuals that have career aspirations? We want people to start here, stay here, and know they'll hit their career goals and life journeys right here at Chipotle. So those are the three things that I continue to pound the drum on. This team is a line behind. But it's still grounded in the five key strategies that remain unchanged."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question today comes from Zach Fadem with Wells Fargo. Please go ahead."
},
{
"speaker": "Zach Fadem",
"content": "So wanted to follow up on the restaurant level margins. As we've been looking at about 20% incremental flow through in the second half of the year, it seems like we should expect similar in the first half of the year. But as the portion investment eases, maybe you have some equipment productivity, a return to, I guess, reaccelerating comps. Is the high 30% to low 40% incremental margins still the right way to think about this business? Or are there any other puts and takes we should keep in mind?"
},
{
"speaker": "Adam Rymer",
"content": "No, that 40% flow through is still very much intact. And you're right on the pieces as to why the second half of the year, it's been closer to call it 20% because of the portion investment. And then as we start to chip away at that in the first half of this year, like you said, as well as start to drive transaction comps, we'll climb back to that, I believe for the second half of the year. So you've got the pieces spot on."
},
{
"speaker": "Zach Fadem",
"content": "Perfect. And then, Scott, you just mentioned, the potential to explore additional partnerships around the world. So I guess first question is, I presume the relationship with Alshaya is going well and second, in any additional color on regions that you might be interested in down the road."
},
{
"speaker": "Scott Boatwright",
"content": "I's our belief that Chipotle works in all geographies around the globe. We think we have an extraordinary product. And it's hard to argue that rice, beans and chicken doesn't work around the globe. So we have a lot of confidence in our strategy. The partnership with Alshaya, I'll talk about first is going really, really well. And so we have three restaurants open, two in Kuwait, one in Dubai. We have one additional restaurant in Dubai opening very soon. We're happy. Mohammed Alshaya is really happy with the relationship, and we'll continue to expand pretty aggressively with the Alshaya Group here in 2025. As we think about other partnerships around the globe, I'm sure you can probably think about or come up with the countries we're thinking about, whether it's Southeast Asia or Latin America. And we will probably go with like-minded partners, big robust organizations with a lot of track record of success with American brands within their geography and folks that we know that will have as much passion around what we do as the people in this building. So hopefully that gives you some additional color."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes our question-and-answer session. I'd like to turn the conference back over to Scott Boatwright for the closing remarks."
},
{
"speaker": "Scott Boatwright",
"content": "Well, thank you all for listening in today. I was really proud of how the year landed. I'm really proud of this organization and what this team has accomplished, whether you're in our support centers, doing the good work, supporting our restaurant teams of 130,000 people out in our restaurants today that show up every day with a lot of passion around this idea of cultivating a better world. I couldn't be prouder of where we sit. I couldn't be more excited about the year ahead of us. Thank you all. Thank you all for listening in today and we'll talk soon."
},
{
"speaker": "Operator",
"content": "Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day."
}
] |
cmg | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Chipotle Mexican Grill Third Quarter 2024 Results Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note today’s event is being recorded. I would now like to turn the conference over to Cindy Olsen, Head of Investor Relations and Strategy. Please go ahead."
},
{
"speaker": "Cindy Olsen",
"content": "Hello, everyone, and welcome to our third quarter fiscal 2023 earnings call. By now, you should have access to our earnings press release. If not, it may be found on our Investor Relations website at ir.chipotle.com. I will begin by reminding you that certain statements and projections made in this presentation about our future business and financial results constitute forward-looking statements. These statements are based on management's current business and market expectations, and our actual results could differ materially from those projections in the forward-looking statements. Please see the risk factors contained in our Annual Report on Form 10-K and in our Form 10-Q for a discussion of risks that may cause our actual results to vary from these forward-looking statements. Our discussion today will include non-GAAP financial measures. A reconciliation to GAAP measures can be found via the link included on the presentation page within the Investor Relations section of our website. We will start today's call with prepared remarks from Scott Boatwright, Interim Chief Executive Officer; and Jack Hartung, President and Chief Strategy Officer and Adam Rymer, Chief Financial Officer, after which we will take your questions. Our entire Executive leadership team is available during the Q&A session. And with that, I'll turn the call over to Scott."
},
{
"speaker": "Scott Boatwright",
"content": "Thanks Cindy and hello everyone. Before I get into the details of the quarter, I know I speak on behalf of everyone at Chipotle when I say that we are grateful for Brian's leadership and for the transformation he led. Over the past several years, we built a strong team with a great culture and have developed compelling and successful strategies together. With that said, after leading our operations for the last seven years, I'm excited and honored for the opportunity to lead Chipotle as our Interim CEO. To start, there are three things I want to make very clear today. The first is that I'm extremely passionate about our brand and purpose. We are truly a special company that cares about the culinary heritage that Chipotle was founded upon. And our purpose of cultivating a better world resonates with our teams at all levels of our organization, as well as with the guests we serve in our restaurants each and every day. I'm also passionate about our people, and I strongly believe we have the best in the industry, both in our restaurants and at our support centers. Since joining Chipotle in 2017, I've had the privilege and responsibility of leading our restaurant teams as we have grown from under 2,300 restaurants to over 3,600 restaurants today, employing over 125,000 people. I can tell you firsthand how hard our teams work to provide our fresh, delicious, and customizable culinary experience at accessible prices to millions of people every day. These exceptional people are the backbone of our great brand. And the third is that our strategy is not changing. I have worked alongside our talented executive team to craft and evolve our successful strategy, and we will continue to execute against it. This includes our long-term targets of expanding to 7,000 restaurants in North America, increasing our AUVs to over 4 million, and expanding our restaurant-level margins and growing internationally. Now, before I dive into our five strategies, I want to run through our third quarter results. We had another outstanding quarter with positive transaction growth every month. We saw momentum build throughout the quarter as the impact from summer seasonality normalized and as we successfully launched Smoked Brisket, which is off to a fantastic start. For the quarter, sales grew 13% to reach $2.8 billion, driven by a 6% comp with over 3% transaction comp growth. In-restaurant sales grew by 80% over last year. Digital sales represented 34% of sales. Restaurant level margin was 25.5%, a decrease of 80 basis points year-over-year. Adjusted diluted EPS was $0.27, representing 17% growth over last year. And we opened 86 new restaurants, including 73 Chipotlane. The momentum of the business has continued into the fourth quarter with accelerating transaction trends, and we are maintaining our full year guidance of mid to high single-digit comps. Now let me provide an update on our five key strategies that have helped us win today and will grow our future. These strategies include learning successful restaurants with a people-accountable culture that provides great food with integrity while delivering exceptional in-restaurant and digital experiences, amplifying technology and innovation to drive growth and productivity at our restaurants, support centers, and in our supply chain, sustaining world-class people leadership by developing and retaining diverse talent at every level, making the brand visible, relevant, and loved to acquire new guests and improve overall guest engagement, and expanding access and convenience by accelerating new restaurant openings in North America and internationally. Let's start with running successful restaurants and our progress on throughput. We have mentioned this in the past, but it's important to say it again. Throughput is a core focus for Chipotle because it is the outcome of a strong operational engine that delivers a great experience for our guests and teams. And execution in our restaurant is improving as we continue to build our throughput muscle. Last quarter, we began concentrating our efforts on the expo position as it is a critical pillar of throughput. As a reminder, this is the crew member between salsa and cash who helps expedite the order assembly and payment process. Restaurants with an expo in place are averaging five incremental entrees in their peak 15 minutes. We are often asked why it's so challenging to execute this key pillar of throughput. Well the crew member responsible for the expo position may be doing other tasks like prep which prevents them from being properly deployed. In late August, we made a decision to have the manager on duty deployed to the expo position during peaks. This has helped to improve the percentage of restaurants with an expo in place to over 60% compared to just over 50% last quarter. It has also helped to drive accountability, improve communication with the guests and ensure we are properly ringing up each order. While we are making great progress on executing the four pillars of throughput, we still have work to do. Of the restaurants that do not have the four pillars in place, we are finding that often our crew members are still prepping food during peak periods. The fact is, preparing our delicious food is a lot of work and requires strong culinary skills. Our teams are beginning prep at 6 or 7 a.m. in the morning to be able to deliver our food on time when we open. This includes slicing and dicing produce, hand-mashing avocados to make our delicious guacamole, frying on chips every day, and grilling items like the heat of veggies and adobo chicken on the plancha. In addition to coaching and training around throughput, we are also exploring ways to make the prep process easier on our teams while ensuring we are maintaining or improving upon our high culinary standards. This brings me to technology and innovation. We now have several initiatives in stage gate that can help to improve the prep and cooking process and drive a better experience for our teams. Two, that I'm particularly excited about are the dual-sided plancha and the produce slicer. As we mentioned last quarter, we are in the process of rolling out the dual-sided plancha to an incremental 74 restaurants, which will be complete by the end of next month. And as part of the stage gate process, we are now evaluating and implementing the dual-sided plancha into new restaurant openings, as well as retrofitting existing restaurants, and we'll have more to share on this early next year. Additionally, over the last year, we have been testing a produce slicer. In our restaurants, slicing and dicing vegetables like jalapenos and bell peppers is one of the most time-consuming and repetitive tasks. It would be an understatement to say our teams are excited about this new tool. In fact, at our all-major conference in March, nearly 5,000 managers and above-restaurant leaders gave it a standing ovation. The new produce slicer drives improved efficiency, which will allow our teams to complete the prep process on time in every restaurant, resulting in better deployment at peak and better throughput. And it also improves our culinary by delivering consistent cut sizes. I'm excited to share that we are beginning to roll out the new produce slicer in all restaurants, which should be complete by next summer. Beyond these two initiatives are augmented make line by Hyphen and Autocado, which cuts, cores, and scoops avocados were installed into their first restaurants for pilot testing during the quarter. These are both highly customized technologies that could provide big unlocks for us in the future. We have already received a lot of learnings on both innovations from our crew and our guests that will be used for future iterations. As you can see, we have a number of initiatives underway, and I envision significant back-of-the-house changes in the near future that will drive efficiencies and improve the consistency of our culinary in our restaurants. This will enable our teams to focus on and execute the four pillars of throughput better than we ever have and deliver an exceptional experience for our guests in restaurants every day. Let's shift to world-class people leadership. In addition to innovation that helps to better enable the preparation of our delicious food, we are also rolling out a new technology platform across all restaurants that will make the hiring process simpler, faster, and more automated. The new AI hiring platform automates the communication and scheduling between applicants and our general managers, reducing the amount of time it takes to hire an employee for an in-restaurant position by as much as 75%. The automation of this administrative task will allow our GMs to spend more time coaching and developing their teams and providing excellent hospitality for our guests. And it also gives us a competitive advantage against the other restaurant chains in the high-volume hiring market because we can hire talent faster. As I mentioned earlier, I'm passionate about our people and building a strong culture that recruits, retains, and grows the very best. And I'm thrilled to share that Chipotle was ranked first among 400 of the largest publicly traded companies in the American Opportunity Index of best places for high school graduates to start a career. The rankings were based on how well a company hires entry-level employees, promotes from within, and prepares them for opportunities when they leave. One of the very best benefits we offer our teams is our career advancement opportunity. We have so many stories of crew members who have started at Chipotle and grown within the organization, resulting in life-changing careers, including several to the position of Regional Vice President, overseeing hundreds of restaurants, and a billion dollar plus business. In fact, our team director out of the Chicago region has one of these inspiring journeys. She came to the US at the age of seven with her parents and brother as refugees. And at the age of 18, she started working at Chipotle as a crew member for her first job out of high school. She has advanced within Chipotle to become a top performing team director and now is responsible for 61 restaurants or almost $200 million in sales each year. She clearly demonstrates and understands that developing and growing future leaders is what makes Chipotle a special company. My favorite part about her journey is that through her financial success at Chipotle, she was able to help her mom retire, which she views as her biggest accomplishment. I could not be prouder to be part of an organization that prioritizes our people and their growth. And the exciting part is that as we look to grow to 7,000 restaurants in North America and expand internationally, we will be adding hundreds of new restaurant leadership roles each year, and we will continue to pursue our goal of promoting over 90% from within. The future is very bright at Chipotle. Now turning to marketing, I have to take a moment to acknowledge our marketing team for their outstanding work over the years and making Chipotle more visible, more relevant, and more loved. Our brand continues to lead and gain momentum in many categories like quality of ingredients, quality of food for the money, and healthy and nutritious. This is a result of a strong marketing strategy and brand campaigns like Behind the Foil, which showcases our Chipotle teams preparing our fresh, delicious food. The campaign is certainly resonating well, and we will continue to evolve it and find new ways to put a spotlight on what differentiates Chipotle, which is our food, our people, our purpose, and our values. Turning to menu innovation, our limited time offers continue to surpass our expectations. Our guests have been craving the return of Smoked Brisket for three years and it's off to a very strong start driving incremental transactions and spend. As we have mentioned in the past given the limited supply of responsibly raised beef it was a huge cross-muscle effort to bring back this fan favorite and we anticipate it will last through the fourth quarter. We also been testing Chipotle Honey Chicken which is our adobo chicken seasoned with savory Mexican spices and finished with a touch of pure honey. Similar to Chicken Al Pastor it is simple to execute in our restaurants and absolutely delicious. This has been one of our most successful tests to date both in early century testing as well as in the broader two market test we are currently running in Nashville and Sacramento. I'm delighted to share that Chipotle Honey Chicken has made its way through the stage gate process and is ready to be rolled out in the future. Finally coming up this week will be our annual boom reader promotion. This year our marketing team found another creative way to lead culture as we collaborated with spirit Halloween and launched a new collection of Chipotle costumes inspired by popular memes on our social channels which is generated some of our highest social engagement this year. Now moving on to our final strategy which is to expand access and convenience both in North America and internationally. In North America, our development team made great progress smoothing the cadence of openings with 185 new restaurant openings year-to-date which compares to 149 at this same time last year. We remain on track to open between 285 and 315 new restaurants this year which will mark another record for us. As we look at 2025, we anticipate opening 315 and 345 new restaurants with at least 80% including at Chipotlane. In Canada, our new restaurant openings continue to be outstanding and in the third quarter we entered another new market with our first restaurant in Edmonton which broke an opening day record for North America. We will surpass 50 restaurants in Canada next month which is a huge milestone. Our unit level economics and returns remain on par with the US and we will continue to accelerate growth in Canada in 2025. Turning to Europe, under the new leadership team we are beginning to see promising results. We have better aligned our culinary menu to the North American standards and we are in the process of fully unlocking the functionalities of our operational tools to better manage labor and food costs. Additionally, similar to our successful strategy in Canada, we are rolling out local and digital marketing initiatives which are building brand awareness and bringing more guests into our restaurants. The recent performance gives us confidence that we can begin to build our restaurant pipeline for the future. And I'm optimistic that Europe will be a sizable growth opportunity for Chipotle over the coming years. Finally, I'm excited to share that our first restaurant in Dubai opened earlier this month. The restaurant is absolutely beautiful and located along the beachside boulevard of Jumeirah Beach. This is the third restaurant we have opened this year with our partner Alshaya Group. All three restaurants are exceeding our expectations and Chipotle is one of the top performing brands in AlShaya's portfolio. This is further strengthening our confidence that Chipotle is responsibly sourced, classically cooked, real ingredients, resonates across geographies. We are targeting to open a second restaurant in Dubai early next year and plan to accelerate growth with Alshaya Group in 2025. In closing, I want to thank our restaurant and support center teams for another great quarter driven by strong transaction growth. I always say that at Chipotle, we are either directly serving our guests or serving someone who is serving our guests. And it's important that as a team we continue to focus on exceptional food, exceptional people, and exceptional throughput. This will drive great execution in our restaurants that will enable us to continue down our very long runway for growth as we expand to 7,000 restaurants in North America and grow internationally. And as we make our way down this path, I strongly believe Chipotle will become a purpose driven, global lifestyle brand. With that, I'll turn it over to Jack."
},
{
"speaker": "Jack Hartung",
"content": "Thank you, Scott. Good afternoon, everyone. Before I hand it over to Adam to go through the third quarter financial results, I want to make a few comments about the management transition. While Brian’s departure was not expected, our focus on succession planning at all levels of the organization allowed for this to be a seamless transition with Scott assuming the role as our Interim CEO. We're all very supportive of Scott as his leadership at the company is unparalleled, having led our restaurant teams over the last seven years. And Adam and Jamie were already well prepared to take on their new roles earlier than anticipated so that I could step into my new role as President and Chief Strategy Officer. Also I want to emphasize that the culture and morale at Chipotle has never been stronger. We have so many passionate leaders running our restaurants and at our sports centers that are all connected by our purpose of cultivating a better world. There's positive energy and a real sense of responsibility to keep the momentum going and to continue to execute against our very successful strategy. Finally, I'm committed to my new role and plan to stay on indefinitely to ensure a smooth transition. As you can imagine, having spent 22 years at Chipotle, I love this company. I'm passionate about our purpose and I strongly believe we have a very long growth runway ahead of us as we expand Chipotle in North America and around the world. With that, I'll now turn it over to Adam, our new Chief Financial Officer to go through the results. Adam, congratulations and over to you."
},
{
"speaker": "Adam Rymer",
"content": "Thank you, Jack. I'm excited to take on the role of Chief Financial Officer for this great company and I'm happy to be with all of you on my first conference call. With that said, I will turn to our quarterly results. Sales in the third quarter grew 13% year-over-year to reach about $2.8 billion as comp sales grew 6%, driven by over 3% transaction growth. Restaurant level margin of 25.5% decreased about 80 basis points compared to last year. Earnings per share adjusted for unusual items was $0.27, representing 17% year-over-year growth. The third quarter benefited from equity awards forfeited by our former CEO and a gain on an investment. These were partially offset by the impairment of a corporate asset and equity awards granted for retention of key executives. Collectively, these positively impacted our earnings per share by $0.01, leading to GAAP earnings per share of $0.28. As Scott mentioned, comps accelerated throughout the quarter, with transaction trends strongest in September as the impact from summer seasonality normalized and we rolled out Smoked Brisket. Looking to Q4 and taking into consideration that the strong transaction trends have continued so far in October, as well as the tougher comparison against Carne asada, we anticipate our transaction comps to modestly accelerate from Q3. As a reminder, we roll off about three points of pricing at mid-October, as the impact of pricing in the fourth quarter will be just over 1% due to the price increase, we took in our California restaurants in April. For the full year, we continue to expect our overall comp to be in the mid to high single digit range. I will now go through the key P&L line items beginning with cost of sales. Cost of sales in the quarter were 30.6%, an increase of about 90 basis points from last year. The benefit of last year's menu price increase was more than offset by inflation across several items, most notably avocados and dairy, as well as higher usage as we focused on ensuring consistent and generous portions, and the mixed impact from our premium Smoked Brisket LTO. For Q4, we anticipate our cost of sales to be just about 31%, as we have a full quarter of our Smoked Brisket LTO. As we mentioned last quarter, we believe we can offset the 60 basis point portion investment through efficiencies and innovation over the next several quarters. This includes efficiencies we have identified within our supply chain, as well as several in-restaurant initiatives, including the produce slicers that Scott mentioned earlier. While we anticipate some of the benefit to begin in Q4, we don't anticipate a full offset until the second half of 2025. Labor costs for the quarter were 24.9%, about flat to last year, as the benefit from sales leverage offset wage inflation. For Q4, we expect our labor cost to be in the low 25% range due to seasonally lower sales, with wage inflation to remain in the mid-single digit range. As a reminder, about half of the wage inflation is due to the nearly 20% step up in wages in California, from the increase in minimum wage for restaurant companies like ours that took effect in April. Other operating costs for the quarter were 13.8%, a decrease of about 20 basis points from last year. The decrease was primarily driven by sales leverage and a lower delivery mix, partially offset by higher marketing and promo costs. Marketing and promo costs were 2.1% of sales in Q3, and in Q4, we expect marketing costs to step up to the low 3% range. In Q4, other operating costs are expected to be in the low 14% range, as we anticipate higher marketing costs to be partially offset by lower seasonal expenses, like utilities and maintenance and repair. G&A for the quarter was $127 million on a GAAP basis or $149 million on a non-GAAP basis excluding a net $22 million benefit from equity awards forfeited by our former CEO, partially offset by the expense for awards granted for retention of key executives. G&A also includes $126 million in underlying G&A, $25 million related to non-cash stock compensation and a $2 million benefit from a bonus adjustment. Non-cash stock compensation and bonus expense benefited in the quarter from our CEO's departure as well as performance-based adjustments. We expect our underlying G&A to step up to around $130 million in Q4 as we invest in people to support our growth. We anticipate stock comp will be around $28 million in Q4, although this amount could move up or down based on our actual performance. We also expect to recognize around $4 million related to higher bonus accruals and employer taxes associated with shares that best during the quarter and $1 million for costs associated with our field leadership conference in early 2025, bringing our anticipated total G&A in Q4 to around $163 million. Depreciation for the quarter was $84 million or 3% of sales. In Q4, we expect depreciation to step up slightly as we open more restaurants. Our effective tax rate for Q3 was 22.9% for GAAP and 23.8% for non-GAAP. Our effective tax rate benefited from a reduction in nondeductible expenses related to our CEO's departure. For fiscal 2024, we estimate our underlying tax rate will now be in the 24% to 26% range, although it may vary based on discrete items. Our balance sheet remains strong as we ended the quarter with $2.3 billion in cash, restricted cash and investments with no debt. During the quarter, we repurchased $488 million of our stock at an average price of $54.55. In the third quarter, our Board of Directors approved an incremental $900 million in share repurchase authorization. And at the end of the quarter, we had nearly $1.1 billion remaining. To close, I am grateful for Jack's mentorship over the last 15 years and honored to be a part of our leadership team, serving our 125,000 employees in our restaurants and support centers. We will continue to protect the special brand and our unique economic model that allows us to spend more on our real ingredients, yet remain one of the best values in the industry, while also maintaining industry-leading margins. This is a huge competitive advantage and will continue to require a relentless focus on driving an exceptional experience for our restaurant teams and our guests each and every day. And with that, let's open it up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Today's first question comes from Andrew Charles of TD Cowan."
},
{
"speaker": "Andrew Charles",
"content": "Great. Thank you. First off, Adam, Jack, as well as Scott, congrats on your new roles. Last call, you guys were contemplating a price increase in 4Q. I was curious if this strengthened traffic in recent months, along with missing widget labor cost pressures, to help solidify your decision on this."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, this is Scott. I'll jump in here. Thanks for the question. We're keeping a really close eye on the consumer, as you can imagine. Also a close eye on this very competitive market that we're in today, given the macros and what's going on with value wars and QSR and fast casual. But also note that we are seeing some modest inflation. I'll let Adam speak to that in the business today. So nothing planned today, but that's not to say we wouldn't look at a pricing action at some point in the future."
},
{
"speaker": "Adam Rymer",
"content": "Yes, and to go a little bit further into inflation. So yes, like you said, Andrew, we're kind of seeing low single digit inflation on cost of sales. That's after you peel back a few layers. So one of that's going to be the investment that we made in portions, so roughly that 60 basis points that we mentioned on the call. We believe we can offset that through efficiencies within our supply chain as well as within the back of house of our restaurants. Probably a full offset by the end of next year, so that's not included. Neither is the impact of Brisket, kind of that premium item and what that's doing to cost of sales right now, as well as the avocado comparison. So if you remember about a year ago, avocados were abnormally low. And so once you peel back those layers, you're seeing about a low single digit inflation on cost of sales and then a similar amount on labor. We mentioned mid-single digit on labor, but that includes the FAST Act. We've already taken prices back in April of this year to offset that roughly 20% increase in wages in California. And so the remaining underlying inflation on labor is kind of in that low single digit range."
},
{
"speaker": "Andrew Charles",
"content": "Okay, very helpful. And then, Jack or Adam, you guys previously talked about aspirations to ramp to 10% net restaurant growth in 2025. While the guidance for 315 to 345 openings is a strong number, it was a bit light of the aspirations you guys previously laid out. So I was wondering if you could talk through what is factored into the development guidance for ‘25."
},
{
"speaker": "Scott Boatwright",
"content": "Hey, this is Scott. I'll jump in here again. I'll let Adam come in behind. I'll tell you we will see year-over-year incremental new restaurant growth in 2025. The percentage will move closer to 10% than we've been in years past. We feel really comfortable about the number today to successfully open that many restaurants with high-quality leaders that we know we can execute and deliver with excellence. We feel really comfortable in the 8% to 10% range. Can we move closer to 10%? Perhaps. Timelines remain pretty consistent at 21 months. And we have a really robust pipeline. We have a lot of confidence in our development team and operations team to deliver great results in the years to come."
},
{
"speaker": "Operator",
"content": "And our next question comes from David Tarantino with Baird."
},
{
"speaker": "David Tarantino",
"content": "Hi, good afternoon. My question's on new unit performance. At least the way we calculate it this quarter, it looked a little lower than it has been in past quarters. So I was wondering if you could explain what you're seeing there and whether there's something unusual in the numbers affecting the calculations of that."
},
{
"speaker": "Adam Rymer",
"content": "Yes, I'll start, and it's got definitely jump in. So nothing unusual in this quarter to really call out. We're still seeing productivity kind of in that low 80% range. And so we're still really excited about how our new units are performing."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, and the year two ROI is still holding pretty steadily. And we feel really good about the performance of this class of restaurants."
},
{
"speaker": "David Tarantino",
"content": "Great, thank you. And then I guess my other question was about the path to get back to the high 20s restaurant margin. I think you've talked about that being something that you would have at this level of average unit volume. So I guess I know you mentioned some efficiency gains or productivity gains you're expecting but I guess as you think forward is there anything you can share with respect to the path to get there in the next few years."
},
{
"speaker": "Scott Boatwright",
"content": "David, I'll start again flip it over to Adam, but I think in general we have a lot of confidence in our ability to get back to high 20s. We think the algorithm still holds at $4 million and 30%. There are several initiatives that are in the pipeline today whether it's supply chain initiatives or efficiencies and or technologies like equipment technologies will help us be more efficient at the restaurant level. Adam, is there anything else you would add to that?"
},
{
"speaker": "Adam Rymer",
"content": "No, I would just say that within the margin algorithm, that 40% flow through on incremental transactions still very much in line. And I know in Q3, it was about an 80 basis point decline year-over-year. But you have to take into account a few different things. One, the portion investment, which again, will offset that 60 basis points through efficiencies. The avocado comparison is another 50 basis points or so. And then there's an add promo timing that added another 20 basis points. So if you take those into consideration, we would have gone from kind of a minus 80 basis points to a positive 50, which would be more in line with the transactions that we drove. So a few unique items in the quarter."
},
{
"speaker": "Operator",
"content": "Our next question today comes from Sara Senatore with Bank of America."
},
{
"speaker": "Sara Senatore",
"content": "Thank you. I guess a clarification on the comps and then a question on the throughput. So you mentioned that the comparisons, Carne asada comparisons are difficult, but I thought Carne asada was on the menu for all of the fourth quarter of last year. So just trying to understand if you're saying that you would expect traffic trends, which accelerated nicely into October, to somehow be a flow through the rest of the quarter. And whether or not, again, that any of this is seasonality, similar to what we saw in the second quarter where maybe April was very strong, but then some other kind of variability. So I wanted to make sure I was understanding the commentary on the traffic outlook for 4Q and then just a question about throughput."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, Sarah, we are seeing acceleration in the business and that's even in the light of what we believe to have been a very successful Carne asada promotion, which we're rolling over at present. As well as, if you recall, we have 3% pricing that is rolling off, rolled off a couple of weeks ago. And so we feel great about the trends and I think it's a combination of an exceptional product offering, great marketing around what makes our brand unique and special as well as operational execution. I'll tell you, Sarah, our ops teams are delivering on a level I have not seen before in my 30-year history. I couldn't be more proud of them. I think all of those things together are driving the performance that we're seeing in the business today."
},
{
"speaker": "Adam Rymer",
"content": "Yes, and then I can expand a little bit on throughput. So we saw great progress in the quarter. Like Scott mentioned, expo execution went from like 50% of our restaurants to 60% of our restaurants. So that was a nice step up. And then we saw an increase in Max 15 of about 1.2 entrees in our 15-minute period. And so we believe that, again, the fueling of not only the positive 3.3% transaction, but also that execution that Scott talked about just amazing in our restaurants to help drive that result."
},
{
"speaker": "Sara Senatore",
"content": "Right, thank you. That's great color and just on the throughput just one quick question. Is that how you think about the some of the technology of equipment you're rolling out? I mean I know you talked about efficiencies and it seems like it's that'll largely be reinvested into the portion sizing, but would you expect to see a step change in throughput as well or is that again more incremental?"
},
{
"speaker": "Scott Boatwright",
"content": "I do, Sara, absolutely. One of the challenges that we have in our restaurants is in the mornings our teams are so involved in cutting, slicing, dicing, chopping, and really preparing all the wonderful ingredients to be used throughout the day that oftentimes they fall behind for a host of reasons whether that's a call out or a new team member joining the team that is less talented with a knife. Those challenges are formidable and that oftentimes causes us to not be deployed effectively at peak and not able to drive great throughput. The technologies we're talking about will help enable our teams to deliver great culinary, but also get the process done in time to be deployed effectively and really drive great throughput of the business."
},
{
"speaker": "Operator",
"content": "And our next question today comes from David Palmer with Evercore ISI."
},
{
"speaker": "David Palmer",
"content": "Thanks. Good evening. Scott, I actually heard you on CNBC just now, just a half hour ago or so, and you were talking about some of the technology the AI enabled customized marketing that you would imagine happening and some of the bespoke type suggestions or whatnot. I'm trying to imagine what you could have been talking about there. Maybe you can maybe bring that to life for us about maybe what iterations of enhanced digital experiences and what that could mean ultimately to comps. And just to follow up on that throughput question that Sara was asking about, you mentioned something like a 1.2 improvement in entrees per 15 minutes, and we saw that you had driven, looks like your labor hours might have been roughly flat versus the traffic up 3%. Is that the type of relationship that happens from that? I mean, you talked about five more entrees per 15 minutes being the opportunity. Does that mean that you can kind of do this for another, is there a relationship there that we should think about as we model between those two things? Or maybe I'm overthinking that. Thanks."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, thanks David. On to the CRM and CDP, I'm sorry, CDP loyalty and personalization I spoke of earlier. And that way, Curt Garner and his team and talked through some of the early stages of what would an AI model look like to really drive greater efficiency with our loyalty members. And we're early innings and we're still experimenting with some really, really unique ideas. He has an extraordinarily talented team that continues to figure out ways to iterate and drive performance in that channel. And so it's really early days, but we think the AI model's sitting on top that's really searching out whether you're a lapsed user, an at-risk user, or an active user within the program. How do we serve up a bespoke experience, a truly bespoke experience, beyond some of the traditional format pitches that you typically get in a loyalty program, but something that's really tailored for the user, not just a checkout for ads, but also a bespoke experience. When you enter the experience, you'll see something tailored for you as an individual based on your needs, your usages over the past or your history. So we think it's a really cool play on how do we continue to drive incremental value within that platform."
},
{
"speaker": "Adam Rymer",
"content": "Yes, and then David, I can comment on the labor comments. I mean, outside of normal leverage, as we drive additional transactions, whether that be through throughput or marketing initiatives or really all of the above, labor hours, there's no kind of relationship, I think, other than the leverage that you're talking about. So if I'm understanding that question correctly."
},
{
"speaker": "David Palmer",
"content": "Yes, no, and we can, I'll ask about it more offline, but thank you."
},
{
"speaker": "Scott Boatwright",
"content": "David, I will add, one of the challenges we face, again, is getting all the work done in the AM and being deployed correctly. So it's the same amount of labor in the building, but someone's taking care of pot companions at the district and someone else is wrapping up prep on onions or peppers or bell peppers or jalapenos and not being deployed. So if we can get all that work done, put away in the right way, in every restaurant consistently every day, we can deploy all those individuals to the guest experience, which is where we'll drive the most value."
},
{
"speaker": "Operator",
"content": "And our next question comes from Christine Zhao with Goldman Sachs."
},
{
"speaker": "Christine Zhao",
"content": "Thank you. Congrats, Scott, Jack, and Adam. I was wondering if you can share any internal metrics or measures on the impact and returns of these portion size investments. So do you think these investments have been sufficient in protecting the core brand equity? And what do you need to see to kind of move on gradually? I know you mentioned that you won't expect to fully cycle until the second half, but how you see the returns on the investment so far. Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, it's really hard to quantify. Here's what I will tell you is, if you think about one of the core equities of this rolling brand for the last 30 years, it's all been grounded and this idea of high quality, fresh ingredients prepared for classic culinary techniques in variety and abundance and a speed in which you can't get anywhere else, at an extraordinary price point. And so we know that portioning is a core equity of hours in the organization, and we are committed to ensuring that we give the right portion to every guest that walks into the building. We've seen strong improvement, even through our social channels and people about, it's a reverse of what we saw earlier in the year. Around people posting big burritos, big bowls, and really excited about portioning their getting a Chipotle brand. We also see that show up in our brand tracker and other third party sources where value for the money, food for the money, and quality for the money exceed most of our peers in the category. So also internal consumer metrics that we measured through our digital channel and then restaurant experience show portioning positive scores are up 500 points over the spring. So, we know we're making great progress. We know we're delivering value for the consumer, especially in this really tight environment. And we'll continue to lean into that."
},
{
"speaker": "Operator",
"content": "And our next question is from Brian Harbour with Morgan Stanley."
},
{
"speaker": "Brian Harbour",
"content": "Yes, thanks. Good afternoon, guys. Maybe just first one. Adam, do you have any kind of thoughts on inflation next year or so far? Do you think low single digit for food and wages can kind of continue?"
},
{
"speaker": "Adam Rymer",
"content": "Yes, from what we see at this point, we believe that that will continue. Labor has been kind of in that level outside of the FAST Act for quite some time now. So we have no reason to believe that'll change. And then our first initial looks at cost of sales in the next year are still going to be more of the same. But we'll update you guys if that changes in upcoming calls."
},
{
"speaker": "Brian Harbour",
"content": "Okay, thanks. Scott, maybe just on some of the new equipment and automation, how fast do you think some of that can be deployed? And I guess just kind of like philosophically, is this something where it's really -- it’s mainly about kind of creating a better experience for employees? Is it something that you think kind of drives better margins over time? Or on the other hand, do you sort of, if it creates efficiencies, do you share that with the customer in the form of kind of lower pricing versus some of your competition over time? How do you kind of manage that over the longer term?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes, Brian, I'll tell you, we have a number of initiatives in our stage gate process today. Some short range, some mid-range, some long range. A couple of pieces that are in the short range at the stage gate that have moved their way through. The dual-sided plancha which will drive great efficiency and unlock increased capacity, I should say, in the kitchen, and also drive efficiencies as it relates to the labor model. The produce slicer, we feel really good about it, have already talked about that. We also have, we're testing a new dual backfire that will be more efficient as we cook chips daily in season chips in our restaurants. So all of these things will be items that will help the team member experience, drive efficiency, remove some of the mundane repetitive tasks in the restaurant, which will always ladder to a better guest experience. And some of them will have a margin improvement baked into the program. So we feel really good about the long-range items around avocado and Hyphen. Recall these are companies that we've invested in that were building, co-building really bespoke pieces of technology that we know will help us down the road somewhere, but we continue to refine and iterate on how those show up in the restaurant. And so you'll see those items, I think it's important to know, go into restaurants, we'll test and learn, bring it out of the restaurant, refine the piece of equipment, put it back in. But we feel really good about what the value they can bring long term for the organization. Hopefully that answers your question, Brian."
},
{
"speaker": "Operator",
"content": "And our next question comes from John Ivankoe with JPMorgan."
},
{
"speaker": "John Ivankoe",
"content": "Hi. Thank you, two, if I may. The first question is on your investment in Brassica, in the Mediterranean and the Columbus area. Should we read anything in Chipotle, maybe extending itself a little bit more in terms of being a platform company? I mean, was that a one-off type of transaction, or could we expect a series of interesting businesses like that, that could eventually fit within the Food with Integrity broader theme?"
},
{
"speaker": "Scott Boatwright",
"content": "That was an investment we made from our Chipotle Next fund, and we felt really good about it. So we were, we've been looking around the industry for concepts, emerging concepts that are aligned with our food ethos and how we think food should be eaten that were aligned to our business model and practices that we could co-invest with. Now, keep in mind, this is a passive investment and a minority investment and will not be a distraction on the Chipotle organization. And so we see them as they think about growth down the road. We'll give them some guidance and counsel on development and how they grow, but it won't be the distraction of this organization, and it could be a growth platform somewhere 10, 15 years down the road that adds a layer of growth for the business."
},
{
"speaker": "John Ivankoe",
"content": "Okay. Sounds good. Thank you. And secondly, we spent a good amount of time today talking about prep, prep labor, complexity, and to some extent the repetitiveness around it, stores that need to be staffed at 6 or 7 in the morning. I've asked a question before, and sometimes I don't think I've asked it correctly. Is there an opportunity over time to maybe have certain prep stores that are densely clustered within a market that can maybe take care of some prep work for stores that are in their immediate surroundings. I'm not asking for a central kitchen per se, as we would normally define those terms on an industry basis, but maybe one store that takes care of prep for five or 10 stores around it that could make it easier to run all stores within a specific trade area. Is that something that you're considering over time?"
},
{
"speaker": "Scott Boatwright",
"content": "Hey, it's a great question, and it's something we have looked at in the past. Now, it comes with its own set of complexities and inherent risks, and largely the opportunity is how do we create that experience? We can be consistent with regard to how we prep, but then distributing and keeping that food safe during the distribution process from the central location out to, call it, a spoken hub. It’s just challenging. And when we looked at it a few years back, it was cost prohibitive as well. And so right now, we feel like the working model we have is the best way to Chipotle to deliver our unique experience, but that's not to say we couldn't look at something different down the road."
},
{
"speaker": "Operator",
"content": "And our next question comes from Lauren Silberman at Deutsche Bank."
},
{
"speaker": "Lauren Silberman",
"content": "Great. Thanks so much. I just wanted to ask about the consumer, some of the behavior you're seeing across different cohorts, the low, middle income, high income consumer, any differences that you're seeing across regions at all?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes. I'll start, and I'll flip it over to Adam here. We're still seeing strength across all income cohorts, even in this competitive environment, which gives us the belief that we are still delivering extraordinary value for the consumer. You can get all the core equities that I talked about earlier, and the chicken burrito on average is still under $10, which we believe is still a 15% to 30% discount compared to our peer group. And so we'll continue to lead into that as we move forward. Again, all income cohorts, even low income, are showing positive signs of strength."
},
{
"speaker": "Adam Rymer",
"content": "Yes. And I would just add, across the board, too, in terms of our regions, I mean, really all performing very, very well. We called out California on the last call, of course, after the FAST Act price increase there. We did see some weakness overall in our sales in California after the FAST Act, but we sell that across the entire industry, so it seemed to be more of a macro based, or really just a reaction to the inflation in restaurants in California. So that has kind of continued on into Q3, but outside of that, it's really been pretty broad based on our strength."
},
{
"speaker": "Lauren Silberman",
"content": "Great. Very helpful. And then just a follow up on the 4Q guide, you talked about traffic modestly accelerating, have price rolling off. Are you assuming traffic decelerates as we move through the quarter and just a level set? Are you thinking 4.5% to 5% in terms of the comp guide for the quarter? Thank you."
},
{
"speaker": "Adam Rymer",
"content": "Yes, and so like I said earlier, September was kind of a mid-7% comp of which trans were kind of in that low 4% range. That trans comp has continued into October. And at this point our assumption is that will continue into Q4. And then in the prepared comments I talked about how the price impact would be just above 1%. And there'll be a slight mixed drag. So I believe check will be somewhere around 1%. So I think you're thinking about it the right way if you get kind of into that mid-5% range."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Chris O’Cull with Stifel."
},
{
"speaker": "Chris O’Cull",
"content": "Thank you. First, Scott, I wanted to clarify the level of improvement in the number of entrees per 15 minutes that you believe is ultimately possible after implementing the throughput and issues that are planned for the next six to nine months or so."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, I think it's possible for us to get back to where we were in the heyday of Chipotle in the low 30s, and today we're trending around the mid-20s. So you have to include digital in that number. The digital entrees are coming through the digital channel as well, but if you think about just the true business, the in-restaurant experience, that is, we think there's still pretty significant upsides."
},
{
"speaker": "Chris O’Cull",
"content": "Okay, and then just one other question. I was hoping you could provide a bit more color on the performance of the Smoked Brisket. In particular, has the repeat usage been as high this time as it was the last time it was promoted?"
},
{
"speaker": "Adam Rymer",
"content": "Yes, so I'll start, and then, Scott, you can jump in. And so Brisket is performing really well, especially compared to Carne asada. It's kind of in that mid-teens incident in terms of a percent of entrees. It's driving spend. It's driving additional transactions, comping really well over Carne asada. And then in terms of repeat usage, I mean, I know it's driving amazing new customers to the brand, as well as getting people in and increasing their frequency. And then what's beauty, the beauty of all of these LTOs is they come in, they try Brisket, and then we see on the second or third businesses, sometimes they go back to Brisket, sometimes they go to chicken, steak, or other items. So really seeing some great trends there."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, it's not often that you find an LTO that you can put in the marketplace that's going to drive check, transactions, and margin. This is one of them. And so we're super excited about the product. We love how it's performing."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Brian Bittner in Oppenheimer."
},
{
"speaker": "Brian Bittner",
"content": "Hey, thank you. And congratulations to everybody on their new roles. As it relates to margins, specifically the COGS margin line, you saw the deleverage this quarter of about 90 basis points, and obviously that was expected. But can you bridge that deleverage broken down between the actual portion investments that you deployed versus underlying dynamics, like food cost inflation for us, so we can understand bridge little bit better. And I totally understand that a price action doesn't seem necessarily on the table for 4Q, but how do you want us all thinking about the potential base case for pricing as we go into 2025? Because I think that is going to be a debate on investors' minds moving forward."
},
{
"speaker": "Adam Rymer",
"content": "Yes. So like I talked about earlier, so within cost of sales, that portion investment of about 60 basis points, that's fully in that cost of sales number. And then the avocado comparison of being about another 50 basis points or so of just it being abnormally low in the prior year is also in there as well. And so once you peel back those two layers and then the fact that Brisket, which like Scott talked about, it drives margin overall. However, it does increase our cost of sales, I think roughly 40 or 50 basis points in a quarter. And so that's another layer that's basically temporary hit to cost of sales. However, because of the price point of Brisket, you leverage on labor and other operating and things like that. And so once you peel back the layers, look at the underlying inflation of cost of sales, labor, and other operating expense, that menu price impact that we would need to offset that and maintain our margins would be probably somewhere in that like 2% to 3% range."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Sharon Zackfia with William Blair."
},
{
"speaker": "Sharon Zackfia",
"content": "Hi, good afternoon. It sounds like things are on a really good path to Alshaya so far. And I'm curious just given what seems to be a good start there, are you thinking about other kind of shortlisted regions that you'd like to find licensees to operate Chipotle? And are you fully committed to continuing to own your locations in France, Germany, and the UK?"
},
{
"speaker": "Scott Boatwright",
"content": "Yes, thank you. Here's what I'll tell you is we're really pleased with our partnership with Alshaya. And I said on the call, we're one of the best performing brands in Alshaya's portfolio. We plan pretty aggressive growth with Alshaya over the next few years. We will strategically look at other like partners around the globe that we could potentially partner with to expand, whether that's Latin America or APAC or otherwise, those opportunities, I am sure emerge over the coming months. And we'll look at those very closely on what the market entry would look like for us, how we think about those partnerships. We will continue to own our presence in Western Europe as well as North America. We think that's the greatest way to drive value for our brand and for our shareholders."
},
{
"speaker": "Sharon Zackfia",
"content": "Thanks for that. And then there's a question on Hyphen. I know it's early days and you've only have it, I think, in one location. But is that helping keeping kind of the aces in their places, having that tool in the restaurant?"
},
{
"speaker": "Scott Boatwright",
"content": "It is. More importantly, it will allow us to unlock demand in that channel. And so we think, we don't think. We know that the table with one individual, the output is far greater than one or two individuals on the table. And so the goal here is 60% of our entrees are either bowls or salads. And so the table is taking care of all of that lifting, heavy lifting, if you will. And then the operator at the table can focus on burritos and tacos. We think it's a pretty magnificent lift in overall demand. And we're driving improved performance, whether it's plating or accuracy for the consumer."
},
{
"speaker": "Operator",
"content": "And our final question today will come from Danilo Gargiulo with Bernstein."
},
{
"speaker": "Danilo Gargiulo",
"content": "Thank you. And once again, congrats everybody, for your new and expanded roles. Scott, clearly your message has been that of continuity with the strategy at Chipotle. So if your appointment was to become permanent, what would you like to be known for and which opportunities for acceleration of the current strategy do you see more likely for Chipotle? I mean, it sounds like you're more open to international growth as a natural evolution, but maybe there is more areas that you are going deeper on. Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, terrific question. It is my endeavor to keep our organization, this leadership team, and all the 125,000 folks in our field organization clearly focused on our five strategic priorities that have served our brand for the last many years. Sure, there'll be some iteration or modification in the years to come, but we feel very confident those five key strategies will continue to drive extraordinary performance for this organization. It'll also, two other things I think I'd like to point out is I'd like to continue to move our organization to a more connected organization to the consumer through our restaurant teams. And so, I think that's an important note, right. I mean, everyone in the organization, I said this in the prepared remarks, is either serving a Chipotle guest or serving someone who is. And when you have that kind of power and focus in an organization, extraordinary things can happen. And the last thing I'd leave you with is this brand has had extraordinary success here in North America. We have our sites clearly aligned on 7,000 restaurants, but I also want to give an eye towards how do we continue to push Chipotle to be more of an iconic global brand? And so, that's what you'll see probably in the coming years and coming months. And that's probably it."
},
{
"speaker": "Danilo Gargiulo",
"content": "Okay, great. And if I may, just double-clicking on the international expansion, given your continued successes in Europe, if you were to borrow from your experience in Canada, how many quarters of the way do you think we are from Chipotle growing units in Europe? And what is still pending before the performance in Europe can really close the full gap versus Canada or Europe? Thank you."
},
{
"speaker": "Scott Boatwright",
"content": "Yes, so if you look back at what happened historically when we worked on the turnaround in Canada, it started about six years ago, and of course appointing a new leader in Canada and Anat Davidzon was critical and really the fulcrum to leverage the business in a more full way, whether it's supply chain efficiencies, operational efficiencies or marketing, demand driven marketing. She's done an amazing job in that country getting margins to US, comparable to US margins and we're growing at 25 to 35% in country today. The reason we put Anat in Western Europe is to probably, not probably, to look for a similar outcome and she's already making incredible progress aligning the co-native US standards, getting operational efficiencies and processes in place around cost of labor, cost of food. And so we feel really good about the progress. To put a time to it, I couldn't really give you a timetable. Here's what I'm telling you is we know we could have hundreds of restaurants in the markets in which we operate today and potentially thousands in Western Europe over time. So that's what I leave you with."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes our question and answer session. I'd like to turn the conference back over to the company for the closing remarks."
},
{
"speaker": "Scott Boatwright",
"content": "Thank you. And I just want to say thank you to everyone for joining the call today. And I want to ensure I really believe that I'm incredibly proud of this entire Chipotle family for driving another, what I believe to be, incredible quarter around transaction trends and accelerating momentum. Our culture, brand, and value proposition have never been stronger and we have a lot of exciting initiatives in the pipeline that will continue to grow and strengthen our great company and our brand for many years to come. We look forward to speaking to all of you in our fourth quarter earnings call in February. Thank you so much."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines. And have a wonderful day."
}
] |
cmg | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good afternoon, and welcome to the Chipotle Second Quarter Fiscal 2024 Earnings Call. All participants will be in 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 record. I would now like to turn the conference over to Cindy Olsen, Head of Investor Relations and Strategy. Please go ahead."
},
{
"speaker": "Cindy Olsen",
"content": "Hello, everyone, and welcome to our second quarter fiscal 2024 earnings call. By now, you should have access to our earnings press release. If not, it may be found on our Investor Relations website at ir.chipotle.com. I will begin by reminding you that certain statements and projections made in this presentation about our future business and financial results constitute forward-looking statements. These statements are based on management's current business and market expectations and our actual results could differ materially from those projected in the forward-looking statements. Please see the risk factors contained in our annual report on Form 10-K and in our Form 10-Qs for a discussion of risks that may cause our actual results to vary from these forward-looking statements. Our discussion today will include non-GAAP financial measures. A reconciliation to GAAP measures can be found via the link included on the presentation page within the Investor Relations section of our website. We will start today’s call with prepared remarks from Brian Niccol, Chairman and Chief Executive Officer; and Jack Hartung, Chief Financial and Administrative Officer, after which we will take your questions. Our entire executive leadership team is available during the Q&A session. And with that, I will turn the call over to Brian."
},
{
"speaker": "Brian Niccol",
"content": "Thanks Cindy and good afternoon everyone. Before I begin discussing our results, I need to recognize and congratulate Jack Hartung on his nearly 25 years with Chipotle and roughly 80 earnings calls with all of you. I want to thank him for being a great friend, a terrific leader and a champion for our purpose and brand. I'll say a few more words about Jack and Adam before I hand it over to him. Now, turning to our results. The second quarter was outstanding as successful brand marketing, including the return of Chicken Al Pastor as a limited time offer drove strong demand to our restaurants. Additionally, our focus and training around throughput paid off as we were able to meet the stronger demand trends with terrific service and speed in -- driving in – driving over an 8% transaction comp in the quarter. For the quarter, sales grew 18% to reach nearly $3 billion, driven by an 11.1% comp. In-store sale grew by 24% over last year. Digital sales represented 35% of sales. Restaurant level margin was 28.9%, an increase of 140 basis points year-over-year. Adjusted diluted EPS was $0.34, representing 36% growth over last year, and we opened 53 new restaurants, including 46 Chipotlanes. Before I give an update on our five key strategies, I want to take a minute to address the portion concerns that have been brought up in social media. First, there was never a directive to provide less to our customers. Generous portion is a core brand equity of Chipotle. It always has been, and it always will be. With that said, getting the feedback caused us to relook at our execution across our entire system with the intention to always serve our guests delicious, fresh, custom burritos, and bulls with generous portions. To be more consistent across all 3,500 restaurants, we have focused in on those with outlier portion scores based on consumer surveys, and we are reemphasizing training and coaching around ensuring we are consistently making bowls and burritos correctly. We have also leaned in and reemphasized generous portions across all of our restaurants as it is a core brand equity of Chipotle. Our guests expect this now more than ever, and we are committed to making this investment to reinforce that Chipotle stands for a generous amount of delicious, fresh food at fair prices for every customer, visit. The good news is that we are already beginning to see our actions positively reflected in our consumer scores and our value proposition remains very strong. We believe our focus on operations, including throughput as well as terrific marketing and menu innovation, have strengthened the brand and our value proposition. And we will continue to listen to and treasure our guests to earn every transaction. I will turn to our five key strategies that help us to win today while we grow our future. These strategies include running successful restaurants with a people accountable culture that provides great food with integrity while delivering an exceptional in-restaurant and digital experiences, sustaining world-class people leadership by developing and retaining diverse talent at every level, making the brand visible relevant and love to improve overall guest engagement, amplifying technology and innovation to drive growth productivity at our restaurants, support centers and in our supply chain and expanding access convenience by accelerating new restaurant openings in North America and internationally. First, I will start with running successful restaurants. As I mentioned, the improvements we have seen in throughput positions us well to meet the strong demand we experienced in the second quarter, driven by what we call burrito season or our peak seasonality as well the success of Chicken al Pastor. We often are asked why throughput is such an important operational KPI for Chipotle. So I thought I would begin by expanding on this. It is the outcome of a strong operational engine that delivers a great experience for our teams and our guests. In order to deliver exceptional throughput, restaurants need to be fully staffed and properly deployed. Our crew needs to complete all food prep on time and they need to be well trained execute the four pillars. This results in a better overall experience for our crew, which leads to more stability and, therefore, more experienced teams that execute better every day. And for our guests, faster lines with hotter, fresher food. This type of guest experience strengthens our value proposition and drive incremental transactions. Over the last year, we have improved our tools and training to deliver exceptional throughput. This included rightsizing the cadence of digital orders during peak periods and enabling our restaurants to see in real time at the point of sale, the number of entrees in each 15-minute interval. This has received tremendous feedback from our restaurant teams. It has helped to accelerate momentum as it creates excitement and allows our teams to celebrate in a moment when they achieve their goal. And our GMs can coach in the moment when they fall short. In fact, one of our field leaders in New York have 5 five of his eight restaurants achieved their throughput goal in the second quarter, which compares to just one of his restaurants a year ago. While we are seeing progress, we still have a lot of opportunity to increase the percentage of restaurants executing the four pillars. Expo is a great example as it is the most impactful pillar. As a reminder, Expo is the crew member between Salsa and Kash, who helps expedite the bagging and payment process. restaurants within Expo in Expo in place are averaging five incremental entrees in their peak 15 minutes, yet we only see a little over half of our restaurants with place during peak periods. This is certainly better than where it was a couple of quarters ago, but it should be a lot higher. The good news is that I strongly believe we have the right leaders in training in place to keep the momentum going as we continue to gather the data on the execution of the four pillars and provide feedback and coaching on a weekly basis, I am confident throughput can go much higher. This brings me to world-class people leadership. As we mentioned last quarter, crew and GM turnover is at some of the best levels I've seen since I joined the company. And the stability is allowing us to develop and grow our people pipeline to achieve our goal of promoting over 90% from within. We have many inspiring stories at Chipotle of crew members who have grown with the company to become some of our top leaders. In fact, our recently promoted regional Vice President started as a crew member 25 years ago. She moved to the United States at 14 years old without knowing English. At 19, she started working at Chipotle and has moved her way up, including spending time in a language development role, supporting other employees at Chipotle to learn English as a second language. Her people-first mentality is what has made her so successful at hiring, developing and retaining many of our best leaders. And she has two sisters that have each been with Chipotle for over 15 years and our top-performing field leaders. With the addition of her role, we now have three of our 10 regional vice presidents who started as crew members and have made their way up to leading a region and managing over a $1 billion business. These stories really do inspire our entire organization, as the opportunity to develop and grow within Chipotle, along with our industry leading benefits and pay, enables us to attract and retain exceptional people. In fact, as we look to expand to 7,000 restaurants in North America, we will be adding an RVP nearly every year along with hundreds of restaurant leadership roles. Finally, our 50-to-1 stock split: One of the largest in New York stock Exchange history enables our employees' and others to purchase whole shares, at more affordable prices and gives us more flexibility to compensate our top performers in stock, all with the goal to have more employees participate in the financial success of our company. It really is an exciting time to be part of Chipotle. Now, turning to marketing, the Chipotle brand continues to gain momentum as we focus on exceptional operations and making the brand more visible, more relevant, and more loved. Chicken Al Pastor is a great example as it once again surpassed our expectations, reaching over a 20% incidence rate and more importantly, driving incremental transactions and spend. Similar to Carne Asada, we proved that when we bring back a limited time offer, we were able to make it more delicious with seamless execution. And while Chicken al Pastor will end later this summer, I am excited to share that we will be bringing back Smoke Brisket this fall for a limited time. Brisket was among the most requested in many items, as our guests love the combination of Smoked Beef, Charred on the grill and finish with the Brisket sauce made with smoky chili peppers. It took a huge cross-functional effort across supply chain, culinary finance and marketing to bring back this delicious LTO. Our marketing team also continues to find creative ways to generate excitement drive more engagement around our annual promotions. In the second quarter, we had a record-breaking National Burrito Day, where gamified promotion resulted in Chipotle's best sales and digital sales day ever. It also drove an influx of new and lapsed customers and was the best enrollment day of the year for our rewards program. I'm also thrilled to share that later this week, team Chipotle will be visible on the world stage as we leverage our real food for real athletes' platform for those competing in Paris. We highlighted the inspiring journeys of Anthony Edwards, Sophia Smith, Taylor Fritz, Sara Hughes and Jagger Eaton. Their go to Chipotle meals and Howard Greens have been a key component of their training regimens. We will also bring back our gold foil for burritos for a limited time in both North America and France to celebrate all the athletes competing. Shifting to technology and innovation, I want to provide an update on a few of our in-restaurant initiatives starting with the Dual-Sided grill. Over the last year, the Grill has been in 10 restaurants, and we have received consistent feedback that our teams and our guests love it. The grill can cook the chicken and steak in, under half the time it takes on the Plancha with consistent execution and the same sear and char. It also maintains better moisture resulting in juicier chicken and steak with less waste. And for our teams, it takes one of the most complex positions in our restaurants and significantly improves the learning curve. Finally, for high-volume restaurants, it opens up capacity and drives efficiency during morning prep, as chicken and steak can be closer to serving. We are in the process of rolling out the dual sided grill to an additional 74 high-volume restaurants this year, and we'll continue to evaluate the economics prior to rolling it out further across the organization. Additionally, our automated digital makeline in Autocado are making their way through final checks ahead of being pilot tested in their first restaurant. Our food safety and operation teams have worked closely with our technology teams to assure that the design takes into account things like cleaning, speed and accuracy as well as maintaining our high culinary standards. The next step will be to get each device into a restaurant to continue to learn and iterate part of our stage gate process. I'm excited about each of these initiatives, and I strongly believe we will see some impactful back-of-house changes in the years to come, that will help to improve consistency in our restaurants and drive a better overall experience for our teams and our guests. I’m also proud Chipotle continues to be a learning organization. Using the stage gate process is our way to drive discipline around what ultimately gets rolled out. I'm confident this process will further strengthen Chipotle as a leader in technology and innovation. Now moving to our final strategy, which is to expand access and convenience. In North America, we remain on track to open 285 to 315 new restaurants this year, and our openings remain strong across all markets. While our time lines remain consistent to last quarter, our development team continues to see groundbreaks meaningfully higher compared to last year, which should help smooth the cadence of openings as we get into the back half of the year. I also wanted to share an update on our partnership with the Alshaya Group. Our first restaurant in Kuwait has been open for several months and continues to have strong performance. The good news is that the feedback from guests is that the culinary experience is right on par with North America, which is fantastic to hear. It also tells me that when we execute our culinary and delivering an exceptional experience for our guests, Chipotle's brand resonates across geographies. We look forward to opening our second restaurant in Kuwait as well as expanding into Dubai with the Alshaya Group later this year. To close, our crew members, GMs and field leadership delivered an excellent second quarter helped by our committed support centers that enable restaurants to better succeed. We are very fortunate to have a clear purpose and an organization that is full of talented people at all levels. It is exciting to see the progress we have made so far, and I am confident there is much more growth in front of us. Finally, I want to spend a few minutes reflecting on my time with Jack and his extraordinary 25 years at Chipotle. Jack is just as passionate about our brand and our purpose as he is about protecting our economic model. I know you all agree with me that he is one of the best CFOs in the business and has played an instrumental role in growing Chipotle from under 200 restaurants to over 3,500 restaurants, investing in our premium ingredients, and supply chain, protecting our exceptional value proposition and delivering industry-leading economics and returns. As Jack always says, these three characteristics are incredibly difficult to replicate, premium ingredients, affordable prices and attractive margins. Beyond that, he has developed an exceptional finance team, including Adam Rymer, who will become our next Chief Financial Officer. Over the last 15 years, Adam has reported directly or indirectly to and been mentored by Jack in preparation for this role. And importantly, he is just as passionate about our brand, our purpose and protecting our economic model. I'm highly confident he is the right leader to become our next CFO, and that it will be a smooth transition. So again, thank you, Jack, for your friendship, leadership and so many contributions to Chipotle. And with that, I'll turn it over to you."
},
{
"speaker": "Jack Hartung",
"content": "Thank you, Brian, for those kind words. I'm extremely fortunate to have had the privilege and honor to serve Chipotle, our employees our shareholders for all these years. While retiring was one of the hardest decisions, it was also one of the easiest I've ever had to make. It was hard because Chipotle is a special brand, a special company and it's full of special people. But it was also easy because I know Chipotle is in great hands with a family of smart, talented people who are committed to our purpose to cultivate a better world. It's also easy because I have a large and growing extended family, and I treasure the time I get to spend with every one of them, and now we'll have the chance to enjoy even more special experiences with them. I'm delighted that Adam Rymer will be our next CFO, and as Brian mentioned, Adam has worked with me for 15 years, and I can tell you he's a very talented leader who knows our brand and our business well, and I'm confident in his ability to help lead Chipotle to the next level. In addition, Jamie McConnell will be elevated to our Chief Accounting and Administrative Officer. And since joining Chipotle six years ago, Jamie has provided great leadership, built strong teams and is well prepared to serve in our new role. With that said, I'll turn now to our quarterly results. Sales in the second quarter grew 18.2% year-over-year to reach about $3 billion as comp sales grew 11.1%, driven by 8.7% transaction growth. Restaurant-level margin of 28.9% increased about 140 basis points compared to last year. Earnings per share adjusted for unusual items was $0.34, representing 36% year-over-year growth. The second quarter had unusual expenses related to unrealized loss on investment and an increase in legal reserves, which negatively impacted our earnings per share by $0.01, leading to GAAP per share of $0.33. Sales comps were highest in April, driven by the Easter shift, a strong reaction to the return of Chicken al Pastor and several successful activations, including National Burrito day. Comps settled back to around 6% in June, and continue to be driven by positive transactions. July has been more difficult to read so far due to the fourth holiday, weather disruptions in Texas and the impact from a recent technology outage, but we believe the underlying trend remains similar to June. We are maintaining our full year comp guidance of mid- to high single-digit. And as a reminder, we will roll off about 3 points of pricing in early Q4 as we lap our menu price increase from last year. Before I go through the individual P&L line items, I want to give an overview of what to anticipate. We expect our margins will be under pressure for the next couple of quarters. Most, if not all of this pressure is seasonal, temporary, or it's an investment that we can offset through efficiencies, and we believe our industry-leading margin structure is still intact. I'll now go through each of the key P&L line items, beginning with cost of sales. Cost of sales in the quarter were 29.4% in line with last year Benefit of last year's menu price increase was offset by inflation in avocados, increased oil usage and higher incidence of beef as a result of the continued success of Braised Beef Barbacoa marketing initiative. For Q3, we expect our cost of sales to be just below 31%. About one-third of the step-up is due to the higher protein costs as we roll out Chicken al Pastor and then launched Smoke Brisket later in the quarter. About one-third is due to an uptick in dairy and avocado prices and the final one-third are about 40 to 60 basis points is an investment we are making as we focus on outlier restaurants to ensure correct and generous portion. We expect this investment will ease from these levels somewhat. We also believe that we can offset the remaining investment with efficiencies and innovation over time. While avocado prices are higher than the very favorable levels we have seen over the past several quarters, this is in line with our expectations from earlier this year. Additionally, we are less impacted by the recent volatility in the Mexican avocado market, as our supply chain team has done a fantastic job of diversifying our exposure, and in the third quarter, the majority of our avocados come from Peru. Outside of avocados and the protein mix shift, we anticipate underlying cost of sales inflation will be in the low single-digits range for the remainder of the year. Labor costs for the quarter were 24.1%, a decrease of about 20 basis points from last year, as the benefit from sales leverage more than offset wage inflation. For Q3, we expect our labor costs to be in the low 25% range due to seasonally lower sales, with wage inflation to remain at about 6%. And as a reminder, about half of the wage inflation is due to the nearly 20% step-up in wages in California as a result of the increase in minimum wage for restaurant companies like ours that took effect in April. Other operating costs for the quarter were 12.9%, a decrease of about 100 basis points from last year. The decrease was primarily driven by sales leverage. Marketing and promo costs were 2.1% of sales in Q2. And in Q3, we expect marketing costs to remain in the low 2% range with the full year to be in the high 2% range. In Q3, other operating costs are expected to be in the high 13% range, due to seasonally lower sales and higher seasonal expenses like utilities and maintenance and repair. Based on these expectations provided, we anticipate restaurant level margin to be around 25% in Q3. As I mentioned earlier, some of the pressure is seasonal, like the shift from Chicken al Pastor to Brisket. Some is temporary like the higher prices in avocados and dairy, which if they persist, we can address with menu prices overtime. And finally, we're confident that the investment we're making to ensure we are delivering correct and generous portions can be offset by efficiencies and innovation overtime. G&A for the quarter was $175 million on a GAAP basis or about $171 million on a non-GAAP basis, excluding $4 million increase in legal reserves. G&A also includes $122 million in underlying G&A, $43 million related to non-cash stock compensation and $6 million related to higher bonus accruals and payroll taxes and equity vesting and exercises. We expect our underlying G&A to be around $128 million in Q3 and step-up each quarter as we make investments in people to support ongoing growth. Anticipated stock comp will be around $40 million in Q3, although this amount could move up or down based on our actual results. We also expect to recognize around $6 million related to higher bonus accruals and employer taxes associated with shares that vest during the quarter, bringing our anticipated total DNA in Q3 to around $175 million. Depreciation for the quarter was $84 million, or 2.8% of sales, and we expect depreciation to step up slightly each quarter, as we continue to open more restaurants. Our effective tax rate for Q2 was 25% for GAAP as well as for non-GAAP. Our effective tax rate benefited from option exercises and equity vesting above the grant values. And for fiscal 2024, we estimate our underlying effective tax rate will be in the 25% to 27% range, though it may vary based on discrete items. On June 26, we successfully completed our 50-to-1 stock split: One of the largest in New York Stock Exchange history. We believe this will make our stock more accessible to our employees as well as a broader range of investors. Our balance sheet remains strong as we ended the quarter with $2.5 billion in cash, restricted cash and investments with no debt. During the quarter, we repurchased $151 million of our stock at an average price of $63.52. At the end of the quarter, we had nearly $650 million remaining under our share authorization program. We opened 53 new restaurants in the second quarter, of which 46 at Chipotle. We continue to anticipate opening between 285 to 315 new restaurants in 2024 with over 80% having at Chipotle, and we remain on track to move towards the high-end of the 8% to 10% range by 2025, assuming time line conditions do not worsen. To close, I also want to thank our employees for all their hard work in driving our strong results and for continuing to build and grow Chipotle. I also want to reflect how our historic 50-for-1 stock split. When Chipotle went public at $22 per share -- I was very optimistic that we have a special brand with a tremendous growth opportunity. I'm not sure I could have ever imagined then that we would split the shares at just over $3,200 per share, but I did envision that we would reach over 3,000 restaurants, as we have today in the U.S. And today, I know we have a special brand with industry-leading economics and returns. I'm also just as optimistic about our growth opportunity to reach 7,000 restaurants in North America and to expand internationally. And we further our purpose of cultivating a better world we'll continue to drive extraordinary value for our guests, our employees and our shareholders. It is truly and exciting time to be part of this purpose-driven company with seemingly limitless opportunity. And with that I’ll open lines for your questions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from David Tarantino with Baird. Please go ahead."
},
{
"speaker": "David Tarantino",
"content": "Hi. Good afternoon. First, Jack, congratulations on an amazing career at Chipotle. And you're going to be missed, and we look forward to working with Adam going forward."
},
{
"speaker": "Jack Hartung",
"content": "Thanks David."
},
{
"speaker": "David Tarantino",
"content": "So, my question is about the sales trends you called out, I think you said the comps moderated into the kind of 6% ballpark in June, and you think that underlying trend is carried over into July. While that's very good relative to what we're seeing from a lot of brands, it is slower than what you were running previously. So, I just wanted to get your thoughts on why you think you saw that slowdown -- whether it's macro or something inside the business that may have caused that?"
},
{
"speaker": "Brian Niccol",
"content": "Why don't I start and then Jack can fill in. The -- look, first of all, David, I would tell you the quarter was really spectacular. And when we look at brand metrics, they've never been stronger. So, value, food scores all the key metrics to make sure that the brand is in a good spot really continue to improve throughout the quarter. And then from an operating standpoint, I don't know if you've been to our restaurants recently, but I think the teams are doing a terrific job on continuing to deliver quick culinary grade throughput. And then, obviously, we mentioned in our earlier comments, we've doubled down on making sure we're also providing great portions, which is, I think, a key equity for this business as well. One of the things we've seen, which is consistent with what we saw last year, is this kind of seasonal move with kind of the summer change of behaviors. And so obviously, we're trying to understand what that looks like because it appears to be new trends since coming out of COVID. So, that's one piece of the puzzle. And then obviously, we're trying to understand if there are any macro things going on as well. But the one thing we know for sure is the feedback on the business from our customers has been great value, great culinary and improving speed. And those are the things we can control, and those are the things we're going to forward. Jack, I don't know if you want to add anything."
},
{
"speaker": "Jack Hartung",
"content": "No, I mean, just to add some more text to like seasonality things like July 4 used to be a weekend and now it looks like it's two weekends. So, it looks like the combination of there's a holiday and then work from home is more acceptable. Now it just seems like the holidays, it used to be three or four days or so. It seems like they're stretching out a little bit. We even saw for the first time ever on Juneteenth, we saw a little softness there as well. So, we wonder if that's also kind of a work-from-home environment as well. So the last couple of summers have been very hard to predict. And so we think that's definitely a big part of what we're seeing."
},
{
"speaker": "David Tarantino",
"content": "Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "The next question comes from Sara Senatore with Bank of America. Please go ahead."
},
{
"speaker": "Sara Senatore",
"content": "Thank you. First of all, congratulations to both Jack and Adam. I've enjoyed working with both of you, but the question I have first is just a quick follow-up. If you could just maybe talk a little bit about the composition of the price mix and how you're thinking about that going forward, given some of the reinvestments that you are making? And then also wanted to get a sense of store growth and how that is progressing. Just I know there have been endemic problems across the industry, but the goal was to get the growth rate higher and perhaps into that 10% range next year. So, any updates there? Thanks."
},
{
"speaker": "Jack Hartung",
"content": "Yes, I'll start with the components of the comps, Sara. Transactions were up 8.7% during the quarter. We also had a menu price increase effectively was 3.3%. That was 3% that we took, effectively a 3% that we took last year, and then we had the 1% effective that we took for the FAST Act as well. And we did have a negative mix, and the negative mix was based on group size. The negative mix was 1%. Group size was down about 2%, but that was offset by we did have some add-ons, mostly in chips, queso, and extra meat as well. What we're seeing as we moved into June, we're still seeing transactions be the main driver. So, transactions were in the 3%, 3.5% during the month of June. And then on openings, I mean, we're still on track, Sara. We're not seeing the timelines really change at all. We did see some modest improvements so far this year, but the pipeline is very robust, and we feel good about the openings for this year. If that continues, just based on the inventory building alone, and if timelines don't worsen, we think we can get close to, if not all the way to that 10% in the next year."
},
{
"speaker": "Sara Senatore",
"content": "Got it. Thank you. And just pricing for the rest of the year?"
},
{
"speaker": "Jack Hartung",
"content": "So, we have the 3% from last year that runs out in the middle of October. We'll continue to have California. Right now, we have no plans for further pricing. I mean, we'll look at how the rest of the next few months unfold. We'd love to get through the rest of the year based on what's going on, and again, we don't know how much is seasonality, whether there's something bigger going on. But it'd be great to not have to take any price for the rest of this year."
},
{
"speaker": "Sara Senatore",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Dennis Geiger with UBS. Please go ahead."
},
{
"speaker": "Dennis Geiger",
"content": "Great. Thanks very much, and Jack and Adam, congratulations to you both. Just wanted to ask Jack a little bit more on the margin commentary that you made, specifically as it relates to some of that pressure over the coming quarters. If you could dive in a little more to some of the moving pieces there, and maybe some of the efficiency offsets that you spoke to? Thank you."
},
{
"speaker": "Jack Hartung",
"content": "Yes. So, there's three main buckets. We've got inflation. Inflation generally has been relatively benign. We have two items we called out, avocado and dairy. Both of those ingredients we do expect either near the end of the year or into early next year. We think those will normalize. Avocados, as you guys know, has been really a benefit. We've had great avocado prices for the last several quarters. And so even the current avocado prices we're seeing right now are more in the normal range, but we think that those will ease through the end of the year or into next year, so both of those we feel good about. We do have pricing power, so we'll watch that very closely, and at some point in the future we'll be able to offset that. The other item that we talked about, Brian mentioned, we decided that that this brand equity called Generous Portions is something we don't want to take for granted. We don't want to take something that's been a positive for all these years and then have it turned out to be a negative because of some of the social media comment. So, we've made this investment, we'll continue to make the investment. We already have a number of initiatives underway. Some of them are operational. Some of those are supply chain efficiencies. We won't go into details of what those are, but we do think over the next couple of quarters that we'll be able to see some of efficiencies and I think that's really in terms of where our margins are and what we think--"
},
{
"speaker": "Dennis Geiger",
"content": "Just to move from Chicken Al Pastor."
},
{
"speaker": "Jack Hartung",
"content": "Yes. I mean, that's clearly temporary."
},
{
"speaker": "Dennis Geiger",
"content": "Yes."
},
{
"speaker": "Jack Hartung",
"content": "I mean, you have the mix shift. Clearly that's going to be in LTO, once we move from brisket into the next LTO, especially if it's a chicken. Not only will that reverse, but it'll turn into a positive for us."
},
{
"speaker": "Dennis Geiger",
"content": "Make sense. Thanks and congratulations."
},
{
"speaker": "Operator",
"content": "The next question comes from Peter Saleh with BTIG. Please go ahead."
},
{
"speaker": "Peter Saleh",
"content": "Great. Thanks. I did want to ask about labor, if I could. I think, Brian, I think you mentioned a little over half of the units with an expeditor during peak hours. What's the holdup in terms of expanding the expeditor to more units, because it feels like that's a key driver of throughput? Is labor just really tight? Is there a lot of turnover? Just any thoughts around that would be helpful. Thank you."
},
{
"speaker": "Brian Niccol",
"content": "Yes, sure. So, look, the good news is we've made progress to get the 50%. The other piece of good news is, we've got experienced in the past. We've been able to get to that number closer to 70%-plus. So, I'm confident with our operational leadership that's going on in the field right now, and here's a key piece of us think that gives us the ability to improve from where we are. We have really great staffing levels right now with turnover at some of the best levels it's been to-date. And so the fact that we're getting these teams to be, I would say, more cohesive, more centered on the culture of great throughput, combined with great culinary, I'm confident that these teams will continue to improve. The other thing, too, you guys might have seen is we talked about this, giving our teams the visibility through reporting has really enabled them to enhance their performance. And I think just repetition using the tools that we have, and then just making sure that we don't have any real disruption to what the organization needs to be focused on. I think we've done a nice job of keeping the teams focused. If you look at our leadership hierarchy, I think you talked to anybody in the operational leadership hierarchy. They all know we want great deployment. We want great culinary. We want great throughput. We want great culture. And like you, I wish it would go faster. I'm sure the good news is that we're making progress. And that's what I continue to keep an eye on. And I continue to make that we're staying consistent with our message. And we're supporting the teams with tools to set them up for success."
},
{
"speaker": "Operator",
"content": "The next question comes from Christine Cho with Goldman Sachs. Please go ahead."
},
{
"speaker": "Christine Cho",
"content": "Thank you so much. Congratulations Jack and Adam and congrats on a great quarter. I just wanted to get -- to pick your brain on the overall industry trying to win traffic share with discounts and promotions. And I think you mentioned that to pull a value proposition is still very strong. But do you see any shift within the consumers that you can highlight? And specifically, I think a question for Brian. I think the last instance when we had this pretty fierce price competition, you were kind of on the other side of the fence. So, any key lessons you would take away from that experience back then? And how that applies to your plans going forward in navigating through this environment? Thank you."
},
{
"speaker": "Brian Niccol",
"content": "Yes. So, look, there's a lot there. But I'll start with -- I think I've said this over and over again. The thing that we need to make sure we do really well is great culinary, great burritos and bulls and treasure every single guest that comes into our restaurants, whether it's in-line or online. And when we do that, we see our value scores our brand become more loved. And one of the things that I keep an eye on closely is, are we gaining market share? And what's great to see is we're gaining market share every month, okay? So as we stay focused on executing Chipotle's core business, we see the results not only in the comp and transactions that we're delivering, but also the market share gains that we're making. And I've said this before Chipotle is not built on this idea of promotional footballing prices, okay? Chipotle is built on this idea of great culinary, exactly how you want it and with great speed. And look, we’ve had a simple idea. Great food done fast. We keep executing against that simple idea. I think we'll continue to get market share. And I think our value scores will continue to go up and our team will continue to be successful. And -- obviously, we've got to let other people play how they want to play. We're going to play our offense throughout process."
},
{
"speaker": "Operator",
"content": "The next question comes from Sharon Zackfia with William Blair. Please go ahead."
},
{
"speaker": "Sharon Zackfia",
"content": "Hi. Good afternoon. Thanks for taking my question. I guess just following up on that. I think in the prior few quarters, you had talked about kind of outperforming amongst lower-income consumers. And I apologize if you mentioned that, it's a really choppy connection on my end. But are you still seeing that kind of strength across income cohorts? And on the Brisket, is that something we should expect, Jack, to impact the fourth quarter as well? Thanks."
},
{
"speaker": "Brian Niccol",
"content": "So, I'll answer your first question. The good news is we are seeing transaction growth from every income cohort, which I think speaks to the strength of our brand and value proposition. And then as we continue to march forward, our goal is to continue to give people the bowls and burritos that they want at the speed that really delights them. So, hopefully, that continues to resonate with every income cohort. To-date, it has -- and from what we see in our consumer research, it will continue to delight every income cohort. On your Brisket question, I'll let Jack jump in on that."
},
{
"speaker": "Jack Hartung",
"content": "Yes, Sharon, what I can tell you is there will be an impact, but there's other things going on as well. So, our food costs -- we expect our food cost to be similar in Q4 as Q3. So, not another up."
},
{
"speaker": "Sharon Zackfia",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from John Ivankoe with JPMorgan. Please go ahead."
},
{
"speaker": "John Ivankoe",
"content": "Hi. Thank you. The question was on the automated digital make line. Just in terms of what you've seen in your cultivate center and your culinary center, how scalable is this machine? In other words, if you do decide and like what you see in the stage-gate process, how fast could this potentially be nationally? Does your equipment supplier have the capacity to kind of get up and running for the entire system is kind of the first question? And then secondly, related to that, if we are talking about consistency and speed as being two things that you want to do really well, it does seem like an automated make line would be perfect for that, not just on the digital make line, but even putting it into the front counter as well, whether kiosk ordering or app ordering or whatever that case may be. Would that be considered as part of an early stage gate process as well once you establish it on the back make line? Thank you."
},
{
"speaker": "Jack Hartung",
"content": "Yes, and thanks for the question. Obviously, we're really excited about Python and the automated digital make line. We will have that in a restaurant probably here at the end of August, early September, somewhere around there, which will be really exciting to see. Look, obviously we want to stay after consistency and speed. Those are two equities of the brand that are really important. The good news is we've got a bunch of different initiatives in the stage gate process. So, look, I never like to have all my eggs in one basket, right? And what I'm really delighted about is we've got things that make us more efficient with prep, whether it's avocado, a veggie slicer, a dual sided grill, looking at modifications to our rice cooker, our fryer equipment. So, there's a lot of things going on back at house to make us more effective culinary-wise, prep-wise, which then sets us up to be successful consistently on the front line and the digital make line. I've talked about these things also where we're also experimenting with AI and vision to ensure that our teams get the support. I'm actually reading a great book right now, it's called Co-Intelligence, it talks about how you use AI as a partner. And that's really what, you've heard us talk about this, is co-biotics, right? I think now this is, I like this term co-intelligence, to help our teams be more effective with forecasting, executing every single bowl correctly, bringing things up exactly correctly. So, look, I'm really excited about all the things we have in the pipeline. Obviously, we've spent a lot of time talking about hyping because it's probably the most visible, it looks pretty darn cool too. But I just want to make sure it's important we talk about, we've got a lot of things from an innovation standpoint that really understand the operating model to make us more efficient, better culinary every single time, consistent every single time, and frankly, makes the job easier for our team members to be successful, which then results in, I think, great outcomes for our customers. So, a bit more answer to your question, but I think it's important to just highlight hyping's a great tool, but there's a lot of tools we're working on that I think are going to make us better in the future."
},
{
"speaker": "John Ivankoe",
"content": "That's great. Jack, congratulations."
},
{
"speaker": "Jack Hartung",
"content": "Thanks John."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Charles with TD Cowen. Please go ahead."
},
{
"speaker": "Andrew Charles",
"content": "Great. Thank you. And just like everyone else, congrats to both Jack and Adam. Jack, what a ride it's been. Jack, curious just with the guidance, why keep the mid-single-digit part just given the blowout from 2Q as well as the fact that it sounds like July spotty, but around that 6% trend. That mid-single-digit piece suggests a pretty wide range of outcomes for the back half of the year and implies some deceleration potentially coming. So, can you just talk more about the guidance philosophy?"
},
{
"speaker": "Jack Hartung",
"content": "Yes, I mean, there's two things going on. One is, like we said, since the pandemic, the summer months have been more difficult to predict. Like the first year when you'd have the normal going back to school and, or leaving school and then going back to school, that was very, very different. Last year, vacations really were pulled forward. This year, vacations were pulled forward again, and it looks like they've even stepped up again. So, there's difficulty in predicting the seasonality. The other thing keep mind is we do have 300 basis points of pricing rolling off. So, now what we hope to do is hopefully in a couple of quarters, we're talking about how the guidance ended up being perhaps on the conservative side. But right now, with everything that's going on, whether it's seasonality or something that's more of a bigger approach or a bigger impact on the consumer. We think this is the right guidance level. And our intent is giving you a little bit more granularity in terms of what the months are looking like to give you kind of idea an idea of what we're seeing right now. And I think with Brisket coming up, we're very optimistic that was a big demand the first time. We actually just couldn't even keep it in stock it. We ran out of it so fast. We're optimistic, but we also want to be cautious in this environment."
},
{
"speaker": "Andrew Charles",
"content": "That's helpful. And in past years, before the inflation issue, we saw that there was typically about a 2% price increase, 2.5% price increase taken in December. What's the likelihood we see that again for next year? I know you're seeing some temporary margin headwinds. But as we think about pricing levels for next year, I mean what's the likelihood we see something coming in December?"
},
{
"speaker": "Jack Hartung",
"content": "Well, that's a long time away. I assume you're thinking December 2025. That's a long ways away. In this environment, we love the idea of being able to get through the rest of this year without a price increase. Where we would feel better in terms of the timing of a price increase, is in an environment where the economy is robust and healthy. The consumer is feeling very, very healthy, and they're spending and the restaurant industry in general is going well. And transactions are accelerating, not decelerating. That's a great environment when you use inflation to take a modest increase our price increases have gone well, but we would not want to take that for granted. So I think it would be really data dependent like what's going on in inflation. But as importantly, what's going on with the consumer, what's going on with transaction trends."
},
{
"speaker": "Andrew Charles",
"content": "That’s helpful. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Silberman with Deutsche Bank. Please go ahead."
},
{
"speaker": "Lauren Silberman",
"content": "Thanks a lot. I wanted to ask on the LTO strategy. You have one in spring, one in fall. It just seems like you generally comped the LTO comp for lack of a better phrase pretty consistently. What enables you to keep growing LTOs year-over-year incidence rates growing each year? And do you tend to see like during the periods of LTOs that comps actually accelerate even though it's off a higher base?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. So, look, the good news is we have a nice mix with our menu news of items that we've done in the past as well as completely new menu items. And I think what we've demonstrated is when we go back to something like a Chicken al Pastor or Carne Asada, we seem to be able to talk about it in a much more exciting way maybe than we did the original time because we learned some things on it. We execute better, because we know how to train on it. The teams are familiar with the execution. So, that's been really nice to see. The one thing I want to remind everybody on all these things, though, is one of the ways make all these initiatives much more effective, great operational execution. If we have terrific throughput, terrific deployment, and we execute culinary really well, the menu innovation gets amplified, because we give our guests a great experience. So, it does a great job of bringing in incremental customers, incremental transactions. But if we have soft operations, these efforts won't be nearly as effective. So, I really think it's a combination of stronger operations than maybe the last time when we executed this program combined with, I think, a more informed marketing program than we did at the prior time. So, that's one of the things I love about this organization. We're committed to learning. We're committed to always figure out how we can be better. And I think that's what you see coming out of Chipotle time and time again."
},
{
"speaker": "Lauren Silberman",
"content": "Great. Thanks. If I could just do a quick follow-up on the 3Q guide. I understand a lot of noise, but can we -- is it safe to assume that the 25% restaurant level margin guide implies about a 6% underlying comp for the quarter?"
},
{
"speaker": "Jack Hartung",
"content": "That's a fair assumption. Yes, you're in the ballpark."
},
{
"speaker": "Lauren Silberman",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "The next question comes from Jon Tower with Citi. Please go ahead."
},
{
"speaker": "Jon Tower",
"content": "Great. Thanks for taking the questions and congrats, Jack and Adam. Maybe just a quick follow-up and then a question. First, you had mentioned earlier the generous portion stuff that you're going to be doing in the short-term. Are you doing anything to message that to the consumer maybe something beyond what Brian you've already done on social media? And then I guess my question is more along the lines of -- there's obviously been a fairly significant price increase in California because of the wage rate hikes. Any sort or change in consumer behavior in that market that you're seeing at your stores or perhaps more broadly across the industry that you could speak to?"
},
{
"speaker": "Brian Niccol",
"content": "So, look, your first question, part of the reason why we went and looked across the system was when we got the feedback on the portion sizes. We've always felt the key equity of Chipotle is these generous portion sizes. So, we wanted to make sure we're executing consistently across the system. And we've probably found about 10% or more of restaurants that we really view as outliers that needed to be retrained re-coached to be executing against what we believe are the right standards. At the same time, we collectively said, look, we do not go back one inch on our -- that equity of generous portion sizes. So, we communicate to the entire system. And look, I'm already seeing it in social media, people commenting on the burritos, the bowls that they're getting. And I think that is the best source of marketing is the word of mouth as people have these experiences with Chipotle. But the thing I want to emphasize is for 90% of our restaurants, they're doing business as usual. So, I don't want it to be lost on the fact that this really was something where we doubled down as a system, but we really needed to kind of train up roughly 10% of the system. So, I think it's going to continue to be a key equity of ours. And as I mentioned in my prepared remarks, it's an equity we care about. So, we'll invest in it, and we'll figure out how to make sure we consistently do it every time."
},
{
"speaker": "Jack Hartung",
"content": "Yes. And then -- and then on California, so I'll make a comment or two. So yes, what we've seen is really across the entire state, we've seen a step down in the industry we've seen individual data points within the individual restaurants. And we've seen reports that there really has been a pullback in spending we've seen it as well. We've also seen that when we've seen individual restaurants. There's not a correlation between the step back in the spending versus the major price increase that was taken. And so it looks like there's just kind of a macro impact of less spending in the restaurant. We saw the same thing. Unfortunately, we raised prices by 100 basis points. We normally don't see much resistance. We still resistant to the point where we didn't get the 100 basis points at all. So, saw a pullback that equal the effect of menu price increase that we took. And it looks like that's about equal to what the pullback in the industry is."
},
{
"speaker": "Jon Tower",
"content": "Got it. Thanks for taking the questions."
},
{
"speaker": "Jack Hartung",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "The next question comes from Brian Harbour with Morgan Stanley. Please go ahead."
},
{
"speaker": "Brian Harbour",
"content": "Thanks. Yes. Good afternoon and Jack and Adam, congratulations as well. The Barbacoa kind of marketing initiative, could you just comment on that? Was it kind of a pretty material driver? Did people respond as you expected? Are there kind of other opportunities to do that sort of thing?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. Look, that was really effective. I think the marketing team did a great job of informing people of a great product that we have on our menu all the time. And as a result, we saw incidents go up and I think it's going to be something we'll revisit in the future. The good news is we got another hidden gem, I think, with Carnitas that we'll evaluate as well. But yes, you'll probably see us do that again because it worked really well for us."
},
{
"speaker": "Brian Harbour",
"content": "Okay, great. And Brian, your comments on automation but also some of the other kind of initiatives that you mentioned. How fast do you think some of those can show up? Is this the sort of thing where we start to see it in a year or two? Or are some of these longer-term? Do we see it in the form of kind of continued margin upside? Or like how should we kind of assess some of those as outsiders?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. Look, I think, like you would expect with any good portfolio of ideas, we have short-term, medium-term, and longer-term, right? And some of those things are much closer in versus something like a hyphen is a little bit further out. And the thing that's great is we're validating all of it through the stage gate. This is one thing I love about the stage gate process is it doesn't slow things down. It just ensures we don't have any unintended consequences. So, that as we roll things out, we're informed with what we're executing. But yes, some of those things can happen on much faster timelines and some of the other things take a little bit longer. So it's a real, it's a really nice blend of, I would say, near-term, mid-term, and long-term."
},
{
"speaker": "Operator",
"content": "The next question comes from Danilo Gargiulo with Bernstein. Please go ahead."
},
{
"speaker": "Danilo Gargiulo",
"content": "Thank you. Brian, last time we discussed, you were talking about throughput that was in the mid-20s. Where do you stand today? And can you maybe help us understand the major catalyst of throughput acceleration from here on?"
},
{
"speaker": "Brian Niccol",
"content": "Yes, sure. So, obviously, we saw our biggest improvement in throughput during the month of April, which was great to see. And we continue to see great throughput execution from folks. The thing that's going to push the throughput forward even further is ultimately the deployment being done correctly, right? So if we get that expo number to a higher percentage, not surprisingly, that expo position is the biggest impact on throughput gains. And so that's why you hear us talking about that position is kind of like the key metric of, are we deployed correctly to execute great throughput during peak? So, I'm optimistic that we're going to move that 50% number up, and I'm optimistic that we'll be able to move from the mid-20s to the high-20s in the not too distant future."
},
{
"speaker": "Danilo Gargiulo",
"content": "Great. And can you please provide an update on the restaurant-level margins and demand that you're seeing in European markets? I mean, you're making some bold investments over there, changing leadership as well. So, when do you think it's going to be realistic to expect an acceleration in units in Europe as well?"
},
{
"speaker": "Brian Niccol",
"content": "Yes, look, I'm really excited about the progress that our team has made over in Europe, in really short order. They've taken a lot of the tools in the U.S. We put them into place in Europe. I think we're managing food better. We're managing the supply chain better, managing deployment better. The culinary, I think, has really improved. So not surprising, you're seeing -- we're seeing nice improvements both in top line and bottom-line. So, I'm optimistic that we're going to be proving those as investable markets to kind of go even faster down the road, similar to what happened in Canada. So, the team has made nice progress. I'm sure they'll be busy in Paris with Olympics coming up, but I'm really, really delighted with Brian have done in kind of short order."
},
{
"speaker": "Operator",
"content": "And our last question will come from Chris O'Cull with Stifel. Please go ahead."
},
{
"speaker": "Chris O'Cull",
"content": "Thanks and congratulations Jack and Adam. I just wanted to ask, Brian, do you see any signs that the increases in value promotions by the QSR chains have had any impact on the company's results?"
},
{
"speaker": "Brian Niccol",
"content": "We really haven't. And I kind of point to the fact that we're gaining market share according to the data we get back. And the brand metrics continue to strengthen, and one of those key strength components is our value proposition. So, when I kind of connect all the dots of market share gains, strength in the brands, strengthen our operational execution, it appears some of these promotions are not having an impact on our business as of this moment. So, again, the thing we have to do is play our offense. And our offense, as I mentioned earlier, is great culinary, great teams, great throughput and that results in great Burritos and Bowls for our customers. So we're going to stay after it. And if the environment gets tougher, the good news for us is if the prior macro issues or recessions that we face, Chipotle is one of the one of the last ones impacted. And we were of the first ones out slowdown. So, it gives me confidence that we've got the right focus, the right operating model. And I think it's going to continue to resonate with customers."
},
{
"speaker": "Chris O'Cull",
"content": "That's helpful. And just as a follow-up. You talked a lot about product innovation, obviously, that has been very successful. And one of the factors, I think, Jack, you mentioned benefiting April sales was the marketing activation event. And I'm just wondering, can you help us understand how impactful these events can be and whether this is something the company could consider using more frequently if the consumer spending environment were to become more challenging?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. Look, it's a great question. And this is really, I think, the power of our combination of our digital marketing/consumer database, combined with what I think are some really clever marketing moments, right, like National Burrito Day, National Avocado Day. Obviously, we have the ability to turn on block mode. We have the ability to do other things that I think are very insight-based that we know resonate with the Chipotle customer. And I think that's one thing that's great about having such a big Canada base on our customers and then doing, I think, a really effective job using digital marketing or traditional marketing tools to communicate these unique opportunities with our customers. So, you'll continue to see us use it. And I think it's a huge advantage that we have, the strength of this loyalty program combined with a really talented marketing team."
},
{
"speaker": "Chris O'Cull",
"content": "Great. Thanks, and congratulations guys."
},
{
"speaker": "Brian Niccol",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Brian Niccol for any closing remarks."
},
{
"speaker": "Brian Niccol",
"content": "All right. Thank you. And thanks, everybody, for all the questions. Again, I do want to recognize Mr. Jack Hartung on having the privilege to work with Jack as well as, I think Chipotle and everybody involved with Chipotle has a huge thank you from Mr. Hartung. So thank you again, Jack."
},
{
"speaker": "Jack Hartung",
"content": "Thank you."
},
{
"speaker": "Brian Niccol",
"content": "And obviously, we're excited for Adam to step into the CFO role and then obviously, Jamie McConnell stepping up into her Chief Accounting role. So terrific leaders under, again, Jack's leadership that are going to get the opportunity to make even bigger contributions to this great brand. So congratulations, everybody. And then on the business, obviously, it was an outstanding quarter. I couldn't be prouder of the results the organization and what we accomplished. We get 8% transaction growth in any environment is pretty special. And I think it's a testament, great operations, great marketing, great digital. I mean we just -- we've got a lot of things going the right way. And as a result, the brand metrics have never been better. The value proposition is super strong. And whatever is in store for us. I'm sure we'll have our ups and downs. I always go back to having a strong brand with a strong organization sets you up for success. And I'm confident that we are building from a position of strength. And I look forward to finishing the year strong. Obviously, we've got a couple of more quarters to go. But I just want to reemphasize what a great quarter. What a great team and really proud of where we are and where we're headed. So thank you, everybody."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cmg | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day and welcome to the Chipotle Mexican Grill First Quarter 2024 Conference Call. [Operator Instructions] Please note, this event is being recorded."
},
{
"speaker": "",
"content": "I would now like to turn the conference over to Cindy Olsen, Head of Investor Relations and Strategy. Please go ahead."
},
{
"speaker": "Cynthia Olsen",
"content": "Hello, everyone, and welcome to our first quarter fiscal 2024 earnings call. By now, you should have access to our earnings press release. If not, it may be found on our Investor Relations website at ir.chipotle.com."
},
{
"speaker": "",
"content": "I will begin by reminding you that certain statements and projections made in this presentation about our future business and financial results constitute forward-looking statements. These statements are based on management's current business and market expectations, and our actual results could differ materially from those projected in the forward-looking statements. Please see the risk factors contained in our annual report on Form 10-K and in our Forms 10-Q for a discussion of risks that may cause our actual results to vary from these forward-looking statements."
},
{
"speaker": "",
"content": "Our discussion today will include non-GAAP financial measures. A reconciliation to GAAP measures can be found via the link included on the Presentation page within the Investor Relations section of our website."
},
{
"speaker": "",
"content": "We will start today's call with prepared remarks from Brian Niccol, Chairman and Chief Executive Officer; and Jack Hartung, Chief Financial and Administrative Officer, after which we will take your questions. Our entire executive leadership team is available during the Q&A session."
},
{
"speaker": "",
"content": "And with that, I will turn the call over to Brian."
},
{
"speaker": "Brian Niccol",
"content": "Thanks, Cindy, and good afternoon, everyone. The momentum in the business continued in the first quarter as we delivered 7% comp sales growth driven by over 5% transaction growth. Our strong sales trends were fueled by our focus on improving throughput in our restaurants as well as successful marketing campaigns, including spotlighting barbacoa and the return of Chicken al Pastor as a limited-time offer."
},
{
"speaker": "",
"content": "For the quarter, sales grew 14% to reach $2.7 billion driven by a 7% comp. In-store sales grew by 19% over last year as throughput reached the highest levels in 4 years. Digital sales represented 37% of sales. Restaurant-level margin was 27.5%, an increase of 190 basis points year-over-year. Adjusted diluted EPS was $13.37, representing 27% growth over last year. And we opened 47 new restaurants, including 43 Chipotlanes."
},
{
"speaker": "",
"content": "The strength in our business has continued into April. And as a result, we are increasing our annual comp guidance and now estimate comps in the mid- to high single-digit range for the full year."
},
{
"speaker": "",
"content": "Now let me shift to an update on our 5 key strategies that help us to win today while we grow our future. These strategies include sustaining world-class people leadership by developing and retaining diverse talent at every level; running successful restaurants with a people-accountable culture that provides great Food with Integrity while delivering exceptional in-restaurant and digital experiences; making the brand visible, relevant and loved to improve overall guest engagement; amplifying technology and innovation to drive growth and productivity in our restaurants, support centers and in our supply chain; and finally, expanding access and convenience by accelerating new restaurant openings in North America and internationally."
},
{
"speaker": "",
"content": "I'll begin with our world-class people leadership. Last month, we held our All Manager Conference, where we brought together 4,500 of our restaurant and support center leaders to celebrate their success as well as amplify our focus on exceptional people, exceptional food and exceptional throughput. The conference included over 3,200 general managers, 100 apprentices, 450 field leaders, 60 team directors and 11 regional vice presidents."
},
{
"speaker": "",
"content": "For the first time, we also included crew members who have worked with us for over 20 years to celebrate their commitment and dedication to Chipotle. In fact, one of our general managers in attendance from Denver, Colorado has been with Chipotle for 23 years, and she also had 4 crew members from her restaurant, who have each been with the company for over 20 years. Collectively, that is over 100 years of Chipotle experience, call it, one restaurant, which is just incredible. And it is no surprise this restaurant has fantastic operations with throughput that is outperforming the overall company."
},
{
"speaker": "",
"content": "At our conference, we highlighted the growth opportunity at Chipotle. To reach our long-term target over 7,000 restaurants in North America, we showed our teams that we will need to double the number of field leadership positions we have. And as we target over 90% internal promotions, the majority of these future leaders will come from the GMs and apprentices at this conference. This was a powerful and motivating message and one that is unique to Chipotle given our scale, growth and company-owned model."
},
{
"speaker": "And in connection with our 50",
"content": "1 stock split, we also announced that all of our GMs as well as crew members who have been with Chipotle over 20 years will receive stock grants once the split is effective. This will allow them to participate in the financial success of the company."
},
{
"speaker": "",
"content": "Bottom line, Chipotle is changing lives for the better. In fact, one of our restaurateurs and certified training managers spoke at the conference and shared that her experience at Chipotle helped her to overcome financial hardship. Now she was even on the verge of homelessness before she joined Chipotle. She started as a crew member over 10 years ago and has thrived, making her way to the highest-level GM and is now well on her way to becoming a field leader. She was able to leverage our education benefits to earn a college degree, the first in her family. And utilizing the stock she received as a restaurateur, she was able to purchase her first home. She is also one of our team members in our Behind the Foil commercials as she really is a great example of exceptional people that makes Chipotle, Chipotle."
},
{
"speaker": "",
"content": "In addition to our world-class people, exceptional food and exceptional throughput are key areas of focus and are both critical to running our successful restaurants. We spent time at our All Manager Conference reminding our teams about Chipotle's culture of Food with Integrity and how there's a direct connection between how food is raised and prepared and how it tastes. We showcased Chipotle's Food with Integrity journey and our strong partnerships with our farmers and suppliers, who take special care in ensuring they are growing our food with the highest standards."
},
{
"speaker": "",
"content": "We also emphasized the importance of teaching and tasting Chipotle, which means that our restaurant teams taste the food they prepare multiple times a day to assure it is delicious and meets our high standards. You see, Chipotle was founded on this idea of real food and real culinary. It's not a marketing slogan or a short-term initiative. It's in our heritage. It's in our DNA. Our restaurant teams take pride our food, and our healthy, high-quality eating experience adds value for our guests."
},
{
"speaker": "",
"content": "In addition to our delicious food, exceptional throughput or the speed of service in our restaurant also adds to the extraordinary value proposition we offer. I'm thrilled to share that the momentum and throughput continued to build in the first quarter as we improved by nearly 2 entrees in our peak 15 minutes compared to last year with each month showing an acceleration."
},
{
"speaker": "",
"content": "At our All Manager Conference, we also focused on coaching the nuances of great throughput or executing what we call the 4 pillars. This includes expo or the crew member between sauce and cash to help expedite the bagging and payment process; linebacker, typically the manager on duty who supplies both lines with freshly prepared food so that the crew on our line can continue to serve our guests without interruption; mise en place or another way of saying that everything that is needed for a lunch or dinner peak is ready and in its place; and aces in their places or having the best trained crew deployed in each position for lunch and dinner peaks."
},
{
"speaker": "",
"content": "We are in the early innings of consistently executing the 4 pillars, but when we do, it creates a flywheel effect in our restaurants. The restaurants run more smoothly as our teams are properly trained and deployed, which allows them to keep up with demand without stress. This leads to more stability, and therefore, more experienced teams that execute better every day. And this can be seen in our latest turnover data, which is at historically low levels. And for our guests, faster throughput results in shorter, faster-moving lines and hotter, fresher food, strengthening our value proposition and driving incremental transactions."
},
{
"speaker": "",
"content": "Our restaurant in the Financial District in Boston is a great example where a year ago, they were doing mid-20 entrees in their peak 15 minutes. And today, they are doing over 40 entrees in their peak 15 minutes with days that can reach as high as 80, which is among the highest in the company. The restaurant has low turnover and outsized transaction growth, which clearly demonstrates they are creating a better overall experience in the restaurant."
},
{
"speaker": "",
"content": "Now turning to marketing. Our marketing team has started the year off strong with outstanding brand advertising and menu innovation. We have continued our successful Behind the Foil brand campaign, showing our real teams prepping our delicious fresh food by hand every day, reinforcing a key differentiator for Chipotle. This ran across all media channels, including high-profile placements in television such as college football and the NFL Playoffs."
},
{
"speaker": "",
"content": "We also began to promote our delicious barbacoa as we leveraged our consumer insights that told us that many of our guests did not know that barbacoa was braised beef. So we renamed it Braised Beef Barbacoa and emphasized the culinary recipe, which is slow-cooked, responsibly raised beef seasoned with garlic and cumin and hand-shredded. It was Chipotle's best-kept secret and is now growing in popularity. The campaign was a success, driving incremental transactions and spend, and it was simple for our operations team to execute since it was an existing menu item. This is a perfect example of how our marketing team continues to make Chipotle more visible, more relevant and more loved."
},
{
"speaker": "",
"content": "During the quarter, we also brought back one of our most requested new menu items, Chicken al Pastor. Our guests loved our spin on the al Pastor using our adobo chicken, Morita peppers with a splash of pineapple, fresh lime and hand-chopped cilantro. Similar to carne asada, when we bring back a past favorite, we are able to improve the entire experience as we leverage our know-how across culinary, supply chain, marketing and operations to make it more delicious with seamless execution. Chicken al Pastor is off to a great start once again, driving incremental transactions into our restaurants."
},
{
"speaker": "",
"content": "Moving on to technology and innovation. Our marketing and digital teams continue to grow and evolve our Rewards program, which recently celebrated its fifth anniversary. It is exciting that we now have a digital reach of about 40 million Rewards members that we can leverage to increase engagement. Through our marketing initiatives, we continue to find successful ways to drive enrollments, and we are leveraging our digital team to create a seamless app experience and deliver more relevant journeys for our Rewards members. The goal is to drive higher engagement in the program, which results in higher frequency and spend over time."
},
{
"speaker": "",
"content": "In our restaurants, we continue to explore technology tools that can drive higher productivity and improve the overall experience for our teams. This includes things like forecasting and deploying labor, recruiting new crew members, preparing our fresh food and automating the preparation of digital orders. In fact, at our All Manager Conference, we showed our teams the latest version of our automated digital makeline and Autocado, which cuts cores and peels avocados. And as we discussed last quarter, we are excited to get both into a restaurant later this year as part of the stage gate process."
},
{
"speaker": "",
"content": "Our final strategic priority is expanding access and convenience by accelerating new restaurant openings in North America and internationally. We remain on track to open 285 to 315 new restaurants this year, mostly in North America. We continue to see strength in openings across geographies and location types, including urban, suburban and small towns. Additionally, our development team is making progress to smooth the cadence of openings throughout the year with the number of restaurants under construction up meaningfully to last year."
},
{
"speaker": "",
"content": "Outside of North America, I'm delighted to share that we opened our first restaurant in Kuwait with the Alshaya Group, which marks the first time we've entered a new country in over 10 years. This was a highly collaborative effort between the Alshaya Group and our Chipotle teams across culinary, food safety, development operations and supply chain to successfully launch Chipotle in a brand-new market with the same food quality standards and customer experience that we have in North America. Although it is very early, the opening was strong, and we look forward to continued success in many restaurants across the region with the Alshaya Group."
},
{
"speaker": "",
"content": "Moving to Europe. As you may recall, we brought over one of our top operators about a year ago, who helped to identify areas of opportunity, including better aligning our training tools, systems and culinary with our North American operations where it makes sense and is feasible. We have made nice progress aligning the culinary and are beginning to better align the operations, including a recent change in leadership structure as we expand the role of our Canadian leader to oversee both Canada and Europe."
},
{
"speaker": "",
"content": "Over the last 5 years, Canada's economics have improved to be on par with the U.S. In fact, Canada is leading our company in many key operational KPIs, including throughput. The successful approach of aligning the local strategy with our overall operational vision and diligently overseeing execution of Chipotle standards has set up Canada for rapid expansion."
},
{
"speaker": "",
"content": "We see many similarities between the European operation today and the Canadian operation 5 years ago. The new leadership team in Europe, including 2 top operators from the U.S., will take a similar strategic approach to improve economics and unlock Europe's growth potential."
},
{
"speaker": "",
"content": "In closing, the strength in our business, including transaction-driven comps, is due to the collective hard work of our 120,000 employees, who are results-driven, passionate about our purpose of cultivating a better world and excited for our growth opportunities ahead. At our All Manager Conference, I highlighted the importance of people development as it represents one of our greatest strengths. Seeing our leaders all in one place was inspiring, and their personal growth stories are real and a key ingredient to Chipotle's success and future growth. This makes me more confident than ever that we have the right people and the right strategy to achieve our long-term goals of more than doubling our restaurants in North America and expanding internationally. As I've said in the past, I believe the next Chipotle is Chipotle."
},
{
"speaker": "",
"content": "And with that, I will turn it over to Jack."
},
{
"speaker": "John Hartung",
"content": "Thanks, Brian, and good afternoon, everyone. Sales in the first quarter grew 14.1% year-over-year to reach $2.7 billion as sales comp grew 7% driven by over 5% transaction growth. Restaurant-level margin of 27.5% increased about 190 basis points compared to last year. Earnings per share adjusted for unusual items was $13.37, representing 27% year-over-year growth. The first quarter had unusual expenses related to an increase in legal reserves."
},
{
"speaker": "",
"content": "As Brian mentioned, based on our strong underlying transaction trends, we are raising our full year comp guidance to the mid- to high single-digit range. We anticipate second quarter comps to be the highest of the year, which includes a benefit of an extra day from the Easter shift, and we anticipate comps to continue to be driven by transactions in the back half of the year. We do have some challenging rollover components, including Chicken al Pastor ending, lapping our menu price increase from the prior year and rolling over the very successful carne asada campaign. With that said, we have a strong plan in place for the back half both in terms of operations and marketing."
},
{
"speaker": "",
"content": "Additionally, in April, minimum wage in California for restaurant companies like ours increased to $20 an hour. As a result, our wages in California went up by nearly 20%, and we subsequently took a 6% to 7% menu price increase in our California restaurants just to cover the cost in dollar terms. This will add almost 1 full point to total company pricing beginning in Q2. California restaurant cash flow is below the company average, so this increase will allow us to maintain cash flow. However, it will have a negative impact to overall company restaurant-level margin by about 20 basis points."
},
{
"speaker": "",
"content": "I'll now go through the key P&L line items, beginning with cost of sales. Cost of sales in the quarter were 28.8%, an increase of about 40 basis points from last year. The benefit of last year's menu price increase was partially offset by inflation across several ingredient costs, primarily beef and produce, and a protein mix headwind and from the successful beef barbacoa marketing initiative. For Q2, we expect our cost of sales to be in the mid-29% range due to higher prices across several items, but most notably avocados as we anticipate a step-up from the low levels we have seen over the past several quarters. We anticipate cost of sales inflation will be in the mid-single-digit range for the remainder of this year."
},
{
"speaker": "",
"content": "Labor costs for the quarter were 24.4%, a decrease of about 20 basis points from last year as the benefit from sales leverage more than offset wage inflation and the higher performance-based compensation. For Q2, we expect our labor costs to stay in the mid-24% range with wage inflation stepping up to about 6% as a result of the minimum wage increase in California."
},
{
"speaker": "",
"content": "Other operating costs for the quarter were 14.3%, a decrease of about 100 basis points from last year. The decrease was driven by sales leverage, lower delivery expenses and lower marketing and promo costs. Marketing and promo costs were 2.9% of sales in Q1, a decrease of about 30 basis points from last year. In Q2, we expect marketing costs to be in the low 2% range with the full year to come in just below 3%. In Q2, other operating costs are expected to be in the low 13% range."
},
{
"speaker": "",
"content": "G&A for the quarter was $204 million on a GAAP basis or $191 million on a non-GAAP basis, excluding a $13 million increase in legal reserves. G&A also includes $126 million in underlying G&A, $34 million related to noncash stock comp, $21 million related to our successful All Manager Conference we held in March and $10 million related to higher bonus accruals and payroll taxes and equity vestings and exercises. We expect our underlying G&A to be around $129 million in Q2 and step up each quarter as we make investments in people and technology to support ongoing growth."
},
{
"speaker": "",
"content": "We anticipate stock comp will be around $36 million in Q2, although this amount could move up or down based on our actual performance. We also expect to recognize around $6 million related to higher bonus accruals and employer taxes associated with shares that vest during the quarter, bringing our total anticipated G&A in Q2 to around $171 million. Depreciation for the quarter was $83 million or 3.1% of sales, and we expect depreciation to step up slightly each quarter as we continue to open more restaurants."
},
{
"speaker": "",
"content": "Our effective tax rate for Q1 was 22% for GAAP and 22.1% for non-GAAP. And our effective tax rate benefited from option exercises and equity vesting above grant values. For fiscal 2024, we estimate our underlying effective tax rate will be in the 25% to 27% range, though it may vary based on discrete items."
},
{
"speaker": "",
"content": "On March 19, we announced that our Board of Directors approved a 50-for-1 stock split, one of the largest in New York Stock Exchange history. We believe this will make our stock more accessible to our employees as well as a broader range of investors. Pending shareholder approval in early June to increase the number of authorized shares, the stock will begin trading on a post-split basis at the market open on Wednesday, June 26."
},
{
"speaker": "",
"content": "Our balance sheet remains strong as we ended the quarter with $2.2 billion in cash, restricted cash and investments with no debt. As a result of the timing of our announcement of the stock split, we were unable to repurchase shares for most of the quarter, which limited our share repurchases to just $25 million at an average price of $2,320. At the end of the quarter, we had nearly $400 million remaining under our share authorization program, and we will be able to resume opportunistically repurchasing our shares when the window opens -- reopens in a few days."
},
{
"speaker": "",
"content": "We opened 47 new restaurants in the first quarter, of which 43 had a Chipotlane. And we continue to anticipate opening between 285 and 315 new restaurants in 2024 with over 80% having a Chipotlane. And we remain on track to move toward the high end of the 8% to 10% range by 2025, assuming time line conditions do not worsen."
},
{
"speaker": "",
"content": "To close, I want to reiterate the message I shared at our recent All Manager Conference. Chipotle started over 30 years ago with a young chef who thought just because food is served fast doesn't mean it has to be a typical fast food experience. That evolved into our Food with Integrity journey, defying the traditional fast food model by investing more in our ingredients and shaping our economic model to help fund that investment. And today, we have a special brand and unique economic model that allows us to spend more on our ingredients yet remain one of the most affordable meals in the industry while also maintaining industry-leading margins."
},
{
"speaker": "These 3 characteristics are incredibly difficult to replicate",
"content": "premium ingredients, affordable prices and attractive margins. And this is a huge competitive advantage. And as we continue to protect and strengthen our economic model, the future looks very bright for Chipotle."
},
{
"speaker": "",
"content": "And with that, we're happy to answer your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question today comes from David Tarantino with Baird."
},
{
"speaker": "David Tarantino",
"content": "My question is on speed of service. And Brian, I think you mentioned that you improved in Q1 by 2 transactions, which I think is the biggest improvement we've seen in quite some time. So I guess the first question is, could you maybe elaborate on the factors that drove such a sharp improvement? And then secondly, could you maybe give us an update on where you think you are exiting the quarter, entering the first -- or the second quarter versus where you ultimately want to be? How much progress, I guess, relative to the ultimate goal that you make in the last 3.5 months?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. So thanks, David. Well, first, I got to give a big kind of applause to our operators. We've really done a great job, I think, of staffing, scheduling and deploying and then really executing against our 4 pillars of great throughput."
},
{
"speaker": "",
"content": "So the nice thing that happened is we saw, frankly, a step-up almost every month. And we continue to see progress as are now in the month of April. In fact, if you remember this, David, we were talking probably in 2023 about being in the low 20s and we want to get into the mid-20s. The good news is we're finally closing in on those mid-20s. And we're starting to see certain days push high 20s."
},
{
"speaker": "",
"content": "So still lots of room for improvement. But I really must say that I think the focus, the staffing, the deployment, the scheduling and then also giving our operators the visibility with reporting has really, I think, driven terrific outcomes on this throughput effort. And we're really excited about where we can go from here."
},
{
"speaker": "David Tarantino",
"content": "And just maybe a quick follow-up on that. So the last year you made this type of progress on throughput that I can remember was all the way back in 2014, and it was a very big comp driver that year. And I just wonder, could this become a big comp driver as you look at the rest of this year and into the next few years? I mean is it possible that this is a big driver as we think about how the next several years plays out? Or is this more of a we're starting to get closer to where you want to be, and maybe it plays out this year, and you normalize versus that base?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. No, you're exactly right, David. So 2014 was kind of our high-water mark on throughput. And we believe we've got years of opportunity in this. Just from what we're seeing, we still have a lot of opportunity to execute against the 4 pillars to great throughput. So our teams are doing a much better job than we were just last month or even 6 months ago. But there's still so much upside in what our teams can do and perform."
},
{
"speaker": "",
"content": "So this is a multiyear -- you're going to hear us talking about throughput for a long time. And I think you're going to be hearing us talk about how we're getting better as time goes by, assuming we're able to keep the staffing, assuming we're able to keep the deployment, assuming we're able to keep the teams focused on this. But rest assured, it is one of our key drivers of our strategy going forward. And our operators know it's critical."
},
{
"speaker": "",
"content": "And the good news is when they have success with throughput, a lot of good things happen for the team. Customer satisfaction scores go up. Bonuses go up. All kinds of good things are happening in the restaurant. The food is better. The experience is better. It's just -- it's one of those things that cascades into everything being a lot better."
},
{
"speaker": "David Tarantino",
"content": "Great. Congrats on a great start to the year."
},
{
"speaker": "Brian Niccol",
"content": "Yes. Thanks, David."
},
{
"speaker": "Operator",
"content": "The next question comes from Lauren Silberman with Deutsche Bank."
},
{
"speaker": "Lauren Silberman",
"content": "So on traffic, incredible numbers. You talked about this trend continuing into April and particularly impressive when considering what we're seeing in the overall industry. Can you give more color on just the cadence of trends you saw throughout the quarter and into April and color on what you're seeing with the consumer performance at the high-income versus low-income consumer?"
},
{
"speaker": "Operator",
"content": "My apologies, it looks like we've lost connection with our speakers. Please hold while we reconnect."
},
{
"speaker": "",
"content": "[Technical Difficulty]"
},
{
"speaker": "",
"content": "Thank you very much for your patience. We have reconnected with our speakers. We currently have Lauren Silberman from Deutsche Bank asking a question."
},
{
"speaker": "Lauren Silberman",
"content": "So if I could just ask about just traffic. Incredible trends during the quarter, strength continuing into April, particularly impressive when considering what's going on in the overall industry. Can you give some more color on the cadence of trends you saw throughout the quarter and into April? And then talk about what you're seeing with the consumer, high-income versus low-income performance."
},
{
"speaker": "Brian Niccol",
"content": "Yes. Sure. So this is Brian. I'll get started, and Jack, feel free to chime in. The good news is, obviously, we had some weather in January, and then we had the timing of the Easter holiday in March and April. But consistently, what we saw was a step-up from that bad weather. And then really our transactions have been running kind of in this mid-single-digit range, which has been, I think, a real testament to the work that's been going on both in the restaurant around throughput and then obviously some of the marketing work that we've got going on both with barbacoa and Chicken al Pastor."
},
{
"speaker": "",
"content": "So we continue to see that strength as we entered April. And when we look at where that strength is coming from because I think your question is about consumer/income cohorts, it's really broad based. So from the low-income consumer to the middle-income to the higher-income consumer, we're just seeing gains with all income cohorts. And when we ask the question, why is that, what we hear back from every group is it's a great value proposition. So the speed at which people can get these quality ingredients, customize the way they want for the price points that we provided is playing back -- is just -- create value in this environment."
},
{
"speaker": "John Hartung",
"content": "And then, Brian, the only thing to add was transactions were up almost 5.5% during the quarter, and that was offset by check increase by about 1.5%. That was driven by part check and then offset by a little mix -- a little negative mix mostly due to group size."
},
{
"speaker": "Lauren Silberman",
"content": "Very helpful. If I could just have a quick one on throughput. Do we expect the throughput efforts to compound over time as consumers recognize the improved operations? Is that what's happening as we move through the quarters?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. Yes, that's exactly right. I think we've talked about this in the past. When you know the line moves quickly, you're willing to get in line. And also what happens is the experience is just all that much better, right? The culinary moves faster, and then you get to your experience faster. So our teams run more efficiently. The food, I think, comes across even better prepared. And then you as a customer move through the line faster. So it is one of those things where kind of speed begets speed is the way to describe it."
},
{
"speaker": "John Hartung",
"content": "Yes. And Brian, I was just going to ask -- add the -- in terms of the in-store channel, it's the fastest-growing channel during the quarter, and that's coming from 2 areas. One, we've got our in-store customers. Those customers that tend to come in store are coming more often. And it makes sense that when the lines are moving, they're going to come more often. And we're actually also seeing a little bit of shift from some of the order-ahead. Those folks are shifting into the order -- into the in-store channel as well. Again, when the lines are moving well, when the restaurant is running well, people like to come in and select their meal along the front line."
},
{
"speaker": "Lauren Silberman",
"content": "Great. Congrats on the quarter."
},
{
"speaker": "Brian Niccol",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Charles with TD Cowen."
},
{
"speaker": "Andrew Charles",
"content": "I wanted to ask though on transactions. Jack, hoping you can talk about apples-to-apples, the impact on traffic this has had. So if you go back to July 2022, when you guys introduced Project Square One, you talked about hundreds of basis points of transactions that are on the table from reclaiming peak same-store sales or peak transactions. So here we are, you're back to pre-COVID levels. Is there way you can help contextualize the last 1.5 years or so since July 2022 what you've seen from transaction growth, same-store transactions from Project Square One?"
},
{
"speaker": "John Hartung",
"content": "Yes. Andrew, it's -- so it's hard to parse out the transactions and say how much is due to things like Chicken al Pastor, how much is due to things like barbacoa. Barbacoa, we think, drove some transactions as well and then throughput -- how much is driven by throughput specifically."
},
{
"speaker": "",
"content": "I think part of what's happening is they complement each other. And so when we're moving into our peak season right now, and these are our peak sales season, and we've got Chicken al Pastor, which has been -- it's off to a great start, and so you've got seasonally more people coming into the restaurant and more people want to come in and enjoy Chicken al Pastor."
},
{
"speaker": "",
"content": "If you don't have throughput, the in-store channel is not going to be the fastest-growing channel or at least it's not going to grow as fast. So is throughput driving the transactions or is it enabling the transaction? So it's hard to sort through whether it's the driver or the enabler. But it really doesn't matter to us because when we've got great LTOs with great advertising and that we're executing great throughput, we know the transactions will flow. And similar to David Tarantino's comment from 2014, that's exactly what was happening, is throughput is an enabler or a driver of transaction growth for not just many quarters but many years."
},
{
"speaker": "Andrew Charles",
"content": "Got it. And then separately, Brian, a philosophical question for you. Just given the strength of the business you're seeing in recent years, which I think is really exemplified in the first quarter given the challenging industry backdrop, just curious how your philosophy on the second concept has perhaps changed. You no doubt have a full plate of exciting opportunities for the brand in the years ahead. But just given the success and the recipe for success that you've seen that you've implemented, does it lead you to believe that you could benefit from a second concept?"
},
{
"speaker": "Brian Niccol",
"content": "Obviously, this comes up every once in a while, people bring it up. And the thing I would say is, right now, we're much more focused on just turning Chipotle into an iconic brand that I think it can be not just in the U.S. but outside the U.S. Obviously, if the opportunity presents itself, where it would make sense for us to do something outside of the brand, I never want to say never, but it's just not a focus area for us right now."
},
{
"speaker": "",
"content": "We've got so much opportunity in front of us just with what we can do with the brand Chipotle that internally, we're not working on it. But you never know. The external environment changes, and we'd be foolish to say we wouldn't be opportunistic. And luckily, we're operating from a position of strength right now. So I want to be as opportunistic as possible on brand Chipotle. And then if the external environment were to change and present other opportunities, maybe we would consider it, but it's not part of our growth strategy right now."
},
{
"speaker": "Operator",
"content": "The next question comes from Sara Senatore with Bank of America."
},
{
"speaker": "Sara Senatore",
"content": "Just a quick housekeeping and then another question, please. So just I think, Jack, you mentioned slightly negative mix. Can you clarify what's pricing this quarter? I think it was just under 3%, like 2.8%, something like that. And then what does that mean for Q2 now that you've taken the price increase in California? So that's just the sort of modeling question."
},
{
"speaker": "John Hartung",
"content": "Yes. Sara, you're right. Pricing in the quarter was like 2.7%, 2.8%. The only change going into next quarter and the next couple of quarters is we've got the California pricing. That's somewhere around 100 basis points or a little bit less. So Q2 and Q3 will be somewhere in that 3.5% range, and then Q4 will fall off and be more in that 1.5% range because we'll compare against last year's pricing."
},
{
"speaker": "Sara Senatore",
"content": "Great. Very helpful. And then I wanted to ask about sort of the store mix, which is you're seeing a shift towards in-store. Does that have any -- I know you said group size is still falling a little bit, presumably from the lower delivery. But do you see any impact from shifting to in-store? I'm thinking more possibly positive from better attach for like beverages, for example. And I'm curious if -- as you look out ahead, if mix could possibly turn positive from a driver like that."
},
{
"speaker": "John Hartung",
"content": "Yes. It's a good question, Sara. We're actually seeing within the, call it, 1.5% of negative -- or it's a 1.5% positive with a mix impact of, call it, about 100 basis points or so. What's happening is the group size is more like declining by about 2%. We actually do have side -- additional side attachment. But we're seeing the side attachment grow in both digital and in in-restaurant, and we are seeing the side attachment increase faster in restaurants than the side. So there is a positive factor there."
},
{
"speaker": "",
"content": "It's less from drinks though. It's more with extra meats. It's chips. It's queso. So we're getting a better attachment in both channels, and it is getting better even in the in-store channel. Part of that, we think, frankly, is when we have the line fully staffed, we do think we do a better job of not only making the burrito but making sure when the burrito or the bowl is presented to our cashier that these extras and these sides are more properly run up. Drinks have been relatively steady. We're not seeing a big shift in drinks."
},
{
"speaker": "Sara Senatore",
"content": "Okay. Got it. So kind of the opposite of the check management that we're seeing elsewhere?"
},
{
"speaker": "John Hartung",
"content": "Correct."
},
{
"speaker": "Operator",
"content": "The next question comes from Jon Tower with Citigroup."
},
{
"speaker": "Jon Tower",
"content": "Just a couple. First, maybe as we think about that path to $4 million AUVs that you've spoken about before, can you help us just maybe think about even your average customer frequency today and how that compares to the rest of maybe some of your competitive set out there for just your average customer?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. I don't know how to think about our frequency relative to some competitive opportunities out there. What I can tell you is the folks that are in our Rewards program, we see -- with their high engagement, we see higher spend and more frequency. And then also what we're seeing in the business, which I think is really nice to see as a result, I think the efforts both in better operational execution and I think our advertising around just the base business, this idea of real ingredients, real culinary, fast customization. We're just seeing the base business grow."
},
{
"speaker": "",
"content": "So obviously, we love what Chicken al Pastor does for us as far as menu variety. Obviously, we love the fact that we're able to rehit barbacoa, which is within our existing business. But I think what's been nice about the cadence of marketing and news combined with, I think, great operational execution is we're just seeing the base business grow. So we're getting more new users. We're getting existing users to come more often. And it's a great recipe to grow your core business in all the various ways we've talked about, right, from marketing to digital to operations."
},
{
"speaker": "Jon Tower",
"content": "Great. Maybe just pivoting a little bit on you. Can you talk about the Canadian market and specifically about the potential you think for that over the long term? And then expanding, I think you had mentioned earlier the idea that Europe looks a lot like Canada 5 years ago. But do you feel like you can, given everything you've learned in Canada, implement a lot of what you've taken there and apply it to Europe such that the time line around getting growth in Europe will be a lot faster versus what you saw in Canada?"
},
{
"speaker": "Brian Niccol",
"content": "Look, I mean, we're delighted with what's happened or what's occurred in Canada 5, 6 years ago. We were struggling to make the unit economics look very compelling. Now they're very compelling. It's right there with the U.S. And as a result, that business is closing in on 50 restaurants. And pretty soon, we'll have 100 restaurants up there. And then I think we'll be talking about having hundreds of restaurants in Canada, which is really exciting."
},
{
"speaker": "",
"content": "To answer your question on Europe, yes, look, I think our belief is we've learned a lot on what we've had to do in Canada to get that business to perform. We're taking that leadership there, giving her the opportunity to oversee our Europe business, take those lessons learned and apply it. And then at the same token, we're taking what we think are some of our best operators in the U.S., giving them the opportunity to grow by working in our European business."
},
{
"speaker": "",
"content": "So the time line, I don't know what the time line is going to be, but I am feeling optimistic that we've got the right operators, the right leadership. And then look, the proposition is compelling, right? Clean food, great culinary, done fast with high levels of customization that resonates. So I'm optimistic about where we go from here for all the reasons I just mentioned."
},
{
"speaker": "Operator",
"content": "The next question comes from Dennis Geiger with UBS."
},
{
"speaker": "Dennis Geiger",
"content": "Brian, I wanted to follow up on your comment there that the incremental traffic or visits are coming both from existing customers coming more as well as from new customers. I don't know if you have this granular level of detail, but I'm curious if you have a sense maybe from where. Maybe it's everywhere, but if it's QSR, if it's other fast casual. Any sense -- are you picking it up more at lunch, the incremental visits and customers more at dinner? Is there any other level of granularity to kind of help explain some of the success and maybe where it's coming from as it shifts to you folks?"
},
{
"speaker": "Brian Niccol",
"content": "No, not really. I mean the good news for us is it's pretty broad based, right? It's coming across all income cohorts. It's coming across lunch and dinner and the afternoon. So it's not like there's one thing that I would identify as like this change in consumer behavior."
},
{
"speaker": "",
"content": "I think the one big change for us is we're performing a lot better in giving people the experience that they actually want from Chipotle. I think you've heard us talk about this time and time again, exceptional food, exceptional people, exceptional throughput. And I think we're just getting better at each of those things. And the good news for us is we have an opportunity to be even better than we are today."
},
{
"speaker": "",
"content": "And then you layer in what I talked about earlier as it relates to marketing, both talking about the brand itself and then some of this menu news. It's just -- it's one of those things that builds on itself, right? Great digital programs, great marketing programs become much more effective when we're executing operations at a higher level. And I think that's what's happening."
},
{
"speaker": "Dennis Geiger",
"content": "That's great. And then just one -- just on the menu innovation follow-up. Just given the success you've seen as you bring back past favorites, as it relates to the go-forward, given the success that you've seen in recent years from that strategy, has that shifted at all how you think about menu innovation going forward as it relates to bringing back past favorites versus some newer items? Any shift there for you and for the team?"
},
{
"speaker": "Brian Niccol",
"content": "No, no real shift. I mean I think we like this cadence of 1 or 2 items a year. The good news is we've got now a great proven group of menu news that we can provide. And the good news is we've got a really talented culinary team and a talented marketing team that continues to help us find, I think, new flavors that make sense that can be executed correctly at Chipotle."
},
{
"speaker": "",
"content": "So you're going to see us continue to hopefully mix in things that we know have worked in the past and things that will be new but have gone through our stage-gate process so that we have a high level of success or belief in success going forward. So we like the cadence we're in. We can operate really well with it, and it seems to be resonating with our customers. So we want to keep doing what's working."
},
{
"speaker": "Dennis Geiger",
"content": "Congratulations."
},
{
"speaker": "Brian Niccol",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from John Ivankoe with JPMorgan."
},
{
"speaker": "John Ivankoe",
"content": "I wanted to get an update on some of the near-term operational initiatives that you've talked about before, the clamshell, Autocado, Hyphen, and just kind of where we are in the stage-gate process. And if you can put that in the context of kind of an updated, I guess, funding of the Cultivate fund, what types of opportunities that you're looking for, for the next phase of opportunities to overall accelerate the Chipotle brand."
},
{
"speaker": "Brian Niccol",
"content": "Yes. Sure. So obviously, all this stuff is really exciting. The dual-sided grill, we've expanded to a few more restaurants, specifically our high-volume restaurants. We think that's not only a great unlock for consistency in the culinary of our proteins and meats, but it's also a nice unlock for high-volume restaurants because you can cook the chicken faster. It allows the teams then to start prep closer to when we want to serve customers, which is really exciting. So we're continuing to test and learn on that front. We've also made some nice progress on the energy usage associated with it, which was something that was a bit of a barrier."
},
{
"speaker": "",
"content": "On Hyphen and Autocado, I'm happy to say we've got both of those units back in our Cultivate Center for a couple of prototypes in. And we are feeling really good about getting those into a restaurant probably in the back half of this year."
},
{
"speaker": "",
"content": "And then there's a lot of other things happening, too, both on like forecasting, deployment, tools to help our team members cut veggies more efficiently, more effectively. So there's a lot of good things happening behind the scenes. And I'm optimistic about what some of these things can do for our team members to give them a better experience, which then I know translates into better culinary and then ultimately better experiences for our customers."
},
{
"speaker": "",
"content": "On the Cultivate Next fund, this continues to be a real, I think, highlight area for us because we're continuing to see great ideas. And these great ideas are all the way from different ways to fertilize, to weeding in the fields, to different ways to actually deliver food or oils. So the thing I know about this is it's perfectly in sync with our purpose of cultivating a better world. And we can use it to really move forward the entire system necessary to give people great culinary, great ingredients, great food, at affordable prices. So you're seeing us invest up and down the supply chain all the way to the point of customer experience."
},
{
"speaker": "Operator",
"content": "The next question comes from Sharon Zackfia with William Blair."
},
{
"speaker": "Sharon Zackfia",
"content": "I guess on California, where you took the price increase, I know it's pretty recent. But could you give us an idea of where average ticket now sits in California and whether you've been seeing any resistance within that market as wages have ticked up and you've had to take that price increase?"
},
{
"speaker": "John Hartung",
"content": "Yes, Sharon. So the average ticket in California is similar to the rest of the country. Until this increase, our menu prices in California were very similar to the averages throughout the country, even though the cost of doing business out in California tends to be higher. After the increase, we still have burritos that are going to be reasonably priced. The chicken burrito is going to be around $10. It's very early, as you mentioned. It's too early to tell. We're not seeing any kind of change in consumer behavior yet, but it's only been a matter of a few weeks so far. So we'll keep a close eye on it."
},
{
"speaker": "",
"content": "We still think in California compared to competitors, we're still a terrific value if you look at what others are charging because if you look at others in California before this increase and compare them to average measure prices throughout the country, they tend to be higher. They're passing on a higher cost of doing business. We've tried to keep our pricing very, very affordable in California. So we still think we offer a great value here. So we think we'll fare quite well. As a consumer absorbs and figures out how do they want to balance their budget, we think Chipotle will stay in the budget."
},
{
"speaker": "Sharon Zackfia",
"content": "Okay. Great. I wanted to ask another question, too, as it relates to Chipotlanes, which obviously have been great. But as you look at kind of the automation and the initiatives you're working on, do you think there's anything that you're looking at or that could come down the pike that would open up kind of the opportunity for a nondigital drive-through, just a regular drive-up and order drive-through? Or is there not something from a robotic assembly standpoint that could answer that for you?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. We don't envision that occurring. The thing that makes Chipotle pretty special is all the customization, and we would hate to screw up that experience. And that's why -- you might remember this. I remember when we first did this. Everybody was like, oh, people are going to be confused, how are they going to know how to order, so on and so forth."
},
{
"speaker": "",
"content": "And it's turned out to be a really pleasant experience for both our team members and our customers because literally all they have to do is pick up their food. Everything is paid for. The order is accurate. It's on time and on you go. So we think there's other places for us to be more productive, where we're hunting on kind of using robotics and AI and finding other ways to do productivity. But you're not going to see that coming down the pike."
},
{
"speaker": "Operator",
"content": "The next question comes from Brian Harbour with Morgan Stanley."
},
{
"speaker": "Brian Harbour",
"content": "I had a question just on your comments about the Rewards program. Obviously, you continue to add people to that. But the effort to kind of drive engagement on a same-user basis, I know you've worked on personalization of offers and such. Have you seen that kind of showing? Have you seen pretty nice improvements in frequency? Or anything you can say just about what you've observed kind of from the same-user base of Rewards members?"
},
{
"speaker": "Brian Niccol",
"content": "Yes. I think one of the things that's pretty interesting that over the last, I'd say, couple of months has really worked well for us is kind of between machine learning and AI. I'm not sure what the right label is here. But we figured out how to identify somebody that might go less frequent so that we can keep them in the mix. And that's proving to be pretty powerful. Still a very small cohort that we're learning on. But the good news is we're seeing nice progress with that cohort that I'm optimistic kind of in our stage-gate process, we'll take that learning and figure out how to apply it on a much bigger scale so that then you can feel it across the digital business."
},
{
"speaker": "",
"content": "But it's those types of things where I think the team is doing a nice job of commercializing the data in a very effective way that ultimately for the customer, it feels like more personalization, more relevance. Therefore, you keep the engagement up. And then obviously, when we keep the engagement up, we see the higher spend and the more frequency."
},
{
"speaker": "Brian Harbour",
"content": "Okay. Got it. There is a comment you made, Brian, just about forecasting and deployment in restaurants. So it's not just equipment. It's also kind of that piece of it, which I assume you're referring to kind of the software tools that you've put there. Is that -- what have you seen from that so far? Has that made a big difference, in your opinion, on throughput and kind of staffing? Could you say more about that?"
},
{
"speaker": "Brian Niccol",
"content": "Yes, definitely. Look, I think one of the things that's happening is because we're getting better at forecasting, better at deploying, better at the scheduling, the job is becoming a better job, right? And one of the ways you see it is in our turnover numbers, right? Our turnover numbers are the lowest they've ever been. We've got some regions well below 100% turnover at the crew level, which I've never seen in my time in this industry. I think some of the lowest numbers I've ever seen, frankly, at Chipotle."
},
{
"speaker": "",
"content": "And to be in that 100% range, I think, is a testament to us making the job a better experience for our team members. I say this all the time to our folks. I said this at our AMC. Our folks show up at work wanting to succeed. The more we can do to surround them so that they have a successful day, the better they feel about the job, the better they feel about the experience that they're giving. Nobody likes to show up and be out of chicken when a customer gets to that point."
},
{
"speaker": "",
"content": "And so the more we can do to ensure they prep correctly, they're staffed correctly, they're deployed correctly, the better the experience is going to be. And I think we're starting to see that in the turnover numbers. We're starting to see that in, frankly, just the performance at throughput, right, the ultimate kind of metric to see like is the whole system really working. The whole system is working when we get great throughput."
},
{
"speaker": "",
"content": "And I'm just -- I'm delighted to see it happen. I talked about this a little bit in my prepared remarks. You really see it all coming alive at our AMC because when I had the opportunity to talk to people in the hallways or on our way to breakouts, I think people are just energized, man. They're fired up about this idea of being successful in their role, being successful as a leader. And that translates into the team. Everybody likes to be part of the winning team. And I think that's what's happening in our restaurants. We've got leaders that know they're leading winning teams. So we're going to do more of that."
},
{
"speaker": "Operator",
"content": "The last question today comes from Chris O'Cull with Stifel."
},
{
"speaker": "Christopher O'Cull",
"content": "I had a follow-up related to execution during peak periods. And in particular, Brian, you've talked about helping teams in the stores have better visibility to know how they're performing in their 15 minutes so they can course-correct, I think, in real time. Is this a fairly new system or a dashboard tool that managers have access to? And then maybe to help us understand the opportunity, I was just wondering if you could tell us what's the difference between the number of entrees during 15-minute peaks for like the top 20% and maybe the bottom 20% performers."
},
{
"speaker": "Brian Niccol",
"content": "Yes. So to answer your first question, it is a new tool that we rolled out in January that gave them real-time visibility, which has been hugely powerful. It's great because now when I visit restaurants and ask people, \"Hey, how are you doing?\" They can tell me what their best 15 has been so far. And a lot of them now are so well aware like, hey, I know we can do better than that. So like we might have did 25 in the last 15, but I think we're going to do 35 in the next 15, which is really exciting to hear them have that type of visibility and have kind of clarity so that as a team, they know what they're all working towards. What was your other question?"
},
{
"speaker": "John Hartung",
"content": "It was the range on throughput."
},
{
"speaker": "Brian Niccol",
"content": "Oh, the range to the top and bottom?"
},
{
"speaker": "John Hartung",
"content": "Yes. And I can take that one. We will see at the bottom -- and these tend to be lower-volume restaurants. You'll see restaurants that are doing in the mid-teens, call it. And then I don't think this is maybe the top 20%. But when we look at the top restaurants, which tells us what the potential is, Brian gave an example during the prepared remarks. In Boston, we've seen as high as 80. We've seen some even higher than that. But I would say the top-performing restaurants are consistently -- or at least on a peak day, it's not going to be in that 40, 50 range. So it's a very wide range. And we're still towards the lower end of that range with a lot of potential ahead of us."
},
{
"speaker": "Christopher O'Cull",
"content": "Great. Congratulations on a great start to the year."
},
{
"speaker": "Brian Niccol",
"content": "Yes. Thank you."
},
{
"speaker": "John Hartung",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Brian Niccol for any closing remarks."
},
{
"speaker": "Brian Niccol",
"content": "Okay. Thank you. And thanks, everybody, for the questions. Obviously, I appreciate the kind words of recognizing how we're off to a great start. Very proud of the momentum that the business has and really proud of what our operators are doing in our restaurants."
},
{
"speaker": "",
"content": "I mentioned it in my prepared remarks, but it was so much fun to be at our AMC with all of our restaurant general managers, apprentices, field leaders, team directors, regional vice presidents, talking about the business. Everybody was clearly aligned on what the task needs to be at hand, which is great culinary, developing great people, great culture, great teams, right, and then ultimately getting great throughput for our customers."
},
{
"speaker": "",
"content": "And I think you're seeing the power of focus, the power of alignment and the power, frankly, of Chipotle's culture and great people in these results in the last quarter. Optimistic about where we go from here. It's exciting to think about how we can double this business, going from 3,400, 3,500 restaurants to 7,000 restaurants, getting to 4 million average unit volumes and then continuing to make great progress on throughput and surrounding this brand, I think, with great digital, great marketing. It's really an exciting moment for the brand and the company."
},
{
"speaker": "",
"content": "And we're just getting started, which really makes this a lot of fun. So thanks for taking the time. It's great to see the business respond with transactions driving the comp. And we're going to stay focused on what we know works. So we'll talk to you guys in a couple of months. Thanks, everybody."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
cmi | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Cummins Inc. Q4 2024 Earnings Conference Call. At this time, all participants are in listen-only mode. [Operator Instructions]. A question-and-answer session will follow the formal presentation. We ask that you please ask one question, one follow-up, then return to the queue. [Operator Instructions]. As a reminder, this conference is being recorded. Joining us today are Chair and CEO, Jennifer Rumsey; Vice President and CFO, Mark Smith; and Chris Clulow, Vice President, Investor Relations. It's now my pleasure to introduce your host, Chris Clulow. Please go ahead, sir."
},
{
"speaker": "Chris Clulow",
"content": "Thank you, Kevin. Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the fourth quarter and full year of 2024. Participating with me today are Jennifer Rumsey, our Chair and Chief Executive Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures, and we will refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website within the Investor Relations section at cummins.com. With that out of the way, I'll turn you over to our Chair and CEO, Jennifer Rumsey, to start us off."
},
{
"speaker": "Jennifer Rumsey",
"content": "Thank you, Chris. Good morning. I'll start with a summary of 2024, discuss our fourth quarter and full year results and finish with a discussion of our outlook for 2025. Mark will then take you through more details of our fourth quarter and full year financial performance and our forecast for this year. As I reflect back on 2024, I am pleased to share that we delivered strong financial results with records in several parts of the business while also making significant progress in the execution of our Destination Zero strategy. I am incredibly proud of what Cummins and our employees accomplished for our stakeholders, and I feel energized about the opportunities ahead for us as we continue to demonstrate our relentless focus on advancing our strategy and executing our financial commitments as we lead the energy transition. It continues to be clear that our multi-solution Destination Zero strategy that leverages advancements and solutions from both our core and Accelera by Cummins businesses will continue to position us to succeed. We demonstrated this in 2024 as we further strengthened our position through evolving our portfolio and expanding and establishing relationships with new and longstanding key stakeholders and partners. Most notably for our core business in 2024, we introduced the Cummins HELM engine platform. Applied across Cummins' legendary B, X10, and X15 series engine portfolios, the HELM platforms provide customers with the option to choose the fuel type, either advanced diesel or alternate fuels like natural gas and hydrogen, that best suits their business needs and offers the power and performance customers expect while also reducing emissions. Cummins began full production of the X15N natural gas engine at the Jamestown Engine Plant earlier this year. And we are actively engaged with some of North America's largest and most demanding heavy-duty fleets as they look to reduce their carbon footprint. Additionally, in our core business, we introduced four new generator sets to the award-winning Centum Series, two each powered by Cummins' QSK50 and QSK78 engines. In response to high market demand, these new models have been engineered specifically for the most critical applications such as data centers. In order to further raise our capacity to meet rising power generation demand, we also intend to invest $200 million across our U.S., England, and India manufacturing sites. As you will see in our full year financial performance details and 2025 guidance, we are excited about the continued impressive performance and growth potential for our Power Systems business. Cummins also successfully completed the separation of our Filtration business, Atmus Filtration Technologies. Cummins will continue its focus on advancing innovative power solutions while Atmus is now well positioned to pursue its own plans for profitable growth. The separation of Atmus resulted in the tax-free exchange of shares, which reduced Cummins' shares outstanding by approximately 5.6 million in the first quarter. In our Accelera business, we completed the formation of our joint venture, Amplify Cell Technologies with Daimler Trucks & Buses PACCAR, and EVE Energy to localize battery cell production and the battery cell supply chain in the United States. This strategic collaboration will advance zero emissions technology for electric commercial vehicles and industrial applications. Amplify began construction this year of a 21-gigawatt hour factory in Mississippi with potential for future expansion as demand grows and is targeting start of production in 2027. Lastly, as we navigate this long and messy transition for our customers, we remain committed to pacing and refocusing our investments on the most promising paths as the adoption of zero-emission solutions slows in some regions around the world. As you can see in our fourth quarter results, we recorded charges related to the reorganization of our Accelera business segment as we underwent a strategic review to streamline the business while also ensuring we are set up for long-term success. We remain committed to Accelera and its mission, and this business continues to play an important role in our Destination Zero strategy. Now I will comment on overall company performance for the fourth quarter of 2024 and cover some of our key markets. Demand for our products remained strong across many of our key markets and regions, offsetting the softening in the North America heavy-duty truck market. Revenues for the quarter totaled $8.4 billion, a decrease of 1% compared to 2023 as lower North America heavy-duty and pickup truck volumes and the reduction in sales from the separation of Atmus were partially offset by continued high demand in our global power generation markets, stronger aftermarket, and North America medium-duty truck volumes as well as improved pricing. EBITDA was $1 billion or 12.1% compared to a loss of $878 million or negative 10.3% a year ago. Fourth quarter 2024 results included 312 million of charges related to the strategic reorganization of our Accelera business segment. This compares to the fourth quarter 2023 results, which included $2 billion of costs related to the agreement to resolve U.S. regulatory claims, $42 million of costs related to our voluntary retirement and separation programs, and $33 million of costs related to the separation of the Atmus business. Excluding those items, EBITDA was $1.3 billion or 15.8% compared to $1.2 billion or 14.4% a year ago. EBITDA and gross margin dollars improved compared to the fourth quarter of 2023 as the benefits of higher power generation volume, pricing and operational efficiency more than exceeded lower North America truck volumes and the separation of Atmus. 2024 revenues were a record $34.1 billion, essentially flat with 2023 despite the decline in North America heavy-duty truck demand in the second half of the year and reduction of sales from the Atmus separation. EBITDA was a record $6.3 billion or 18.6% of sales compared to $3 billion or 8.9% of sales in 2023. 2024 results include a gain, net of transaction costs and other expenses, of $1.3 billion related to the Atmus divestiture, $312 million of charges related to the Accelera reorganization, and $29 million of first quarter restructuring expenses. This compares to the 2023 results that included $2 billion of costs related to the agreement to resolve U.S. regulatory claims, $100 million of costs related to the separation of Atmus, and $42 million of costs related to the voluntary retirement and separation programs. Excluding those items, EBITDA was a record $5.4 billion or 15.7% of sales for 2024 compared to $5.2 billion or 15.3% of sales for 2023 as the benefits of higher power generation volumes, pricing and operational efficiency more than exceeded lower second half North America truck volumes and the reduction in margin from the Atmus separation. EBITDA dollars were a record in Power Systems, Distribution, and Engine segments. Our Power Systems business, in particular, finished 2024 with a record full year EBITDA of 18.4% of sales, up from 14.7% in 2023. I'm very pleased with the performance across our core business segments, and you will see from our guidance that we are excited to continue to build on this momentum. Now let me provide our overall outlook for 2025 and then comment on individual regions and end markets. We are forecasting total company revenues for 2025 to be down 2% to up 3% compared to 2024, and EBITDA to be 16.2% to 17.2% of sales, up from 15.7% in 2024. While we expect weaker first half demand in our North America on-highway truck markets, we expect many of our markets, particularly power generation to remain strong throughout the year. Industry production for heavy-duty trucks in North America is projected to be 260,000 to 290,000 units in 2025, flat to down 10% year-over-year. We anticipate weaker first half demand. And while we do expect a prebuy in the second half of the year, the uncertainty on the exact timing and extent is driving our wider guidance range. In the medium-duty truck market, we expect the market size to be 140,000 to 155,000 units, down 5% to 15% compared to 2024, primarily driven by weaker-than-expected recent net orders and a depleting backlog. Our engine shipments for pickup trucks in North America are expected to be 130,000 to 140,000 in 2025, flat to up 5% year-over-year. In China, we project total revenue, including joint ventures, to increase 5% in 2025. We are projecting a range of down 5% to up 10% in heavy and medium-duty truck demand in China. While export demand is expected to decline slightly, we are hopeful that the recent NS4 scrapping policy and other stimulus actions may lead to domestic demand growth. We have not, however, seen a meaningful recovery thus far. While there is still uncertainty around the China truck market for 2025, we expect strength in other markets, particularly power generation, where demand is expected to remain high as data center momentum continues. In India, we project total revenue, including joint venture to increase 10% in 2024, primarily driven by stronger power generation demand. We expect industry demand for trucks to be down 5% to up 5% for the year. For global construction, we expect flat to down 10% year-over-year, primarily driven by weak property investment and shrinking export demand in China. We project our major global high horsepower markets to remain strong in 2025. Revenues in global power generation markets are expected to increase 5% to 15%, driven by continued high demand in the data center market. Sales of mining engines are expected to be down 5% to up 5%. For aftermarket, we expect revenue improvement with a range of flat to an increase of 5% for 2025. In Accelera, we expect full year sales to be $400 million to $450 million compared to $414 million in 2024. In summary, 2024 was a record year for revenues, net income, EBITDA, and earnings per share. In 2025, we anticipate that demand will be slightly weaker in the North America on-highway truck markets, particularly in the first half of the year but offset by continued strength in the power generation market and resiliency in our Distribution business, given our strong aftermarket presence. Despite a relatively flat revenue forecast, we are expecting to improve profitability and cash flow. We remain committed to our multi-solution approach that is proving to be the right strategy for our customers, for the environment, and for the continued growth of Cummins while also returning cash to investors. Now let me turn it over to Mark who will discuss our financial results in more detail."
},
{
"speaker": "Mark Smith",
"content": "Thank you, Jen, and good morning, everyone. We delivered strong operational results in the fourth quarter, which resulted in revenue achieving the top end of our prior guidance and EBITDA margins exceeding our projections. 2024 was a record year for revenues, EBITDA, and earnings per share, reflecting the strong demand for our products and the strong hard work of our employees. Now let me go into more details on Q4 and the full year performance. There were some notable non-routine transactions in '24 and 2023, and I'll quantify those and describe our underlying results to give a better understanding of the performance from regular operations. Fourth quarter reported revenues were $8.4 billion, and EBITDA was $1 billion or 12.1% of sales. As Jen mentioned, we underwent a strategic review of our Accelera segment, which resulted in charges of $312 million, of which $305 million were non-cash. Excluding this charge, we delivered EBITDA of $1.3 billion or 15.8% of sales. In the fourth quarter of '23, we reported sales of $8.4 billion and an EBITDA loss of $878 million. Excluding the regulatory settlement, Atmus separation costs, and voluntary retirement and separation program costs in Q4 2023, EBITDA was positive $1.2 billion or 14.4%. I know that's a lot to digest. In summary, on an underlying basis, EBITDA improved by 140 basis points on slightly lower sales, excluding those charges I just described. Fourth quarter revenues decreased by 1% from a year ago as organic growth was more than offset by the reduction in sales driven by the separation of Atmus. Sales in North America were flat while international revenues decreased 3%. Foreign currency movements negatively impacted sales by less than 1%. The EBITDA improvement of 140 basis points was primarily due to higher power generation volumes, pricing and operational efficiency, partially offset by lower North America truck volumes and the separation of Atmus. Now let me summarize some of the impacts by line item in the income statement. Gross margin was $2.1 billion or 25.4% of sales compared to $2 billion or 23.7% last year. The improved margins were driven by stronger power generation aftermarket demand, favorable pricing, particularly in Power Systems and Distribution and improved operational efficiency. Selling, administrative, and research expenses were $1.1 billion or 13.6% of sales compared to $1.2 billion or 14.2% last year due to lower research and development costs. Joint venture income of $87 million decreased $26 million primarily driven by lower technology fees from some of our international partnerships and costs incurred in the ramp-up of the Amplify Cell Technology battery joint venture here in the U.S., which was formed in the second quarter of '24. Other income was negative $25 million, a decrease of $75 million from a year ago, primarily driven by mark-to-market losses on investments related to company-owned life insurance. Interest expense was $89 million, a decrease of $3 million from a prior year, driven by lower weighted average interest rates. The all-in effective tax rate in the fourth quarter was 32.8%, principally due to non-deductible costs related to the Accelera reorganization. All in, net earnings for the quarter were $418 million or $3.02 per diluted share, which includes $312 million or $2.14 per diluted share of Accelera reorganization charges. Excluding the Accelera charges, EPS was $5.16 per diluted share. Operating cash flow was an inflow of $1.4 billion, just $37 million lower than the level we saw in the first quarter last year. For the full year 2024, revenues were a record $34.1 billion, slightly above a year ago and reflecting 4% growth if we exclude Atmus from both 2023 and '24. EBITDA in '24 was $6.3 billion or 18.6%. Excluding the gain in costs associated with the separation of Atmus, the Accelera charge in the fourth quarter, and first quarter restructuring expenses, EBITDA in 2024 was $5.4 billion or 15.7%. 2023 EBITDA was $3 billion or $5.2 billion and 15.3% excluding the regulatory settlement, Atmus separation costs, and voluntary retirement and separation programs. The increase in the EBITDA percent was primarily driven by higher power generation volumes, pricing and operational efficiencies, more than offsetting the impact of lower North American heavy-duty truck volumes and the reduction in margin from the Atmus separation. All-in net earnings were $3.9 billion or $28.37 per diluted share compared to $735 million or $5.15 per diluted share a year ago. 2024 results included the gain related to the separation of Atmus, net of transaction costs and other expenses of $1.3 billion or $9.28 per diluted share, charges related to Accelera reorganization of $2.12 per diluted share, and first quarter restructuring costs of $0.16 per diluted share. Capital expenditures in 2024 were $1.2 billion, flat compared to 2023 as we continue to invest in the new products and capabilities to drive growth, particularly related to the HELM platforms within our core business in North America. Our long-term goal is to deliver at least 50% of operating cash flow to shareholders. And over the past five years, we've returned 54% in the form of share repurchase and dividends even while we absorbed the significant acquisition in the form of Meritor. In 2024, we focused our capital allocation on organic investments, dividend growth, and returning $969 million to shareholders via the cash dividend and debt reduction. We also reduced our shares outstanding by approximately 5.6 million shares from the tax-free Atmus separation share exchange. I will now summarize the 2024 results for the operating segments and provide guidance for 2025. And thankfully for you and for me, I'm going to exclude all those nonroutine items in the following pages, and thanks for staying with me as I work through that. For the Engine segment 2024 revenues were a record $11.7 billion or up $28 million compared to last year. EBITDA was 14.1% of sales, flat compared to a year ago. In 2025, we project revenues for the Engine business will be down 2% to up 3% due to expected weakness in the North American truck market, particularly in the first half of the year, slightly offset by improved demand in pickup and some international markets. 2024 EBITDA is expected to improve with projections in the range of 14.2% to 15.2%. Components segment revenues were $11.7 billion in 2024, 13% lower than the prior year, and EBITDA was 13.8% of sales compared to 14.4% in '23. There were a lot of work done to improve existing operations but that was offset in the year-over-year comparisons due to the separation of Atmus. For 2025, we expect total revenue for the Components business to range from down 5% to flat as 2024 included Atmus in the first quarter through March 18. EBITDA margins are expected to be between 13.8% and 14.8%. In the Distribution segment, revenues increased 11% in '24 compared to 2023 and were a record $11.4 billion. EBITDA was 12.1% compared to 11.8% a year ago, driven by higher power generation volumes and pricing. We expect 2025 distribution revenues to increase 2% to 7% and EBITDA margins to be in the range of 12% to 13%. In the Power Systems segment, revenues were a record $6.4 billion, up 13% over 2023 driven primarily by power generation demand, especially data center applications. EBITDA was 18.4% or 370 basis points higher than 2023, driven by stronger volume, favorable pricing, and a continued focus on operational performance and cost reduction. In 2025, we expect Power Systems revenues to be at 2% to 7% and EBITDA to improve again and be in the range of 19% to 20%. Accelera revenues increased to $414 million in 2024 with a net operating loss of $452 million as we lowered costs in existing operations, partially offset by additional losses in the Amplify cell joint venture as it advances its operations. In 2025, we anticipate revenues to be in the range of $400 million to $450 million and net losses to reduce to $385 million to $415 million as we continue to make targeted investments aligned with market demand whilst reducing cost. We currently project 2025 company revenues to be down 2% to 3%. Company EBITDA margins are projected to be approximately 16.2% to 17.2% compared to an equivalent 15.7% in 2024. Our effective tax rate this year is expected to be 24.5%, excluding any discrete items. Capital investments will be in the range of $1.4 billion to $1.5 billion as we continue to make critical investments to support future growth. To summarize, we delivered record sales and profitability in 2024, including strong results in the second half of the year even as demand in the North American heavy-duty truck market declined. Cash generation has been and will continue to be a focus as we enter 2025, enabling us to continue investing in new products for new and existing markets, returning cash to shareholders, and maintaining a strong balance sheet. Last May, we laid out our updated financial targets through 2030. Our strong performance in 2024 represented encouraging progress towards those targets. And despite a relatively flat revenue forecast and expected weakness in North American heavy-duty truck, we expect to further improve profitability and cash flow in 2025. Thanks for joining us today, and let me turn it back over to Chris."
},
{
"speaker": "Chris Clulow",
"content": "Thank you, Mark. Out of consideration to others on the call, I would ask that you limit yourself to one question and a related follow-up. If you have an additional question, please re-join the queue. Operator, we're ready for our first question."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions]. Our first question today is coming from Angel Castillo from Morgan Stanley. Your line is now live."
},
{
"speaker": "Angel Castillo",
"content": "Hi. Thanks for taking my question, and congrats on another strong quarter here. Just wanted to unpack the power generation guide of 5% to 15% a little bit more. Could you just split that out between kind of price and volume? And then maybe just tying into that, I think you mentioned a new investment of 200 million in power gen. Can you just talk about maybe what's entailed in that? I thought, I guess there was already an expansion of doubling capacity so what is kind of the incremental being done?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So as you said, we're currently in the midst of a $200 million investment across our plants in and see more Minnesota, UK, and India to ramp up capacity to meet what is a growing demand for power generation products. And so you're seeing in that guide and expectation that we have been able to take up capacity. We're continuing to look at strategic pricing and where we can bring value to the customer so you've got some price in there as well. But really, it's about capacity ramp-up and continued sales of larger engines. In the power generation and data center market, it's really the 50 to 60 liter, the 78 and the 95 liters so these are large engines as we're able to bring more capacity online in our supply chain and our plants, you see that flowing through in revenue. And we expect that trend to continue over time. And so we're tracking on plan or even slightly ahead of plan to double our capacity by end of this year and looking forward to being able to meet what is a really strong demand from those customers."
},
{
"speaker": "Angel Castillo",
"content": "That's very helpful. And then maybe as a follow-up, just on separate on the trucks. Can you just give us your latest thoughts on EPA27? It sounds like you're still assuming some prebuy in the second half. But just given, I guess, what we've seen from the administration so far, any thoughts on the likelihood of any kind of challenges to the EPA27 rule?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes, our current view is that we expect the EPA27 regulations will stay in place. Many companies, including us, have been investing over multiple years in those products to bring those products to market, and we're looking forward to having a nationwide standard again in '27. And with that, we are still anticipating some -- both economic recovery and prebuy happening in the North America trucking market that helped bring higher revenue in the second half this year and into next year. We do anticipate there'll be more discussion and potential challenge over the greenhouse gas regulations that we see out into the 2030 and beyond time frame."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Stephen Volkmann from Jefferies. Your line is now live."
},
{
"speaker": "Stephen Volkmann",
"content": "Great. Good morning, everyone. Maybe starting off, can you just talk a little bit more about the Accelera restructuring? And how have you changed the focus of that business? And what are you doing less of or more of or just some color around that?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes, I'll start and then Mark can add if he wants to share more detail. But really, this business has all along been about remaining agile and investing as we see technology advancing and markets starting to move in these zero emissions technologies. And we formed it through a number of acquisitions as well. So what that meant was we had kind of a distributed footprint and investment coming from those different acquisitions, and so we really looked at where we see market moving. We expect that battery electric vehicles will be important in some of our commercial vehicle and industrial applications, and we feel well positioned with the battery cell joint venture and some of the wins that we have with customers as that market develops so we're continuing to invest there. We're continuing to invest but pace investment in electrolyzers as we've seen some slowing in customer demand and uncertainty around incentives there, and then being selective in fuel cells and some of the other technologies where adoption continues to push out. But we think we're well positioned. Frankly, the slower and messier this goes, my view is the better it is strategically for Cummins. And so we're positioning ourselves in the places where we see that market and technology beginning to increase."
},
{
"speaker": "Stephen Volkmann",
"content": "Okay, good. Sorry, I thought Mark was going to add something. Can I ask -- well, you've been talking a lot as it is. Hopefully, you'll be doing less of that this year on all these adjustments. Can I just follow up -- can I follow up on the HELM platform? Do you have targets relative to the types of unit volumes you might expect either on the nat gas side or on any of the other engine -- sorry, any of the other fuel options that you can use with that platform?"
},
{
"speaker": "Jennifer Rumsey",
"content": "We've got -- the rate of -- the beauty of the HELM platform is it's got that fuel flexibility. And so the reality is we're still going to sell a lot of the diesel version of that, and it will be a higher efficiency version, which means lower CO2 and lower fuel costs for our customers. We've set a goal of getting to 8% on the natural gas version of that. We're starting to see customers adopt. PACCAR has launched it. Daimler Trucks will launch that 15-liter natural gas this year. Fleets are testing it. I was with a big customer last week. They're finishing their field testing. They feel good about the product, and they're looking to start to increase penetration, but it really depends on diesel fuel prices and regulation and customer CO2 goals. And so it's hard to give specific numbers on the rate of natural gas or hydrogen adoption because of that dependency on infrastructure cost and regulation."
},
{
"speaker": "Operator",
"content": "Thank you. Next question today is coming from Jerry Revich from Goldman Sachs. Your line is now live."
},
{
"speaker": "Jerry Revich",
"content": "Yes. Hi. Good morning, everyone. In Power Systems, you had a really excellent 30% year-over-year growth in revenue per unit in the quarter, so the ramp in the supply base was progressing nicely. I'm wondering if you could just update us on how much more throughput you expect to get out of the supply base in 2025 for those large products. And I appreciate there could be a wide range of outcomes but would love to get your updated views on that?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Well, I think it's important to remember that the revenue growth, in particular, for 2024 was also about launching those new Centum products, so we're seeing new products coming online that serve the market in addition to ramping up capacity. And for this year, it really is focused on continuing to max out our capacity capability that we have when we're making the investment and more capacity across that range of products. And the team has done a really phenomenal job of doing that, improving operating efficiency, working with the supply base to try to get as much out of what we have. But there's some major investments that need to happen by the end of this year to really get to the full doubling of capacity."
},
{
"speaker": "Mark Smith",
"content": "So unfortunately, Jerry, units are not a great indicator just because the size of the generator set we've been selling is going up. The average selling price has gone up a lot over and above pricing, just the size of the set that we're selling. So the revenue has outgrown the units significant."
},
{
"speaker": "Jerry Revich",
"content": "Nice problem to have. And separately on the China truck market, as you mentioned in the prepared remarks, there is some optimism in the market about potentially stronger demand. Can you just calibrate us, I believe, including the JV and wholly-owned business, China truck profits are maybe 10% of total company profits at this point. And given we're at the trough of the cycle, is it fair to think about pretty attractive incremental margins if demand does indeed surprise the upside?"
},
{
"speaker": "Mark Smith",
"content": "Yes on the latter. I mean, China in total, maybe on a more normal run rate would be in the range of 15% to 20% of our earnings. And yes, on-highway would typically be more than half of that so you're in the ballpark, Jerry, yes. And there's no massive structural investments going on there in the current year. So if we get more volume, we'd expect to convert that into more profits. There's also just some lumpiness around tech fees and other things. But I think the underlying operational business is well set as it's done in prior cycles when demand improves, we see that. And I think that just reinforces how well the Engine business and Components did in '24. Not just did we have weakening heavy-duty truck in the second half of the year but we had weaker China throughout the year. So hopefully, at some point, confident China is going to turn. We don't have a lot of visibility into that right now. Hopefully, that's another leg to come."
},
{
"speaker": "Operator",
"content": "Thank you. Next question today is coming from Tim Thein from Raymond James. Your line is now live."
},
{
"speaker": "TimThein",
"content": "Thank you. Good morning. Maybe I'll ask 1 to start on components, Mark. Just as you think about the margin outlook for '25 on flat to down revenues, a pretty nice improvement. I'm wondering how much of that is -- is it maybe a benefit from lapping the Atmus spin or separation? Or is there -- obviously, there's more to it than that. So maybe just a line or two in terms of what you're projecting there for Components."
},
{
"speaker": "Mark Smith",
"content": "I think when you look across the company, we've done a lot on cost reduction. It hasn't been enormous in any given quarter, but we've been working at it really since the fourth quarter of 2023 when we announced voluntary separation package. We did a lot of work internally during 2024 to look at how we weighted the amount of resources we put between lines of business, functions, regional structures. And a lot of this work has paid off in terms of improving our cost structure and focus. And so yes, the Components business is going to benefit from some of that. We're not breaking it out separately but what was formerly known as Meritor, Drivetrain, and Braking Systems business, results have continued to improve their underlying. So I think there are a number of things. We are working incredibly hard on a flattish revenue environment to drive cost and efficiency where we can."
},
{
"speaker": "TimThein",
"content": "Okay. And then Mark, on the Accelera, just in light of the restructuring and given what's -- how the global backdrop is changing or has changed, the expectation to get that business to EBITDA breakeven by '27, is that still in the cards or you're thinking that maybe is a tougher one to hit?"
},
{
"speaker": "Mark Smith",
"content": "Yes. I think overall, relative to our 2030 targets for the total company, we feel like we've had a really good start in 2024 and on track. And we're doing a bit better on the core business and headwinds have come more frequently and more severely to Accelera. So we are committed to significant loss reduction. But right now, we are not on track towards that breakeven, but we do feel we're very much on track for the overall company targets. And that's really the reason why we took more pronounced actions or the Accelera team did in the fourth quarter, recognizing that we're not going to get enormous help from demand here in the near term, Tim. So we're managing what we can and in the context of overall company results, we feel confident, but we are not, right now, on track to get to breakeven as we sit here today."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Kyle Menges from Citi. Your line is now live."
},
{
"speaker": "Kyle Menges",
"content": "Thank you. I was hoping if you could just comment on how you're thinking about R&D spend in 2025 versus 2024, maybe more specifically within Engine and Components. And then just beyond 2025, how you're thinking about that and how we should be thinking?"
},
{
"speaker": "Mark Smith",
"content": "Yes, good question. So I think beyond 2025 is where we should see more momentum to the downside on Engine expense. We did see some improvement through the year in the Engine business. We've got a lot of new product launches, both in Engines and Components in 2025. But after we get through those launches and through 2027, that's definitely part of our margin expansion story in those two businesses, but not a dramatic shift this year, some puts and takes between Engines and Components."
},
{
"speaker": "Kyle Menges",
"content": "Thanks. That's helpful. And then just could you comment a little bit on how you're thinking about the parts outlook for 2025?"
},
{
"speaker": "Mark Smith",
"content": "Yes, Parts held up pretty well, in fact, pretty a little bit better than expected in the fourth quarter across our businesses, and so we think in the range of flat to up 5%. Probably some pricing baked in there. So yes, growing in line with the economy, I would say, at least on par with the economy with what we know today."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Jamie Cook from Truist Securities. Your line is now live."
},
{
"speaker": "Jamie Cook",
"content": "Hi, good morning. Nice quarter. I guess similar question that Tim asked on, I think it was the Components business. Just the margins mark in Power Systems are very good despite sort of what I would call a muted top line forecast. So is that just pricing in some of the new products? And then I guess, how do you think about margin targets relative to the ones you just gave us, I guess, last year? Is it looking conservative? And then my second question obviously, lots of puts and takes around tariffs and who knows what happens. But are there any changes in your -- how your terms and conditions or contracts with your customers that if we do get into an environment where tariffs and that causes price increases, that we're able to absorb costs or increase price more frequently relative to last time within Engines, I guess?"
},
{
"speaker": "Mark Smith",
"content": "Great. So yes, Power Systems doing well. I think continuing to focus on supply chain efficient output. They did a great job last year so I don't want to sound like we're dissatisfied. Quite the opposite, very impressed, but still think there's more to come on raising volume, raising productivity, and a little bit on pricing Power Systems. So all of those things contribute towards raising the margin guidance for the year and quite a bit above the fourth quarter levels. And I guess if we really had a robust U.S. economy, we could see growth in some of the smaller generator sets. We have high market share in some of the consumer segments that are particularly robust. So I guess that -- we don't see signs of that, but if we want to get on to the bullish side and saw more strength in the U.S. economy, that could be another leg to help. On tariffs, by and large, our strategy is to make most of our products in the market in which they're sold. But of course, we do have a global supply chain and we -- of course, nobody knows exactly what the tariff situation is going to be. But to the extent that we do incur them, then we think it's important that the market feels those and we'll look to pass those on. Let's hope that's not significant for everybody involved. But really, we're just focused on controlling what we can control. And I think, yes, we've got secular tailwinds in Power Systems, but the biggest driver is being able to scale growth effectively and pushing out cost. And then you don't see it on the inside but the work we've done inside to try and simplify our structure, improve the speed of decision-making, all of those things help and have helped kind of raise the bar in 2024."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from David Raso from Evercore. Your line is now live."
},
{
"speaker": "David Raso",
"content": "Hi, thank you. I'm trying to better understand the margin expansion in Engines and really, for that matter, of Components. First, the D&A, the growth in the D&A, is that mostly in Engines or Components? It's just the margin improvement is impressive but I'm just wondering it drives it down a little bit because there's more D&A than it is operational, but if you can…?"
},
{
"speaker": "Mark Smith",
"content": "Well, there is an increase in D&A because that's where we're investing most of the capital in North America, particularly in the Engine business over the last couple of years."
},
{
"speaker": "David Raso",
"content": "So of the 100 D&A increase, is it 50 Engines, 25 Components? Just some sense so I can get a better sense of the underlying operation."
},
{
"speaker": "Mark Smith",
"content": "Yes, I mean, it won't be significantly in distribution. Power Systems, whilst we're increasing investment is still modest relative to those 2 segments. And so on an incremental basis, most of it is going to go through Engines and Components, a little bit in corporate, which ends up mostly in Engines and Components, yes."
},
{
"speaker": "David Raso",
"content": "Okay, that's helpful. And then even with that, it looks like there still is some slight operating, let's say, non-D&A margin improvement in Engines. What's driving that? Is it a little bit of mix? Is it -- I'm just trying to think about maybe the new medium engines you're outperforming the market. How to think about those margins versus heavy? Because it's all wrapped in the idea of trying to figure out where do you think Engine margins are as we sort of move out of '25 and people start to pontificate about earnings power in '26 with the prebuy in the Engine division."
},
{
"speaker": "Mark Smith",
"content": "Yes, I think those are all really important questions and will be big contributors to the long-term performance. In the near term, I think we'll continue to expect to do well in the aftermarket side, of which the Engine business is our biggest single driver. So that's probably where there's still some pricing opportunity into 2025. And then yes, the engineering starts coming down enormously, but I think we've come down off the peak there, Components probably going up a little bit. But those would be the main drivers. And as you can see, we haven't factored a lot in from China yet so really, it's cost control and aftermarket in the near term."
},
{
"speaker": "Operator",
"content": "Thank you. Next question is coming from Avi Jaroslawicz from UBS. Your line is now live."
},
{
"speaker": "AviJaroslawicz",
"content": "Hi, good morning, guys. I guess in terms of your guidance for the market outlook for North America heavy-duty trucks this year, it sounds like if, for whatever reason, you don't do a pre-buy materialized this year that you'd expect retail demand may be still to be negative in the second half. So I guess, one, am I interpreting that correctly? And can you just discuss how you're thinking about it?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, I think if you look at the underlying performance in the heavy-duty market, spot rates dropped early in '23, so truckload carriers have really had challenges now for two years, and I think there's a very real chance that we'll see improvement in that over the course of this year, just depending on what the underlying economy and interest rates do. So there's some potential upside in the second half for that in addition to this prebuy phenomenon that we would anticipate would lead to a stronger second half versus first half. The range is quite wide because how high that goes is really dependent on the prebuy and when that starts."
},
{
"speaker": "AviJaroslawicz",
"content": "Got it, okay. And then in terms of medium-duty, just breaking down kind of market share gains versus market growth for 2024. How did those net against each other? And then in terms of your sales guidance for this year within Engines, are we thinking about further share gains this year or not as much?"
},
{
"speaker": "Mark Smith",
"content": "I think really, I think we're talking about following the market in 2025. There's been a long track record of significant market share gains in that market. Our engine is clearly the leader in that market and there were some share gains. But going forwards, it's very much primarily going to be truck in the market, but there can be some modest changes around that from where we are now."
},
{
"speaker": "Jennifer Rumsey",
"content": "There is a buy down for the year, it’s reflective of what we've seen in order made in backlog."
},
{
"speaker": "Mark Smith",
"content": "Yes. It's industry -- the industry orders, we will feel that, yes."
},
{
"speaker": "Jennifer Rumsey",
"content": "From a product perspective, we continue to feel really positive about how our products are performing in the market and our position across medium and heavy duty."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from Rob Wertheimer from Melius Research."
},
{
"speaker": "RobWertheimer",
"content": "Thank you. I had two questions around Power Systems, if I may. And one is, as this data center market continues to develop, historically at least, I suppose, the selling an engine is one thing and then servicing is another. And if you have backup power, it doesn't get turned on that much and it's not as profitable. But obviously, there's a high uptime, high criticality kind of operations. Do you see any opportunity to change that profit algorithm, such that you'll be making more recurring revenue or otherwise on that massive build-out of engines that you're going to do? And then secondly, if I can just wrap it in. You've had excellent results in Power Systems. I'm not sure if all of it's really this surge in data center or maybe the stuff you've touched on a couple of times on the call already, operational improvements. I wonder if you could just expand on how you've made that business better."
},
{
"speaker": "Jennifer Rumsey",
"content": "Sure. So first on the data center market, so with power generation and data centers, we have engine, gen sets, and then a good portion of that business also flows through the distribution business. So the strong performance you see in the distribution business last year and the outlook is reflecting the strength in power generation as well as aftermarket. But as you noted, they don't, today, run a lot for backup power. So typically, Parts revenue is relatively low as we look at shortage of power availability, and how do you meet power demand in the U.S. and around the world. There's a potential for some shift in that. And so strategically, we're considering how we think about our role in that, which was part of the discussion on micro-grids and what we do there today, but today, still very much heavily backup power and because of the high reliability demand for those applications. In terms of the Power Systems performance, we undertook now, two years ago, focused effort to really look at operating performance structure, how we made sure, we were investing in the right products, and getting returns on the investments we were making for our customers, and working through some of the supply challenges that have built up through the pandemic, and then the rebound in the market after that. And so that really has come together at exactly the time when this data center trend has also happened. And so we really had strong underlying operating structure and performance in the business that we continue to drive improvement in, as we're also taking up volumes. And so both of those are contributing to really the remarkable profitability improvement that you've seen in Power Systems."
},
{
"speaker": "Mark Smith",
"content": "Just to add, Rob, the distribution, of course, adds that extra slice of revenue on data centers. And in fact, it's fundamental to winning and supporting this data center business around the world. I think that's one of the strengths we have and a few others have, and that's why you see that the market demand is concentrated amongst a couple of large engine manufacturers like us because of that service capability. But just to underline what you said, Rob, and your intuition, it would be very wrong to attribute Power Systems improvement just to data centers. That's a journey that's still got legs left but tide -- the performance level has been elevated across that segment, including in the alternator business, which supplies across -- really across that supply chain. So we're incredibly pleased with the way that business has improved."
},
{
"speaker": "Operator",
"content": "Thank you. Our final question today is coming from Tami Zakaria from JPMorgan."
},
{
"speaker": "Tami Zakaria",
"content": "Hi, good morning. Thank you so much. So the distribution segment guide, the 2% to 7%, it seems quite healthy. Given the underlying truck market outlook, are you able to comment on the core distribution outlook versus the power generation-related services? The reason I ask, if power generation demand holds at these levels, it seems like distribution could see another double-digit growth year in 2025. So any comments there would be helpful."
},
{
"speaker": "Mark Smith",
"content": "Yes. I think you're typically seeing Parts growth maybe slightly above the rate of economic growth. And then in this cycle, you're right, the power generation demand in data centers and in some other applications has really provided that extra leg. So I would say in the short run, yes, power gen will be the main swing factor. I would say that some of the other segments, mining, oil and gas, if we look beyond this year, we'd expect to see more growth in the future. There's not enormous momentum in those businesses, but they're also important end markets for distribution. One of the reasons that we like distribution; it generates a lot of cash. It's less volatile than other parts of the business and have that really strong aftermarket piece, which doesn't get the extraordinary growth rates that underpins the kind of year-to-year level of performance. So yes, distribution is doing well. And hopefully, the global economy strengthens and then all of our businesses will do well."
},
{
"speaker": "Tami Zakaria",
"content": "Got it. That's very helpful. And then one follow-up question on that comment that you expect some pre-buy in the back half, but the timing is uncertain. I'm curious what pre-buy lift is embedded in the current heavy-duty and medium-duty outlook for North America? I'm just trying to understand what the market could look like, let's see, if there is no pre-buy."
},
{
"speaker": "Mark Smith",
"content": "There are so many factors at play, but that's one of the factors we believe can help. We're going to start off at a fairly modest level in the first quarter. Although orders here yet in the fourth quarter of '24 were a little better than expected, I would say, but it's really, we're anticipating that strength in the second half to come somewhat from demand ahead of the regulations and understanding of how flexible the supply chain is for that industry. Again, I think we've all got fairly consistent views of the market at this point and we'll see how it plays out. A big factor, of course, is going to be the strength of the U.S. economy and spot rates and freight activity. All these factors weigh in. The main thing to know is we've got a stronger second half in heavy-duty truck built into our forecasts. Q1, yes, is going to probably be the low point of the year with what we expect right now. The question is, will we get the improvement in the second half?"
},
{
"speaker": "Operator",
"content": "Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back over for any further closing comments."
},
{
"speaker": "Chris Clulow",
"content": "Thank you, everyone, for joining our teleconference today. That concludes the question-and-answer session. As always, the Investor Relations team will be available for questions after the call. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's teleconference webcast. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today."
}
] |
cmi | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Q3 2024 Cummins Inc. Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Chris Clulow, Vice President of Investor Relations. Thank you. You may begin."
},
{
"speaker": "Christopher Clulow",
"content": "Thanks, Julian. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the third quarter of 2024. Participating with me today are Jennifer Rumsey, our Chair and Chief Executive Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures, and we'll refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website within the Investor Relations section at cummins.com. I will now turn you over to our Chair and CEO, Jennifer Rumsey to kick us off."
},
{
"speaker": "Jennifer Rumsey",
"content": "Thank you, Chris, and good morning. I'll start with a summary of our third quarter accomplishments and financial results. Then I will discuss our sales and end market trends by region. I will finish with a discussion of our outlook for 2024. Mark will then take you through more details of both our third quarter financial performance and our forecast for the year. Before getting into the details on our financial performance, I want to take a moment to highlight a few major accomplishments from the third quarter. In September, we started full production of our X15N natural gas engine at our Jamestown Engine plan, which is the first version of our 15-liter helm platform to launch in the U.S. the X15N delivers performance, durability and power required in a variety of applications and is an excellent alternative for fleet looking to significantly reduce their carbon footprint. This is an important milestone in the execution of our Destination Zero strategy as we work to reduce the impact of our products today while investing in cleaner power solutions for the future. Some of North America's largest and most demanding heavy-duty fleets are actively engaged with Cummins, following their own tests of the natural gas engine in the field. For example, UPS has purchased 250 Kenworth X15N powered trucks in a move the company highlights as an important part of decarbonizing its ground fleet. Cummins had the opportunity to further showcase our Destination Zero strategy in action through our diverse portfolio of power solutions at the recent IAA transportation event in Hannover, Germany. At this event, we displayed our fully integrated powertrain concept featuring our helm engine platforms and e-components. I also personally had an opportunity to hear feedback from Cummins' customers on the challenges they are experiencing with their decarbonization strategies. Common remains confident that our customers' needs will not be met with a single solution. And this event was a great opportunity to further demonstrate that Cummins and Accelera have the right components in our portfolio to provide the necessary solutions for our customers and their needs as they evolve over time. In addition, in October, Accelera by Cummins celebrated the opening of its electrolyzer manufacturing plant in Spain. The plant has a capacity to produce 500 megawatts of electrolyzers per year, scalable to more than 1 gigawatt per year in the future. The sustainably designed facility is expected to create 150 highly skilled jobs in the region with the potential to reach 200 jobs as production grows, and will help scale up development, manufacturing and adoption of zero emissions technologies in Europe. Lastly, I'd like to express that our hearts are with those who were impacted and are still recovering from Hurricanes Helene and Milton here in the U.S. We are grateful that our employees in the impacted areas are all accounted for and safe. While we did see minor impacts in our third quarter financial results, I'm proud of how our Cummins employees rallied together to help impacted employees, communities and facilities, and respond to this tragedy while minimizing disruption in our industry. Now I will comment on the overall company performance for the third quarter of 2024 and cover some of our key markets, starting with North America, before moving on to our largest international markets. Demand for our products remains strong across many of our key markets and regions, offset by softening in the North America heavy-duty truck market that was in line with our expectations. Sales for the quarter were $8.5 billion, flat compared to the third quarter of 2023, primarily driven by continued high demand in our global power generation markets and improved pricing. This was offset by lower North America heavy-duty truck volumes and the reduction in sales from the separation of Atmus. EBITDA was $1.4 billion or 16.4% compared to $1.2 billion or 14.6% a year ago. Third quarter 2023 results included $26 million of costs related to the separation of Atmus. EBITDA and gross margin dollars improved compared to the third quarter of 2023 as the benefits of higher power generation volumes, pricing and operational efficiency more than exceeded the reduction in margin from the Atmos separation. Our third quarter revenues in North America declined 1% to $5.2 billion as a softening heavy-duty market, lower light-duty volumes and a reduction in sales from the Atmos separation were mostly offset by strong demand in the medium-duty truck and power generation markets. Industry production of heavy-duty trucks in the third quarter was 68,000 units, down 10% from 2023 levels, while [indiscernible] unit sales were $25,000, down 14% from a year ago. Industry production of medium-duty trucks was 41,000 units in the third quarter of 2024, an increase of 12% from 2023 levels, while our unit sales were 38,000, up 18%. We shipped 28,000 engines Vistalantis for use in the RAM pickups in the third quarter of 2024, down 31% from 2023. Revenues in North America Power generation increased by 18%, driven by continued strong data center and mission-critical power demand. The impressive power generation performance in North America and across the globe helped us achieve record sales and profitability in the Power Systems segment. Our third quarter international revenues increased by 2% compared to last year. Third quarter revenues in China, including joint ventures, were $1.5 billion, a decrease of 4% as weaker domestic truck and construction volumes were partially offset with higher data center demand. Industry demand for medium heavy-duty trucks in China was 207,000 units, a decrease of 15% from last year. Demand in the China truck market continues to run at low levels with continued weak domestic diesel market and now softening natural gas orders as the diesel gas price differential narrows. The light-duty market in China was down 4% from 2023 levels at 424,000 units, while our units sold, including joint ventures, were 30,000, an increase of 14%. Industry demand for excavators in China in the third quarter was 44,000 units, an increase of 10% from 2023 levels. Our units sold were 8,000 units, an increase of 14% as a result of QSM 15 penetration of both new and existing OEM partners and export growth. Sales of power generation equipment in China roughly doubled in the third quarter, primarily driven by continued growth in data center demand. Third quarter revenue in India, including joint ventures, was $641 million, a decrease of 12% from the third quarter a year ago. Industry truck production decreased by 12%, while our shipments decreased by 18%, driven by a slowdown in manufacturing and government infrastructure spending. Power generation's revenues increased 49% year-on-year, driven by prebuy demand for stationary power out of the CPCB4 emissions regulation changes as well as increased data center demand. Now let me provide our outlook for 2024, including some comments on individual regions and end markets. Our revenue outlook for 2024 remains consistent with our prior guidance of down 3% to flat. We are improving our overall EBITDA guidance for the year to be approximately 15.5%, the top end of our prior guide of 15% to 15.5%. We now expect higher revenue and stronger profitability in our Power Systems and Distribution segments, offsetting lower revenue and profitability expected in our Components segment. We are maintaining our forecast for heavy-duty trucks in North America to be 255,000 to 275,000 units in 2024. In the third quarter, we saw industry demand softening in line with our expectations, and we continue to expect further softening in the fourth quarter. In the North America medium-duty truck market, we are also maintaining our forecast to be 150,000 to 160,000 units, flat to up 5% from 2023 as we continue to benefit from an elevated backlog and strength of vocational orders. Consistent with our prior guidance, our engine shipments for pickup trucks in North America are expected to be 135,000 to 145,000 units in 2024, with the planned model year changeover likely to drive sharp, but temporary production decline in the fourth quarter. In China, we project total revenue, including joint ventures to decrease 4% in 2024 as a continued weak domestic diesel truck market is partially offset by higher power generation demand. While we have not yet seen a material impact from the recent stimulus actions, we are encouraged that the emphasis on demand side policies is a positive step forward to build economic momentum in China. In India, we project total revenue, including joint ventures, to increase 1% in 2024, primarily driven by strong power generation demand, which is offsetting lower on-highway demand. We expect industry demand for trucks to be down 5% to up 5% for the year. For global construction, we project down 10% to flat year-over-year, consistent with our prior guidance due to weaker demand in China. We are maintaining our guidance for global power generation markets to be up 15% to 20%, driven by continued increases in the data center and mission-critical markets. Sales of mining engines are expected to be down 5% to up 5%, also consistent with our prior guidance. For aftermarket, our guidance remains at flat to up 5% for 2024, with some softening in rebuild demand expected in the fourth quarter. In summary, we are maintaining our guidance on sales of down 3% to flat and improving our EBITDA guidance to be approximately 15.5%. Our performance in the third quarter, particularly in our Power Systems and Distribution segments resulted in strong profitability despite a softening North America heavy-duty truck market. While we do expect continued softening in several of our key markets in the fourth quarter, we are committed to delivering strong financial performance and returning cash to our shareholders. During the quarter, we returned $250 million to shareholders in the form of dividends, consistent with our long-term plan to return approximately 50% of operating cash flow to shareholders. I continue to be grateful for the commitment of our employees and leaders around the world who are delivering for our customers while also achieving strong financial performance. Our impressive third quarter results and improved full year guidance continue to demonstrate that we remain well positioned to invest in our future growth, bringing sustainable solutions to decarbonize our industry and improve financial performance cycle over cycle. Now let me turn it over to Mark."
},
{
"speaker": "Mark Smith",
"content": "Thank you, Jen, and good morning, everyone. We delivered strong revenue and profitability in the third quarter. Given the strength, we are maintaining our full year revenue guidance and have increased our expectations for EBITDA percent to be at the top end of our prior guidance range. Third quarter revenues were $8.5 billion, flat from a year ago as organic growth offset the reduction in sales driven by the separation of Atmus. Sales in North America decreased 1%, while international revenues gained 2%. Foreign currency fluctuations negatively impacted sales by 1%. EBITDA was $1.4 billion or 16.4% of sales for the quarter compared to $1.2 billion or 14.6% of sales a year ago. That those year ago numbers included $26 million of costs related to the separation of Atmus. The benefits of pricing, strong operational efficiency and the absence of the Atmus separation costs were the primary drivers behind the improved profitability. Now let's look at each line item in a bit more detail. Gross margin for the quarter was $2.2 billion or 25.7% of sales compared to $2.1 billion or 24.6% last year. The improved margins were primarily driven by favorable pricing, which varied across our different segments, and operational improvements. Selling, admin and research expenses were $1.2 billion or 13.8% of sales compared to $1.2 billion or 14.3% last year, which included costs related to the separation of Atmus. Joint venture income of $99 million decreased $19 million from the prior year, primarily driven by lower technology fees in our engine business, costs incurred in the start-up of the AMPLIFY Cell Technologies, our battery cell joint venture, which is reported within Accelera and was formed last quarter. Other income was $22 million, an increase of $29 million from a year ago or improvement, driven by mark-to-market gains on investments related to company-owned life insurance. Interest expense was $83 million, a decrease of $14 million from prior year, primarily due to lower weighted average interest rates. The all-in effective tax rate in the third quarter was 19.2%, including $36 million or $0.26 per diluted share of favorable discrete items. All in, net earnings for the quarter were $809 million or $5.86 per diluted share compared to $656 million or $4.59 per diluted share in 2023. EPS benefited from the increased earnings and also a lower share count resulting from the tax-free share exchange associated with the separation of Atmus that was completed in the first quarter. All-in operating cash flow was an inflow of $640 million. Year-to-date operating cash flow was an inflow of $65 million, which included $1.9 billion of payments required by the previously disclosed settlement agreement with the regulatory agencies. Excluding the settlement, third quarter year-to-date operating cash flow was $2 billion compared to $2.5 billion in the first 9 months of last year. The lower operating cash flow this year is primarily due to higher inventory. We do expect to see stronger operating cash flow in the fourth quarter this year. I'll now comment on segment performance and our guidance for 2024. As a reminder, guidance for 2024 includes the operations of Atmus in our consolidated results up until the full separation, which occurred on March 18. Components revenue was $2.7 billion, a decrease of 16% from the prior year, while EBITDA decreased from 13.6% of sales to 12.9%, driven primarily by the dilutive impact of the Atmus separation and a weaker heavy-duty truck market in North America. Several facilities within our Drivetrain and Braking Systems business in North Carolina were impacted by Hurricane Helene at the end of Q3, disrupting production and causing us to record some costs in our third quarter results. Our employees have shown incredible resilience in extremely challenging circumstances and are working very hard to raise production levels. For Components, we expect 2024 full year revenues to decrease 12% to 15%, a decrease of 2% from the prior guidance at the midpoint, and EBITDA margins in the range of 13.3% to 13.8%, lowering the range from our previous guide of 13.7% to 14.2%. For the Engine segment, third quarter revenues were $2.9 billion, a decrease of 1% from a year ago. EBITDA was 14.7%, an increase from 13.5% a year ago due to operational improvements and positive pricing, including a retroactive pricing agreement in our light-duty business that was finalized within the third quarter. The benefits from pricing and lower operating costs more than offset weaker North American heavy-duty truck volumes. In 2024, we project revenues for the Engine business to be down 2% to [ 1% ], narrowing the range of the prior guidance, and EBITDA to be in the range of 13.7% to 14.2%, consistent with our communication last quarter. In the Distribution segment, revenues increased 16% from a year ago to a record $3 billion, driven by increased demand for power generation products particularly for data center applications. EBITDA increased as a percent of sales 12.5% compared to 12.1% a year ago, primarily due to higher volumes and pricing. We now expect 2024 Distribution revenues to be up 8% to 11%, an increase of 2% at the midpoint from our prior guidance, primarily due to stronger power generation markets. EBITDA margins are now expected in the range of 11.5% to 12%, also up from our previous guide of 11.3% to 11.8%. Results for the Power Systems segment set another new quarterly record. Revenues were $1.7 billion, an increase of 17%, and EBITDA increased from 16.2% to 19.4% of sales, driven by higher volumes, particularly in the power generation markets, improved pricing and other operational improvements. In 2024, we expect Power Systems revenues to be 8% to 11%, an increase of 4% at the midpoint from our prior guide. EBITDA expectations have also increased to approximately 18.3% to 18.8%, up from 17.75% at the midpoint of the prior guide. Accelera revenues increased 7% to $110 million, driven by increased electrolyzer installations. Our EBITDA loss was $115 million compared to a loss of $114 million a year ago as we continue to invest in the products and capabilities to support those parts of the business where strong growth is expected while reducing costs in areas where we assess the prospects for growth have extended into the future. In 2024, we expect revenues to be in the range of $400 million to $450 million and net losses to be in the range of $400 million to $430 million, both unchanged from last quarter. As Jen mentioned, given the strong performance in the third quarter particularly in Power Systems and Distribution, we're improving the full year company guidance for profitability. We still project 2024 company revenues to be down 3% to flat. Company EBITDA margins are now expected -- projected to be approximately 15.5%, which is at the top end of our prior guidance range. Our effective tax rate is expected to be approximately 23.5% for the full year 2024, excluding the tax-free gain related to Atmus and other discrete items, and down from our prior guidance of an expected tax rate of [ 24 ]. Capital investments will be in the range of $1.2 billion to $1.3 billion, consistent with our prior guidance. In summary, we delivered strong sales and record profitability in the third quarter of 2024. We will experience moderation in some markets in the fourth quarter, most notably North America heavy-duty truck. We have updated our projection for EBITDA to the high end of the prior guidance range due to strong execution, particularly the projected record full year EBITDA in Power Systems and Distribution. We took some steps to reduce costs in the fourth quarter of 2023 and the first quarter of 2024, continue to identify ways to streamline our business going forwards, leaving us well positioned to navigate any further economic cyclicality. We are on track to continue our trend of raising performance cycle over cycle whilst continuing to invest in the future. And that's encouraging given that this is projected to be a down year for North American heavy-duty truck production. Our priorities for the remainder of this year for capital allocation remains to reinvest for profitable growth, pay out our strong cash dividends and support our strong credit rating. Thanks for your interest today. Now let me turn it back to Chris."
},
{
"speaker": "Christopher Clulow",
"content": "Thank you, Mark. Now we'll begin our question-and-answer session. [Operator Instructions] Operator, we're ready for our first question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from Steven Fisher, UBS."
},
{
"speaker": "Steven Fisher",
"content": "Congrats on the beat and raise. It's hard to find those in machinery world these days. Nevertheless, I think there were some investors that were a little concerned that maybe the Q4 guidance looks a little conservative after the strong Q3. I don't know how much of that is related to the storm impact in Components. But I guess the bigger picture question here is, even though it's maybe a little early, do you think there are enough positives to offset the rest of the downturn that we have in the heavy-duty truck market, however long that may last to keep EBITDA growing over the next year?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So let me just comment first, Steve. Thanks. Great to hear from you. Let me comment a little bit on the fourth quarter and what we expect. There's really 3 factors that I'd point to in the revenue guide for fourth quarter. We expect further softening in the heavy-duty market. I talked about the product changeover with [indiscernible] that will drive further volume reduction in that pickup truck business. And then just working days with year-end will be fewer, and we see across many of our markets, fewer working days associated with the holidays and normal maintenance and [indiscernible] during that period of time. So those are really the factors. As you can see, we're -- the team has done a great job of continuing to focus on profitability across the business, delivering strong decremental margins where we've seen reductions in heavy-duty, which takes a lot of effort. I just want to acknowledge the great work of the team and then leveraging some of the places that we have strength with really strong performance, of course, power gen that impacted Power Systems and DB. And we expect that to continue as we go into next year."
},
{
"speaker": "Steven Fisher",
"content": "Okay. And maybe just building on that last part there, I mean, how would you describe the momentum in Power Gen right now? I mean, is that new record revenues in the quarter? You're sold out on the 95 liters. Where are you on the capacity utilization on 50 and 78? What's driving the further upside from here? Is it mainly pricing? Or can you kind of push out more volumes?"
},
{
"speaker": "Jennifer Rumsey",
"content": "It's really both. So over the course of this year, we've worked on strategic pricing and offsetting some of the inflationary costs that we've seen and pricing for value in that business. And we've been working on capacity in the supply base and our own operational improvements and launching the new [indiscernible] product. So all of those things have given us improvement over the course of the year. 95-liter is at capacity, but we've been able to increase capacity through these improvements by about 30% on that product in '24 of the new products. And then as we talked about previously, we are investing right now to double capacity in the 95-liter. That will come online late next year as we go into '26. We don't see any end in sight in terms of demand in that market. We're the rebuilds up on the 95-liter out the [ '27 ]. So really focused on how do we leverage the capacity we have now, investment we have now while we're bringing more online late next year."
},
{
"speaker": "Mark Smith",
"content": "And I think, Steve, the only thing I'd add to your first question is, we're not -- we're building our plans with a relatively modest start on heavy-duty truck to the first half of next year with what we see right now. So hear your comments and questions, and we're very focused on kind of managing through the cycle."
},
{
"speaker": "Jennifer Rumsey",
"content": "I will say, I mean, in terms of the impact of Helene and Milton, we're back to regular operation in that business and trying to just work through some of the backlog that built up during the period that we were most severely impacted, but it's been a really tremendous effort by the team there. We have multiple facilities in the Western North Carolina region within Cummins Drivetrain and breaking systems that have been dealing with the impact of that working."
},
{
"speaker": "Operator",
"content": "Our next question comes from Angel Castillo, Morgan Stanley."
},
{
"speaker": "Angel Castillo Malpica",
"content": "Congrats on a strong quarter. Just wanted to dive a little bit deeper into some of the dynamics that are maybe impacting the next couple of years. I saw some headlines around maybe the California Omnibus low NOx regulation, and some states maybe delaying the kind of model year '25 to maybe model year '26 type enforcement. Just any comments or maybe read-throughs to what maybe that tells you about the underlying kind of enforcement of those regulations and the potential for kind of prebuy into '25, just any broader read-through to maybe or just industry demand for your engines?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean what we've seen, of course, this year is the [indiscernible] bus regulations have gone into place. As we get into '27, we see commonization again between EPA and CARB, which we believe is a positive for the industry. What happens between now and then in terms of different states following those CARB regulations, as you noted some have pushed out, it's a little bit difficult to predict. But certainly, you see lower volumes this year in CARB even with some of the flexibilities that they've put in place to sell 200-milligram NOx product and strong demand nationwide. And so we're watching that space closely. I would say, overall, as Mark noted, we're projecting softening as we go into next year in the heavy-duty truck market and then still anticipating, depending on economic conditions, the prebuy likely starting at some point during '25 ahead of the '27 regulations."
},
{
"speaker": "Angel Castillo Malpica",
"content": "That's very helpful. And then just wanted to circle back on the prior question around 2025 for power generation. I think you indicated you kind of see growth in power systems and momentum continuing there. Just curious, it seems like your power generation guide of 15% to 20% was unchanged despite continued strong performance there. Can you talk about 2025, just early indications based on your backlog? Should we anticipate kind of that 15% to 20% type growth to persist into next year? Or how do you kind of see that based on kind of pricing and backlog indications today?"
},
{
"speaker": "Jennifer Rumsey",
"content": "I mean, really that demand in that market is going to remain strong. So it's all about what we can do in terms of capacity and managing our supply base."
},
{
"speaker": "Mark Smith",
"content": "And that's one of the factors that gives us confidence going at the start of the year, that strong backlog and then, of course, distribution should be -- continue to be pretty resilient absent a big economic shock."
},
{
"speaker": "Operator",
"content": "Our next question comes from Kyle Menges, City."
},
{
"speaker": "Kyle Menges",
"content": "I was hoping I noticed within Power Systems, the Industrial portion actually pretty strong growth in the quarter despite certainly some competitors not showing great results in mining this quarter. So just would love to hear kind of what's driving that reacceleration and growth in that industrial portion and just how you're thinking about that into 4Q and into 2025?"
},
{
"speaker": "Jennifer Rumsey",
"content": "I mean, overall, our guidance is pretty flat in the mining market. We've seen some rebuilds demand that you're seeing in those results, but really not significant shifts in that market right now."
},
{
"speaker": "Christopher Clulow",
"content": "Yes. I think overall, Kyle, I'd just add, yes, the mining is really the key market for us in the industrial side, as you know, and that has remained pretty resilient from our perspective, where it's moved a little down the world. We've maintained a pretty good both in the first-fit side as well as in the aftermarket, which drives the rebuild."
},
{
"speaker": "Mark Smith",
"content": "Don't overread in one quarter it."
},
{
"speaker": "Kyle Menges",
"content": "Got it. And then just a follow-up on Power Systems. -- looks like with the new guidance going to be doing incrementals of about 60% in 2024. So it would be helpful if you could frame just how we might think about incremental margins in that segment and in 2025? And I guess why wouldn't it be kind of close to 40% to 60% again? And what factors maybe could cause weaker incrementals next year for that..."
},
{
"speaker": "Mark Smith",
"content": "I do get a use of pushing the Power Systems business a bit hard, so I'll probably stay off the 40% to 60%, but here's what I'd say. Part of the improvement was really a reprioritization and cost kind of reset at the start of this journey, which has really been going on for a couple of years now. So you get that benefit early on, and then there's been a lot more focus on pricing capacity and efficient capacity improvements. So yes, we still think there is more to come on the top line and the bottom line. I don't think we can continue to expect 40% to 60% incremental margins. We will provide specific updates here in February. But with what we know today, we would expect more improvement going into next year."
},
{
"speaker": "Operator",
"content": "And our next question comes from Jerry Revich, Goldman Sachs."
},
{
"speaker": "Jerry Revich",
"content": "I'm wondering if you folks can just expand on the margin performance in engine, really outstanding results in the third quarter. The guidance implies margin expansion in the fourth quarter on lower sales. You mentioned operating efficiencies in the prepared remarks. Can you just expand on where those efficiencies are versus pre-COVID levels? And it feels like there's momentum into '25 even if demand is softer, just given where the exit rate looks to be in the fourth quarter versus the cost structure in the first. But I'm wondering if you could just expand around those points, if you don't mind?"
},
{
"speaker": "Mark Smith",
"content": "Yes. I think there's been a lot of improvement pre-COVID, no doubt about that, but we're still not all the way back to those kind of 2019 operating levels. So I still think there's more room to come on operational efficiencies. And then we've talked about kind of being at the peak part of this investment cycle. Of course, the strong medium-duty demand has really helped in this environment and our positions continue to strengthen there. So that's really helped. And whilst we have flagged, and it is going to happen, there is going to be short, but sharp reduction in pickup truck engine production in the fourth quarter, we view that as largely temporary. And I think that with all the information we have today that that's going to resume. So I think the top line will face some first half year pressure on heavy duty relative to the first half of this year, but yes, continuing to focus on operating costs. I mentioned briefly in my remarks that we've really been making adjustments to our organization structure and costs since for the fourth quarter of last year. And whilst that hasn't been dramatic in any period, I think that helps set us up well going into next year. Just so you didn't miss it, I did point out not to make a huge deal, but we did get some extra pricing, which helped in the third quarter that was retroactive back to the start of the year. So we won't get all of that again in the fourth quarter, but nevertheless, I think the cost base, the operational efficiencies, maybe not in the short term, but maybe in the medium term, we get some boost from China as well because our earnings are okay, but far from what the full potential of China is in the engine business. So I think there's a lot to look forward to, but the exact timing of earnings accelerating the engine business isn't clear yet. So we've kind of got to focus on the cost and efficiency certainly through the next 9 months."
},
{
"speaker": "Jerry Revich",
"content": "Super. And can I shift gears and ask about the natural gas engine demand now that you've opened up a full rate production. Can you just update us on your expectations of natural gas share in the market 6 to 12 months out based on the demand and the performance of the production ramp that you alluded to in the prepared remarks, please?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean we've said that we think we could get up to a -- potentially 8% share in the market with the natural gas product. We had several big fleets that we're testing it during development. And I noted the [indiscernible] UPS has played. So how they start to ramp up volume, get increasing confidence in the strong performance and efficiency. Fundamentally, in most places, it can provide, not only a reduction in CO2 for fleets that want to lower the CO2 footprint, but also reductions in operating costs because of the fuel price differential between natural gas and diesel. And so fleets that are interested in pursuing that, I think over time, we'll ramp up a target for me to exactly predict because it also depends on some of the economic conditions that are impacting [indiscernible] today of what that will be over 12 months. But we're excited to have that product out now with Kenworth and Daimler will be launched as well in '25. So they'll be positioned with that in the market also."
},
{
"speaker": "Operator",
"content": "And our next question comes from Jamie Cook, Truist Securities."
},
{
"speaker": "Jamie Cook",
"content": "Nice quarter. I guess my first question, you guys have talked about adding capacity on the large engine side. One of your peers came out last quarter and talked about adding even additional capacity in large engines because of demand. So I'm wondering if you're making any changes to your capacity increase that you've talked about historically? And then to what degree do -- how much incremental capacity are you adding that could potentially benefit 2025? And then my follow-up question, Mark. Again, I know someone asked the questions on Q4 versus Q3 margins, and there's an implied step down, but how much was that repricing that you talked about that helped the engine business that maybe we view as onetime? And then within Components, how much of an impact was the hurricanes?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Thanks, Jamie. I'll take the first one and let Mark take the second one. So over the course of this year, what you've seen is new products for power generation, capacity within the constraints of the equipment and our supply chain that we have today going up about 30% on the 95-liter. And so that, of course, is going to carry over into next year. And the mantra and power systems right now is just one more, and how do we continue to squeeze every shift, every day, one more out of what we have within our current constraints. And so we'll continue to focus on that and then, of course, working to try to get that doubling of capacity for the 95 by next year. We're continuing to look at it. We want to be smart about where we can make reasonable investments to take capacity up further where we see strong market conditions. So nothing really specific to say right now, but just that we're continuing to look at our footprint and where there may be opportunities."
},
{
"speaker": "Mark Smith",
"content": "On the second part, the first thing I said, we're going to get natural -- I will answer the specific questions you Jamie. I just want to share that we're going to get natural variations from quarter-to-quarter, but I just want to remind that we're very focused on the cost side, on the efficiency side, of course, getting value for the products, which are helping our customers be successful is also important. So yes, the the kind of retroactive element of the pricing was about 50 basis points ballpark for the company in the quarter. There is a go-forward benefit just not as much as that. And then the costs you're talking you're talking low tens of millions of dollars between components and the elimination segment where we incurred some costs for the impacts of Hurricane Helene. So there are puts and takes. There are some positives, there are some negatives in the results. I think the revenue guide, you can see we haven't changed because we are very clear the heavy, medium and pickup truck production and the way that the very well-run customers like to work is to have predictability around the production level. So I think the revenue is well pinned. And I think the key for us is maintaining this strong cost and efficiency discipline as we go into next year and continue to focus on preparing ourselves for more demand and growth in the future and raising these margins as we set out at the Analyst Day and generating more cash, that's a big focus."
},
{
"speaker": "Operator",
"content": "Our next question comes from Tami Zakaria, JP Morgan."
},
{
"speaker": "Tami Zakaria",
"content": "Good morning. Thank you so much. So I sort of adding one more question on incremental margin because I think it's really the start of your performance in recent quarters. So when I look at your incremental margin in the third quarter, it's almost 50% ex the filtration separation, which is quite impressive versus a long-term target of over [ 25 ]. So do you believe your incremental margin target can move up for the long term given the pargeneration product success, engines are seeing some retroactive pricing as well it seems and you have a lot of new products coming in, in the next couple of years. So would you consider revisiting your long-term incremental EBITDA margin target as you begin next year?"
},
{
"speaker": "Mark Smith",
"content": "I don't think -- I think we'll give guidance just for the year, and then we'll see how we do. There's a lot of moving parts to our portfolio. Of course, we're feeling like we've done a pretty good job in our core business. Since we had our Analyst Day, incrementally, there have been more headwinds to the Accelera side of the business. But overall, we're pleased with this year. Let's focus on finishing strong for this year. We'll give you our full guidance with all its technicolor when we get to February. So I appreciate the question, but today, we're not going to talk about longer-term targets."
},
{
"speaker": "Operator",
"content": "Our next question comes from Rob Wertheimer, Melius Research."
},
{
"speaker": "Robert Wertheimer",
"content": "Just a clarification. On the retroactive pricing, I wonder if you can describe what that is or how much continues? And more fundamentally, whether that indicates that you have any enhanced pricing power through engines, if that was something new and different and then I have a more substantial question after that."
},
{
"speaker": "Mark Smith",
"content": "I don't think we should read anything into it other than it's been a protracted discussion. It's back to January 1 Rob. So that's just sometimes things take a while to resolve."
},
{
"speaker": "Christopher Clulow",
"content": "Yes. As a reminder, Rob, that's in our light-duty space. So it was more localized there."
},
{
"speaker": "Robert Wertheimer",
"content": "Perfect. Okay. That helps a lot. Just more fundamentally, obviously, you and largest competitor in large engines are seeing a lot of demand, and your customers must be telling you that you have a big role to play years and years ahead. Is it very clear that even the biggest hyperscale data centers will use RESIP engines on backup. I wonder if you can just talk about what your customers are telling you about the changing sort of design and scope and scale of data centers and where you fit in for the next decade to come?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, I think at this point in the next decade, we think reciprocating engines are going to be the solution for backup power. Of course, they're looking at different potential options for prime power and evaluating what that looks like, but other technologies that we might use from from a lead time cost, reliability, it's hard to match what a diesel gen set can do for backup power. So we really think that's going to be a solution for some time."
},
{
"speaker": "Operator",
"content": "And our next question comes from David Raso, Evercore."
},
{
"speaker": "David Raso",
"content": "Back to the prebuy question, I know we're sitting here on election day, so curious to get your thoughts if anything around the election could alter your thoughts around..."
},
{
"speaker": "Jennifer Rumsey",
"content": "I'm surprised you made it this far without that question, David."
},
{
"speaker": "David Raso",
"content": "Make sure if you could answer the timing of your introduction of a '27-compliant engine, can you take us through your thoughts around that, the idea of maybe introducing that early, building some credits? Obviously, the nat gas engines already are providing some credits as well. Can you just take us through how you're thinking about the timing of your introductions? And obviously, woven within that, anything you want to comment on on whoever wins the White House and Congress how that impacts your thoughts?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, at the end of the day, Cummins is going to do what we've always done. We're going to work across party lines and engage on issues that are important for our business and our industry, and we'll do that. We've done that with the bid administration of the pass administration will do with the next administration. And what's really important to us and our industry is having that regulatory and legislative stability. And we do not expect any change regardless of the outcome of the election on the [ '27 ] regulations for our industry. So as we have in the past, we're really -- we have a history of being first into the market with products that comply with new regulations and deliver increased value to our customers, and we're always focusing on the landscape, what's the right product at the right time, how do we take -- consider regulatory flexibility and credits as a part of that strategy. And given all that, we do intend to launch the diesel version of the 15-liter helm platform in '26 ahead of the '37 regulation. And with that launch, not only deliver a lower NOx product into the market, but also one that had significant improvement in fuel efficiency and operating costs to decline to 7% efficiency improvement in that product that will deliver value to our customers and then looking to how do we further strengthen our position in that market through these regulatory changes. And this is really consistent with our past strategy, and what's worked well for Cummins over the years is delivering value to our customers through these regulatory changes and strengthening our position in the market. So that's our intention. We've got the 15-liter natural gas out now. We'll add a diesel version of that in '26 and then launch our midrange products at the start of '27."
},
{
"speaker": "David Raso",
"content": "The early introduction of the I assume you were thinking first quarter '26 with the new model years. Can you help us though, it appears in the channel there is some sense that there might be a prebuy of your engines in 25 to get in front of that early '26 introduction. Can you help us a bit, a, is that maybe helping some of the truck orders we're seeing in the industry? I mean you are 40% of the trucks out there. So prebuying cummins would impact total industry numbers pretty meaningfully. And the cost of the new '27 engine coming out early in '26, can you give us some sense of the cost to the customer? And the follow-up will be, how much is the warranty versus the components? I'm just trying to get a sense how much you're bring all '27 costs into '26. It's a case of..."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So let me try to frame it to hope you're thinking that, of course, the specifics on pricing, we're still discussing that with customers, the exact timing and transition between the current and the next-generation 15-liter in '26, we're still in discussions with our customers. So I'm not going to give exact answers there. What I will say is that we are adding meaningful engine and aftertreatment content and technology to both comply with the lower NOx regulation as well as deliver better fuel efficiency and operating cost and value to our customers. And that will be added as we launch this new product in '26. The requirement for a longer emissions warranty does not take effect until '27. So customers that buy this this new high-efficiency market-leading products in '26 will not be [indiscernible]."
},
{
"speaker": "Operator",
"content": "Our next question comes from Noah Kaye, Oppenheimer."
},
{
"speaker": "Noah Kaye",
"content": "And related to this transition, I guess, is probably one of the biggest R&D investments the company has ever made. So as we start to kind of get past that. Can you maybe think -- help us think about the direction of R&D spend? It seems like maybe an obvious place to get leverage on future growth. But you did $1.5 billion of spend in '23, going to be around that range for '24. How should we think about that level of spending going forward?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean you've got it. We're investing at a record level, high level with these new platforms that we're bringing into the market. We think those will position us well for the future. And so you'll see some normalization of that. Now the exact shape of that is going to depend, frankly, on how regulations evolve and what the -- what I call the bridge period of technology looks like and how that transitions to zero emissions. But we'll see that coming off of our peak as we get past the '27 product launches, and we'll continue to be investing in R&D to create differentiation and value in the market to grow the business over the long term."
},
{
"speaker": "Noah Kaye",
"content": "So if you're launching next -- late next year -- or sorry, I think you said '26, then implies we'll start to back down on those peaks."
},
{
"speaker": "Jennifer Rumsey",
"content": "[indiscernible]"
},
{
"speaker": "Noah Kaye",
"content": "Okay. And then just sort of switching gears -- can you characterize the durability of strength in medium duty. I think the 6 and 7 classes have done pretty well. There's still some backlog there. but just talk about the demand you're seeing now in the market and whether that kind of continues into next year. You already kind of commented on some of your expectations for heavy duty. So medium-duty color would be helpful."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, for the year, we're seeing medium -- North America medium-duty up a little bit, flat to up 5%. We're continuing to see pretty strong demand. I mean you've seen a little bit of inventory and normalization of backlog, but we continue to see really strong demand. And with future regulations on that horizon, we expect that's likely to continue into next year."
},
{
"speaker": "Operator",
"content": "And our next question comes from Tim Thein, Raymond James."
},
{
"speaker": "Timothy Thein",
"content": "The first question is just on the Distribution business. And I'm curious what, if any, mix impact, there could be given the -- if you look at the strength that we've seen and you're projecting to continue for some time in power gen, that's now running at, call it, 10 points higher as a percentage of distribution revenues from a couple of years ago. And while some of that's coming as we've seen parts come down. So maybe in historical terms, that's a mix negative, just as the whole goods grows as a percentage of revenues, but maybe just given the strength in demand and tightness in supply, that's not the case. So maybe just your thoughts on just the mix within distribution and how to think about that going forward?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, as you noted, that typically whole goods is mix margin negative compared to aftermarket for us. If you just step back and look at the business in total, you've got to consider what we've done around inflationary pricing and operational efficiencies have tried to flex up to higher volume, and we're going to continue to focus on those operational efficiencies. But power generation gross revenue mix compared to aftermarket will be negative on the margin line."
},
{
"speaker": "Timothy Thein",
"content": "Got it. Okay. And then maybe 1..."
},
{
"speaker": "Mark Smith",
"content": "Tim, that's where we continue to drive on those operational efficiencies and other areas and, of course, continue to drive as much of the parts business as we can underline. But the most important thing is we're meeting customer expectations and growing earnings in an efficient way."
},
{
"speaker": "Timothy Thein",
"content": "Got it. And then, Mark, just on the gross margin color that you gave earlier, was the -- you highlighted pricing several times. Was there -- was that -- was all of that from this retroactive deal you had in the light duty? Or was there maybe just..."
},
{
"speaker": "Mark Smith",
"content": "I mean year-over-year, there's other pricing, it just -- it was appropriate for the engine to note for the engine business that that was a particular fact. But no, there was other pricing and the overall expectations haven't significantly changed for the rest of the business. Quite frankly, this other pricing we'd expect it to get it at the start of the year and it's just taking time. The most important thing is it's been reset. It's more of a timing issue and a concentration in Q3, we always anticipated something in our full year numbers. So on a full year basis, there's not much to say, but it just came in a more lumpy fashion because of the catch-up nature."
},
{
"speaker": "Operator",
"content": "Thank you for our last question. I would now like to turn the floor back to Chris Clulow for closing remarks."
},
{
"speaker": "Christopher Clulow",
"content": "Great. Thanks very much. I appreciate everyone joining today. That concludes our teleconference. I appreciate your participation and continued interest. As always, the Investor Relations team will be available for questions after the call."
},
{
"speaker": "Operator",
"content": "We thank you for your participation. You may disconnect your lines at this time."
}
] |
cmi | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings and welcome to Cummins, Inc. Second Quarter 2024 Earnings Call. On our call today is Jen Rumsey, Chair and CEO; Mark Smith, Vice President and CFO; and Chris Clulow, Vice President of Investor Relations. 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, Chris Clulow. Thank you. You may begin."
},
{
"speaker": "Chris Clulow",
"content": "Thanks very much. Good morning, everyone, and welcome to our teleconference today to discuss Cummins’ results for the second quarter 2024. Participating with me today are Jennifer Rumsey, our Chair and Chief Executive Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures and we will refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today’s webcast presentation are available on our website within the Investor Relations section at cummins.com. I will turn you over to our Chair and CEO, Jennifer Rumsey, to kick us off."
},
{
"speaker": "Jennifer Rumsey",
"content": "Thank you, Chris and good morning. I'm excited to be with all of you today as I celebrate my two-year anniversary of becoming CEO of Cummins. I'll start with a summary of our second quarter financial results. Then I will discuss our sales and end market trends by region. I will finish with a discussion of our outlook for 2024. Mark will then take you through more details of both our second quarter financial performance and our forecast for the year. Before getting into the details on our performance, I want to take a moment to highlight a few major accomplishments from the second quarter. At our recent Analyst Day, I shared that we are raising our long-term financial targets as a result of our of our strengthening portfolio and continued execution our Destination Zero strategy. The strong partnerships that we have with customers and stakeholders are key to driving our strategy and growth profile forward. In this quarter, we strengthened those partnerships even further. In May, we announced with Isuzu Motors Limited the launch of a new 6.7-liter engine designed for use in Isuzu medium-duty truck lineup. This engine will power on-highway truck applications for the Japan market and will be available for Asia-Pacific markets and other global markets later this year. We also announced plans to launch a battery electric powertrain for Isuzu's F-Series in North America. Availability of the medium-duty truck is expected in 2026 and will include Accelera's next-generation lithium-ion phosphate or LFP battery technology. These advancements mark an important milestone for both Cummins and Isuzu as Cummins enters the Japan on-highway market for the first time in our history. We are proud of the partnership our two companies have built, and I'm excited to leverage our collective strength and scale to deliver profitable growth for both partners. Also this quarter, we further progressed our partnership with Daimler Trucks and buses and PACCAR as we completed the formation of joint venture now known as Amplify Cell Technologies, to localize battery cell production in the in the battery supply chain the United States. This included naming the Chief Executive Officer of joint venture and breaking ground at a new manufacturing plant in Marshall County, Mississippi. Amplify Cell Technologies will enable Accelera by Cummins and our partners to advance battery cells focused on commercial and industrial applications in North America and serve our customers' evolving needs. This is a significant step forward as we continue leading our industry into the next era of smarter, cleaner power. And in July, Accelera was awarded $75 million from the Department of Energy to convert approximately 360,000 square feet of existing manufacturing space at our Columbus, Indiana engine plant for zero emissions components, including battery packs and electric powertrain systems. The $75 million grant is the largest federal grant ever awarded solely to Cummins and as part of the appropriations related to the inflation Reduction Act. The Columbus engine plant is also where we manufacture blocks and heads for our current and next-generation engine-based solutions, further showcasing our Destination Zero strategy in action. Now, I will comment on the overall company performance for the second quarter of 2024 and cover some of our key markets, starting with North America before moving on to our largest international markets. Demand for our products remain strong across many of our key markets and regions, resulting in record revenues the second quarter of 2024. Sales for the quarter were $8.8 billion, an increase of 2% compared to the second quarter of 2023, driven by continued high demand and improved pricing. EBITDA was $1.35 billion or 15.3% compared to $1.3 billion or 15.1% a year ago. Second quarter 2023 results included $23 million of costs related to the separation of Atmus. EBITDA and gross margin dollars improved compared to the second quarter of 2023 as the benefits of higher volume and pricing exceeded supply chain cost increases and offset the impact of the Atmus separation. Our second quarter revenues in North America grew 4% to $5.5 billion, driven by the strong demand in our core markets more than offsetting the impact of the separation of Atmus. Industry production of heavy-duty trucks in the second quarter were 75,000 units, up 1% from 2023 levels. While our heavy-duty unit sales were 31,000, up 7% from a year ago. The second quarter marked record production volume for our heavy-duty engines at the Jamestown Engine plant. Industry production of medium-duty trucks was 41,000 units in the second quarter of 2024, an increase of 4% from 2023 levels, while our unit sales were 38,000, up 13% and also outpacing the market growth. We shipped 41,000 engines to Stellantis for using the Ram pickups in the second quarter of 2024, up 8% from 2023. Revenues in North America power generation increased by 23% and driven by continued strong data center and mission-critical power demand. The impressive power generation performance in North America and across the globe helped us achieve record sales and profitability in the Power Systems segment. Our second quarter international revenues decreased 2% compared to last year. Second quarter in China, including joint venture, were $1.6 billion, a decrease of 2% as weaker domestic volumes were partially offset with higher data center demand. Industry demand for medium and heavy-duty trucks in China was 270,000 units, a decrease of 3% from last year. Demand in the China truck market continues to run at low levels with higher orders for natural gas engines and strong exports offsetting weak domestic diesel demand. In light-duty market in China, we were up 4% from 2023 levels at 480,000 units while our units sold, including joint ventures, were $33,000, an increase of 18%. The industry demand for excavators in China in the second quarter was 53,000 units, an increase of 4% from 2023 levels. Our units sold were 10,000 units, an increase of 19% as a result of QSM15 penetration at both new and existing OEM partners and export growth. Sales of power generation equipment in China increased 36% in the second quarter, primarily driven by accelerating demand in data centers. This helped drive impressive financial performance at our Cummins Chongqing joint venture within our Power Systems business. Second quarter revenues in India, including joint venture, were $649 million, a decrease of 10% from the second quarter a year ago. Industry truck production increased by 11% and while our shipments increased by 5%. Power Generation revenues decreased by 17% year-on-year as the second quarter of 2023 benefited from pre-buy demand ahead of emissions regulation changes. Now, let me provide our outlook for 2024, including some comments on individual regions and end markets. We have raised our expectations for 2024, while still anticipating the second half to be weaker than the first half, primarily in the North America heavy-duty truck market. We are increasing our revenue guidance to down 3% to flat compared to our prior guidance of down 2% to down 5%. We are also increasing our EBITDA guide to be 15% to 15.5%, compared to our prior guide of 14.5% to 15.5%. We now expect higher revenue in our Engine, Power Systems and Distribution segments, offsetting slightly lower revenue expectations for the Accelera business. We also expect stronger profitability in our Engine and Power Systems segments, driving most of the improvement in EBITDA. We are maintaining our forecast for heavy-duty trucks in North America to be 255,000 to 275,000 units in 2024 as we still expect softening in the second half of the year. In the North America medium-duty truck market, we are raising our forecast to be 150,000 to 160,000 units, flat to up 5% from 2023. This is an increase from our previous guidance by 10,000 units as we continue to benefit from an elevated backlog and strength in vocational orders. Consistent with our prior guidance, our engine shipments for pickup trucks in North America are expected to be 135,000 to 145,000 in 2024, with a planned model year changeover likely to drive a temporary dip in production in the second half. In China, we project total revenue, including joint ventures, to increase 3% in 2024, consistent with our prior guidance. In India, we project total revenue, including joint ventures, to increase 8% in 2024, primarily driven by strong power generation and on-highway demand. We expect industry demand for trucks to be flat to up 5% for the year. For global construction, we project down 10% to flat year-over-year, consistent with our prior guidance. We continue to expect slightly weaker property investment and slowing export demand in China. We are raising our guidance for the global power generation market to be up 15% to 20% compared to our prior guidance of up 10% to 15%, driven by continued increases in the data center and mission-critical markets. Sales of mining engines are expected to be down 5% to up 5%, consistent with our prior guidance. For aftermarket, we have improved our guidance to flat to up 5% for 2024, raising the bottom end of our previous guidance of a decline of 5%, with demand holding up better than expected in on- and off-highway markets. In Accelera, we expect full year sales to be $400 million to $450 million, a reduction of $50 million from the prior guide. As we noted at our Analyst Day, the energy transition is progressing more slowly, impacting both our e-mobility and electrolyzer revenues. In summary, coming off a strong first half of the year, we are raising our guidance on sales to down 3% to flat and raising our EBITDA guidance to 15% to 15.5%. While we anticipate softening in the North America heavy-duty market in the second half of the year, demand in several of our core markets remain strong. Should economic momentum slow, Cummins is in a strong position to keep investing in future growth, bringing new technologies to customers and returning cash shareholders. In July, we announced an 8.3% increase in the quarterly dividend from $1.68 to $1.82 per share, the 15th consecutive year in which we have increased the dividend. During the quarter, we returned $230 million to shareholders in the form of dividends consistent with our long-term plan to return approximately 50% of operating cash flow to our shareholders. Our diluted earnings per share benefited from a lower number of shares outstanding with the impact of the Atmus split more fully reflected in the weighted average share count in the second quarter. In summary, we had a strong performance in the first half of 2024, driven by record demand for Cummins products in our core markets. It is exciting to see our business grow with long-established customers in existing markets and to see newer partnerships yield additional opportunities in previously untapped markets for Cummins. I'm grateful for our employees who continue to execute on our strategy and deliver solutions that help our customers win wherever they operate. Our results reflect our dedication to delivering strong financial performance while also investing in our future growth, bringing sustainable solutions to decarbonize our industry and returning cash to our shareholders. As we discussed at Analyst Day, there is a lot to be excited about in our future. Now let me turn it over to Mark."
},
{
"speaker": "Mark Smith",
"content": "Thank you, Jen, and good morning, everyone. We delivered strong results in the second quarter. Given the strength of those results and our improved outlook, we've raised the midpoint of our full year expectations for 2024. Second quarter revenues were $8.8 billion, up 2% from a year ago, as organic growth more than offset the reduction in sales driven by the separation of Atmus. Sales in North America increased 4%, while international revenues decreased 2%. Foreign currency fluctuations negatively impacted sales by 1%. EBITDA was $1.35 billion or 15.3% of sales for the quarter compared to $1.3 billion or 15.1% a year ago. The year ago numbers included $23 million of costs related to the separation of apps. The benefits of higher volumes and pricing as well as the absence of the separation costs were the primary drivers behind the improved profitability. Now I'll go into a little more detail by line item. Gross margin for the quarter was $2.19 billion or 24.9% of sales compared to $2.15 billion or also 24.9% a year ago. Flat margins were primarily driven by favorable pricing and operational improvements, offset by the removal of Atmus and higher compensation expenses. Selling, admin, and research expenses were $1.21 billion or 13.7% of sales compared to $1.26 billion or 14.6% last year. Joint venture income of $103 million decreased $30 million from the prior year, primarily driven by lower technology fees and the weak domestic truck market in China. Other income was negative $3 million, a decrease of $27 million a year ago. Interest expense was $109 million, an increase of $10 million from prior year, primarily driven by higher weighted average interest rates. The all-in effective tax rate in the quarter was 23%, including $9 million or $0.07 per diluted share of favorable discrete tax items. All in net earnings for the quarter were $726 million or $5.26 per diluted share compared to $720 million or $5.05 per diluted share in Q2 last year. The second quarter reflected the lower weighted average share count as a result of the tax-free share exchange that there was the final separation of Atmus was completed in the first quarter. All-in, operating cash flow was an outflow of $851 million compared to an inflow of $483 million in the second quarter last year, and the decrease was driven mainly by the $1.9 billion payment required by the previously disclosed settlement agreements with the regulatory agencies. Excluding the settlement, operating cash flow was an inflow of $1.1 billion, more than double the cash generated in the second quarter last year. I will now comment on segment performance and our guidance for 2024. As a reminder, guidance for 2024 includes the operations Atmus in our consolidated results up until the full separation that occurred on March 18th. Components segment revenue was $3 billion, a decrease of 13% from the prior year, while EBITDA decreased from 14.2% of sales to 13.6%, with both sales and EBITDA primarily impacted by the Atmus separation. For Components, we expect 2024 revenues to decrease 9% to 14%, consistent with our prior projections and EBITDA margins in the range of 13.7% to 14.2%, narrowing the range from our previous guidance of 13.5% to 14.5%. For the Engine segment, second quarter revenues were a record $3.2 billion, an increase of 5% from a year ago. EBITDA was 14.1%, a slight decrease from 14.2% a year ago. As the benefit from pricing and record on-highway volumes in North America was offset by higher research costs and lower joint venture income, primarily in China. In 2024, we now project 2024, we now project -- for the full year sorry, we now project revenues for the Engine business to be down 3% to up 2%, an increase of 2% from the prior midpoint, driven by a revised outlook in the North American medium-duty truck market. Full year Engine EBITDA is projected to be in the range of $13.7 million to $14.2 million, an increase of 75 basis points at the midpoint from our prior projections due to higher volumes and ongoing operational efficiencies. In the Distribution segment, revenues increased 9% from a year ago to a record $2.8 billion. EBITDA as a percent of sales decreased to 11.1% compared to 11.4% a year ago, primarily due to higher compensation expenses and a higher mix of power generation sales, which are positive for the company overall, but have a dilutive impact on the Distribution segment margins. We now expect 2024 Distribution revenues to be up 5% to 10%, an increase of 5% from the prior midpoint, mainly due to stronger power generation markets. And we've revised our EBITDA margin expectations to be in the range of 11.3% to 11.8%, down a little from our prior range of 11.5% to 12.5%. Results for the Power Systems segment set a new quarterly record. Revenues were $1.6 billion, an increase of 9% and EBITDA increased from 13.8% and to 18.9%, driven by higher volumes, particularly in power generation markets, improved pricing and other operational improvements and cost reduction. For 2024, we expect Power Systems revenues to be up 3% to 8%, an increase of 3% from the prior year guide. EBITDA is now projected to be approximately 17.5% to 18% and up from the previous projections of 16% to 17%. Accelera revenues increased 31% to $111 million, driven by increased electrolyzer installations. Our EBITDA loss was $117 million compared to an EBITDA loss of $114 million a year ago as we continue to invest in the products and capabilities to support those parts of the business where strong growth is expected, whilst reducing costs in areas where we accept the prospects for growth have extended into the future. In 2024, we expect Accelera revenues to be in the range of $400 million to $450 million, down $50 million from our prior guide. Net losses are still expected to be in the range of $400 million to $430 million. As Jen mentioned, given the strong performance in the second quarter and the revised outlook in our key region end markets, we have raised our full year company guidance. We now expect revenues to be down 3% to flat, which is better than our previous guidance of down 2% to down 5%. EBITDA margins are now projected to be approximately 15% to 15.5%, narrowing the range and increasing the midpoint 25 basis points from our prior guide. Our effective tax rate is expected to be approximately 24% in 2024, excluding the tax-free gain related to Atmus and other discrete items. Capital investments will be in the range of $1.2 billion to $1.3 billion, unchanged from three months ago, as we continue make critical investments in new products and capacity expansion to support future growth. In summary, we delivered record sales and solid profitability in the second quarter of 2024. We still do expect some moderation in some key markets in the second half of the year, especially North American heavy-duty truck, as we pointed out at our recent Analyst Day also. We've taken some cost to reduce -- we took some steps to reduce costs in the fourth quarter of 2023 and the first quarter of 2024, continue to identify ways to streamline our business going forward, leaving us well-positioned to navigate any economic cyclicality that we may experience. We continue to deliver strong financial results raising our performance cycle over cycle while still investing for future growth. Our priorities for this year for capital allocation remain to reinvest for growth, increase the dividend, and reduce debt. Overall, a very strong quarter. Thanks for your time today. Now, let me turn it back over to Chris."
},
{
"speaker": "Chris Clulow",
"content": "Thank you, Mark. [Operator Instructions] Operator, we're ready for our first question."
},
{
"speaker": "Operator",
"content": "Thank you. Our comes from the line of Steven Fisher with UBS. Please proceed with your question."
},
{
"speaker": "Steven Fisher",
"content": "Thanks. Good morning. Just on China truck, you didn't change your expectations there. Wondering how you're thinking about some of the new incentives that the government put in place there to support the second half of the year. Is that a potential point of conservatism in your outlook? Or do you think it may not materialize in there?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. Thanks for the question, Steven. Good morning. We've seen pretty consistent performance out of China and the economic conditions over the last 18 to 24 months, and there's been previous indications of actions the government may take, none of which has really translated into any meaningful change in our industry. So, really, we're seeing the strong performance still with natural gas product an export and a relatively weak domestic diesel market and are not anticipating that changing in the near-term."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Jamie Cook with Truist Securities. Please proceed with your question."
},
{
"speaker": "Jamie Cook",
"content": "Hi, congratulations on a nice and clean quarter. I guess two questions. One, Mark, the margins in Power Systems are quite remarkable on a pretty muted sales growth assumption for 2024. So, if you could just help us understand what's going on there, sort of what's structural versus -- and do you see the opportunity for margins to improve from these levels in the out years given you're already assuming a close to 18% margin this year? And then my second question, Jen, just -- I know you don't want to give a guide for 2025, but how you're thinking about the markets? Is there -- as you think about the U.S. with the potential -- with the election and the overruling of Chevron, are you more conservative about a potential pre-buy? Do you think that gets pushed out? I guess the two positives would be China comes back and then the power system. So, I'm wondering, ultimately, is the incremental margin potential better in 2025 with those assumptions on a muted 2025 pre-buy with better mix from Power Systems in China? Thanks."
},
{
"speaker": "Mark Smith",
"content": "Okay. Good questions. We'll try and fit in our answers with the time available for us this evening. On Power Systems, there's really three elements to the margins. And to answer the last part of your question, yes, we do expect there's still more to come. So, the team there is doing a fantastic job, started with some cost reduction, reprioritizing where we're where we're investing, investing less, strong pricing environment on the Power Systems side and then yes, there's more to do on the operational efficiency. So really, it's several strings to the bow in terms of what's been driving the results and still more to come. So we're really, really excited. Hopefully, you felt the confidence from Jenny Bush and to the team from the Analyst Day and have continued to deliver here in the second quarter, and we're bullish on that segment. That's -- those are really the main drivers on Power Systems."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. On the market outlook, what I would say is in the power gen market, the continued growth that we see there, in particular the data center, I don't see that letting up anytime soon, and where we have strong demand, high backlog. And as you know, we talked about in May, making some capacity investments to take advantage of the growing market there. In US on-highway, the medium-duty truck has continued to be strong. We see strong backlog and demand and don't see that letting up in the foreseeable future. and heavy duty, we do see build rates coming down, projecting about 10% down in the third quarter and 20% overall for the second half of year. And the question is what will happen next year with the broader economic environment because well stabilized spot rates and these truck prices are at a lower level than they've been historically, and that's impacted some of our customers demand. And so how that comes together with a pre-buy. The Supreme Court overturning of the Chevron deference, we don't anticipate any impacting regulations in the near-term. We believe that 2027 regulations will continue to move forward. And probably the bigger question is what we see with Phase 3 greenhouse gas in the 2030 time frame. And so we still anticipate some amount of pre-buy ahead of that emissions changeover. But the industry has also demonstrated there's capacity constraints that we've seen in the last couple of years. So how large that pre-buy will be, I think is still question, but we're preparing to have strong demand as we go into the 2027 regulation change."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Steve Volkmann with Jefferies. Please proceed with your question."
},
{
"speaker": "Steve Volkmann",
"content": "Great. Thank you, guys. Mark, I think you mentioned maybe both of your pricing being positive. It sounds like it was positive in truck. It sounds like its positive in Power Gen. Can you just double-click on that for us a little bit? I mean how much pricing are you seeing? And sort of how should we think about that for the rest of the year?"
},
{
"speaker": "Mark Smith",
"content": "Yes. Great questions. So on average, across the company, very, very much by segment, but 2.5% for the year, and that really hasn't changed. That's not changed in the results, but it definitely has been an important driver of the Power Systems results. And I don't think it's going to vary a lot that year-over-year increase should mostly hold across all the quarters."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Jerry Revich",
"content": "Yes, hi. Good morning, everyone. And Jennifer, Happy Anniversary."
},
{
"speaker": "Jennifer Rumsey",
"content": "Thank you."
},
{
"speaker": "Jerry Revich",
"content": "I wanted to ask on the medium-duty engine platforms globally, right? So you folks are picking up Daimler's business, now you're picking up Isuzu business in Japan. Can you just expand and talk to us about how many more medium-duty engines, you folks expect to ship globally 2026 versus, I don't know, call it, two or three years ago, given the timing of the transition? And if you could just comment on Japan, is it -- help place to import product into given the currency. Can you just talk about how you folks are able to do that economically? Thank you."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yeah, sure. So you've seen this trend and some of the announcement that we made over the last few years playing out now as regulations start to occur. So we're seeing growing medium-duty demand in the US, of course, with Daimler transitioning to us and us as well as some other customers like keno here in the US. So we're growing our position in the medium-duty market here. We've now launched the medium-duty product in India with Daimler. So we'll start to see some volume there. Their strategy is really driven by regulation change. So when you see regulation change in Europe and Brazil will continue to grow volume with Daimler. On the Isuzu business, we are building that new B6.7 and their Tohoku plant in Japan. So we're not importing that engine. We're building it in the market. First time we've been on-highway market, we've been in the off-highway market there, of course, for many years. And so we'll see some slow volume growth there in Japan. And then as I noted, they'll then launch that truck into other Asia Pacific and global markets later this year. So you're just going to see steady growth, I would say, from Cummins year-over-year in the medium-duty space as these new customer partnerships grow and emissions regulations change and ads."
},
{
"speaker": "Mark Smith",
"content": "In India and Brazil to the later 2027."
},
{
"speaker": "Jennifer Rumsey",
"content": "2027 through 2029. Yeah."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Angel Castillo with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Angel Castillo",
"content": "Hi. Thanks for taking my question, and congrats on the strong quarter. I was hoping we could just unpack a little bit more the engine segment. You raised the outlook there on margins, and you've been talking about medium duty, but just as we think about your second half that is expected to decelerate on the heavy-duty side, can you talk about the components driving your margin improvement there? And just helping us kind of quantify what's ultimately driving that and how are you thinking about kind of 2025 margin improvement?"
},
{
"speaker": "Mark Smith",
"content": "Yeah. So we've got a little bit of help. We've improved the parts outlook. So that certainly helps overall -- we've been taking some measured actions across the company since the second half of fourth quarter of last year into the fourth quarter -- into the first quarter of this year, those should help with some lower costs in the second half of the year. And then we've got a stronger outlook in medium-duty truck. So those are really the three key elements. We're not going to get into breaking down the profitability by us. Those are really the three things that have helped improve. Yeah, and I think the conversion on the volume and the second quarter showed us there's still more room for improvement just in general operating efficiencies. No real change in -- in pricing most of the segments."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of David Raso with Evercore ISI. Please proceed with your question."
},
{
"speaker": "David Raso",
"content": "Hi. Thank you my question is on the guide. One area little skeptical on -- one area where it seems like you have some upside. The engine business, the second half of the year, you're guiding the revenues down only 3% year-over-year. And I'm just trying to go through heavy truck builds down double digit or the parts business mutes that. The light duty has the soft fourth quarter on the model change. Off-highway, comp fees, China a little better but big declines in Ag and some in construction. So I'm trying to understand why the revenue going down 3%? Or is it there's enough new penetration of customers that can push against all that, and at the same time, the engine margins only go down 30 bps sequentially on lower revs. And then the upside is PowerGen revenue growth less than 5% year-over-year in the second half, you're up over 6% in the first half. And the margins are down sequentially, I mean I understand the industrial piece within power can be down, but at least there are comp fees. So I'm just trying to understand, I assume PowerGen has a little more focus, a little more capacity, right, being pushed at minimum, good pricing. So again, why the -- or maybe it's just conservative, conservative on PowerGen, and if you can make us more comfortable on that engine? Thank you."
},
{
"speaker": "Mark Smith",
"content": "Thanks, David. Good question. So I think on Power Systems, I don't think there's any fundamental changes. So it's really a key like how much do we -- how much product do we deliver to our customers and the conversion. We've given a range of outcomes for the margin. The business is performing well. And quite frankly, we're raising capacity. So I don't think the sales will go a lot above, but yet we're leaning on the profitability strongly, the business is really doing well. So I don't think there's much to be concerned about there, and we've raised the outlook. On the engine business, I think what's helping mitigate the margins, which is, I guess, the most important part is really some of the cost reduction actions that we've taken during the year, slightly better outlook for parts. And then there's just some of the puts and takes on the revenue. But those are the reasons why the margins at those revenue levels, we expect to hold up. Next question please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Tami Zakaria with JPMorgan. Please proceed with your question."
},
{
"speaker": "Tami Zakaria",
"content": "Hi, good morning. Very nice quarter. I have two quick clarification questions. One is on the distribution segment. I think margins were lower, but sales were great. So is that margin guide prudently conservative? Or is this a function of the mix headwind from PowerGen? Or is there anything I need to be aware of for that? And then the other question is on price costs. I think you just said price still you expect 2.5% at the enterprise level. Since some of the raw material prices are coming down, do you expect some improvement in price cost for the year?"
},
{
"speaker": "Mark Smith",
"content": "So to the latter, not significantly, we've probably got about 50 basis points of cost headwind across all the different categories, varies by business and segment. And then on distribution, you're right to point out the margins. So there's really -- yes, for distribution, PowerGen is a little bit dilutive relative to the rest of the segment, even though obviously within Power Systems, its very accretive. So that's true. We've called that out. Also in the first and the second quarter, there was some modest individual charges that didn't merit to be called out in the overall results. So I don't merit a lot of commentary, but just say they've trimmed the margins a little bit. And, therefore, we're really just reflecting where we are for the year. We do believe distribution margins have still got significant potential to improve over time, so that’s what’s going on."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Tim Thein with Raymond James. Please proceed with your question."
},
{
"speaker": "Tim Thein",
"content": "Hi. Good morning. I'll maybe combine these before I get the hook. Actually both pertaining to the North America heavy-duty segment. And the first part is just around market shares, Mark. Obviously, those can and do shift around quarter-to-quarter. And I'm just thinking big picture as we get in a softer back half of the year where the sleeper segment likely is disproportionately impacted from a production standpoint at the expense of vocational. I would imagine that favors Cummins from a share perspective, just absent any kind of specific OEM programs and other factors. So, maybe just your thoughts on that. And then the second part is just on the parts business, obviously, has been kind of a choppy past few quarters, but the commentary seems to be more positive, whereas some of the dealers and OEMs that have reported recently have flagged softness there. So I'm just curious, is that just kind of an absence of customer destocking that you went through last year or better just fleet utilization? What's driving that? If you can things. Thank you."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. Great. Thanks for the question. And as you noted, I mean, we work to create customer pull for the heavy-duty product across different segments. But generally, as you said, for the vocational segment, we have stronger customer pull compared to the truckload, and that's the portion of the market that's been stronger right now. But of course, our goal is always to have the best product and create demand for Cummins products. But as you see that shift between the different segments of market and what OEMs are doing around incentives that could -- as well as capacity that can shift around a little bit over time. On the parts, it's somewhat demand driven and also this inventory destocking was a pretty big factor. There was a focused effort last year to reduce some of the inventory levels that have been carried because of the disruptions that we were all seeing and coming back down to more normal inventory levels. It was a little bit hard to separate between destocking and demand in the market. And so now you see us settling into what we see as pretty steady and solid demand in both our on- and off-highway markets."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Noah Kaye with Oppenheimer. Please proceed with your question."
},
{
"speaker": "Noah Kaye",
"content": "Thanks. Maybe hoping to get an update on demand in the order books for the X15? And how is it looking for the back half? How is it tracking the expectations and basically what's the response so far from the OEs?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. Great. Thanks for the question. No, we are launching that product this month. with PACCAR excited to get it out in the market and then we'll launch it next year with DTNA, so have more offering there. We've got some early demand from some of the big fleet customers that have sustainability goals in the market, and we'll see how that develops over time, really with those fleet and other customers. And so we've projected we could get up to about 8% in the market, but I think it's going to take some time for us to get up to that. that level and for that market to develop in these operating costs and sustainability goals to drive demand up."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Jeff Kauffman with Vertical Research Partners. Please proceed with your question."
},
{
"speaker": "Jeff Kauffman",
"content": "Thank you very much. I just wanted to follow-up on the engine slowdown that you're projecting for the second half of the year and maybe try and carry this into early 2025 because I think there's a perception that we're weak for a quarter or two and then the pre-buy kicks in and we're off to the races. When do you believe we start to show positive comparisons potentially in North American engines? And then we have an election this November, and I don't really know which way it's going, but just any thoughts on how a Republican victory or a Democratic victory might change the outlook for engines or new power?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So in terms of the heavy-duty demand, we all wish we had a crystal ball that could project how this is going to play out. This cycle has been very different than past cycles because of the pent-up demand that we had seen and then, of course, getting into pre-buy expectations. So it's really difficult to predict at what point next year we'll start to see improvement and economic conditions will certainly play a role in that. So I'm not going to project exactly when, but I think at some point in next year, we'll see recovery. And we've taken the steps to be prepared for that softening over the next few quarters. In terms of the election, again, I'm not going to make a prediction on that one either. What I will say is, as always, we worked in the past with the Trump administration, and we worked with the Biden administration. We worked across party lines to make sure that the opportunities and the challenges in our industry are understood and that regulation and policy reflects appropriately what those are. We will continue to do that in particular with the regulations that are in front of us. and our destination strategy at its core is about recognizing the economic importance of commercial and industrial applications and a need to decarbonize that industry over time and how do you take the appropriate steps to regulation and incentives to do that. So we're going to continue advocate for that. And some of the money that has come out of the inflation production Act has been allocated and is flowing into the market and creating jobs across the United States. So we'll continue to do that [indiscernible] those points and the opportunities and challenges that we're facing and how we navigate the energy transition. I think Cummins is really well positioned, regardless of how that plays out, but the industry, of course, is making investments in preparing for that. And so we want to make sure that we have stability and regulation, most importantly."
},
{
"speaker": "Mark Smith",
"content": "And I just -- I know there's a lot of questions about heavy duty. But as we mentioned earlier, the demand for medium duty is getting stronger. We're actually investing to raise capacity over time, partly because of the strength of the market part because of the new business we've won. So right now, the expectation is that less volatility and a sustained high demand is what we're being told right now. Things can change based on the economy. But there's more question marks about heavy. Clearly, it's going down in the near-term and a lot less questions about medium duty for now."
},
{
"speaker": "Operator",
"content": "Thank you. Our final question comes from the line of Kyle Menges with Citigroup. Please proceed with your question."
},
{
"speaker": "Kyle Menges",
"content": "Thank you. I just wanted to dive a little bit deeper into the power systems and really focus on the unit outlook and how to think about capacity for the remainder of the year and then how you think about you could exit the year from a capacity standpoint or just doing the math, it seems like. And assuming you're running pretty hot from a capacity standpoint, it seems like unit shipments capacity for the year would be around 20,000 or so units. I'm curious what that might look like the capacity on an annualized basis exiting the year and looking into 2025 with some of the investments you're making?"
},
{
"speaker": "Mark Smith",
"content": "Well, there's a lot of there, unfortunately, in that business, there's more variation, right? There's just such a wide range of engines and applications. And so it's not a -- unfortunately, it's not a simple explanation as it would be, say, for on-highway markets where there's a narrower range of products across the market. I don't think there's going to be dramatic capacity increases this year, but we're working towards, obviously, supporting the one key global secular theme, which is the data center capacity, Jenny Bush talked about at Analyst Day. That's the one. It varies by segment, some of our more consumer-facing segments demand has dropped over the last 18 months. So there's some more capacity there. So it very much depends by end market. But the general theme is some investment in capacity, some reorganizing where we make product around the world. We feel confident about the revenue guide for this year. We feel confident we can support through our production revenue going into next year. But unfortunately, I just because of the variation in the products, the pricing, the applications that like a rule of thumb on the unit isn't quite as applicable in that segment."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yeah. The only thing I'll add to Mark's comments, which are absolutely accurate is, in particular, the data center market. What you've seen happen in the first half of the year was we worked really hard on our supply base and production and the 95 liter, which is running now at capacity, and then we launched the Symptoms product, which adds -- adds additional platforms, including a 78-liter that's able to run at this 3-megawatt key data center point. And so helped us the supply chain improvement as well as the new product launches helped us increased revenue and what we're selling into the market. But we're continuing to run into capacity constraints on some of the platforms in that data center market, in particular, which is why we're making some modest investments to be able to take up capacity over the next couple of years."
},
{
"speaker": "Operator",
"content": "Thank you. We have reached the end of our question-and-answer session. I'd like to turn the call back over to Mr. Clulow for any closing remarks."
},
{
"speaker": "Chris Clulow",
"content": "Thanks, everybody, for participating today. That concludes it for today. As always, the Investor Relations team will be available for questions further after the call and throughout the rest of the week. Thank you. Bye."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day."
}
] |
cmi | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Q1 2024 Cummins Inc. Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Clulow, Vice President of Investor Relations. Thank you, Chris. You may begin."
},
{
"speaker": "Christopher Clulow",
"content": "Thanks very much. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the first quarter of 2024. Participating with me today are Jennifer Rumsey, our Chair and Chief Executive Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference."
},
{
"speaker": "",
"content": "Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future."
},
{
"speaker": "",
"content": "Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q."
},
{
"speaker": "",
"content": "During the course of this call, we will be discussing certain non-GAAP financial measures, and we'll refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website within the Investor Relations section at cummins.com. With that out of the way, I will turn you over to our Chair and CEO, Jennifer Rumsey to kick us off."
},
{
"speaker": "Jennifer Rumsey",
"content": "Thank you, Chris, and good morning, everyone. I'll start with a summary of our first quarter financial results, and then I will discuss our sales and end market trends by region. I will finish with a discussion of our outlook for 2024. Mark will then take you through more details of both our first quarter financial performance and our forecast for this year. Before getting into the details on our performance, I want to take a moment to highlight a few major events from the first quarter."
},
{
"speaker": "",
"content": "In March, Cummins successfully completed the separation of our Filtration business, Atmus Filtration Technologies. Cummins will continue its focus on advancing innovative power solutions, while Atmus is now well positioned to pursue its own plans for profitable growth. We are proud of our employees' hard work and all who were involved to ensure successful separation, and we are excited to see what the future holds for both Cummins and Atmus. The final step in the separation of Atmus resulted in a tax-free exchange of shares, which reduced Cummins shares outstanding by 5.6 million."
},
{
"speaker": "",
"content": "In addition, we reintroduced our fuel-agnostic platforms with the name that captures the innovation that powers us forward, Cummins HELM platform. With higher efficiency, lower emissions and multiple fuels, the Cummins HELM platforms give our customers control of how they navigate their own journeys as part of the energy transition."
},
{
"speaker": "",
"content": "As the next product in the Cummins HELM 15-liter platform, we announced we will launch the next-generation diesel X15 in North America for the heavy duty on-highway market, which will be compliant with the U.S. EPA and CARB 2027 aligned regulations at launch."
},
{
"speaker": "",
"content": "Lastly, in April, Cummins Power Generation introduced 4 new generator sets to the award-winning Centum Series, powered by Cummins QSK50 and QSK78 engines. These new models have been engineered specifically for the most critical applications such as data centers, health care facilities and wastewater treatment plant."
},
{
"speaker": "",
"content": "I was excited to attend the launch event with our customers and hear about the growing demand for these critical applications and high interest in our genset products, which build on decades of experience meeting our customers' needs and deliver a step change improvement in power density, assured reliability, sustainability and low emissions. Now I will comment on the overall company performance for the first quarter of 2024 and cover some of our key markets."
},
{
"speaker": "",
"content": "Demand for our products remained strong across many of our key markets and regions. Revenues for the first quarter were $8.4 billion, a decrease of 1% compared to the first quarter of 2023. EBITDA was $2.6 billion or 30.6% compared to $1.4 billion or 16.1% a year ago."
},
{
"speaker": "",
"content": "First quarter 2024 results include a gain net of transaction costs and other expenses of $1.3 billion related to the Atmus divestiture and $29 million of restructuring expenses as we continue to work to simplify our operating structure and improve the efficiency of our business for the long term."
},
{
"speaker": "",
"content": "This compares to the first quarter 2023 results, which included $18 million of costs related to the separation of the Atmus business. Excluding the onetime gain and the costs related to the separation of Atmus as well as the restructuring expenses, EBITDA percentage decreased by 80 basis points as improved pricing partially offset lower volumes and higher research and development expenses as we continue to invest in the products and technologies that will create advantages in the future."
},
{
"speaker": "",
"content": "Gross margin dollars improved compared to the first quarter of 2023 as the benefits of pricing more than offset the impact of lower volumes and supply chain cost increases."
},
{
"speaker": "",
"content": "Our first quarter revenues in North America were flat with 2023. Industry production of heavy-duty trucks in the first quarter was 73,000 units, down 5% from 2023 levels, while our heavy-duty unit sales were 26,000, down 7% from 2023."
},
{
"speaker": "",
"content": "Industry production of medium-duty trucks was 41,000 units in the first quarter of 2024, an increase of 8%, while our unit sales were 36,000, up 22% from 2023. We shipped 38,000 engines to Stellantis for use in the Ram pickups in the first quarter of 2024, down 2% from the 2023 levels."
},
{
"speaker": "",
"content": "Revenues for North America power generation increased by 21%, driven by continued strong data center and mission-critical power demand. Our international revenues decreased by 1% in the first quarter of 2024 compared to a year ago."
},
{
"speaker": "",
"content": "First quarter revenues in China, including joint ventures, were $1.6 billion, a decrease of 5% as weaker domestic volumes were partially offset with the accelerating data center demand. Industry demand for medium- and heavy-duty trucks in China was 305,000 units, an increase of 14% from last year. However, shifts in the market share during the first quarter led to a decline in our volumes year-over-year."
},
{
"speaker": "",
"content": "The light-duty market in China was up 2% from 2023 levels at 486,000 units, while our units sold, including joint ventures, were 37,000, an increase of 3%. Industry demand for excavators in the first quarter was 50,000 units, a decrease of 13% from 2023 levels. The decrease in the market size is due to weak property investment, high equipment population and slowing export demand. Our units sold were 9,000 units, an increase of 10% as a result of the QSM15 penetration and export growth. Sales of power generation equipment in China decreased 7% in the first quarter as accelerating data center demand was offset by softening in other markets."
},
{
"speaker": "",
"content": "First quarter revenues in India, including joint ventures, were $758 million, an increase of 1% from the first quarter a year ago. Industry truck production decreased by 7%, while our shipments decreased by 5% as the market slowed ahead of elections in April. Power generation revenues increased by 37% in the first quarter as economic activity remains strong. Now let me provide an outlook for 2024, including some comments on individual regions and end markets."
},
{
"speaker": "",
"content": "Our full year guidance now excludes Atmus from the March 18 separation date onwards and also include -- excludes the first quarter gain related to the divestiture. The guidance provided previously included Atmus for the full year as it preceded the transaction announcement. We are happy to share that our expectations for 2024 have improved from our initial guidance issued in February. Our forecast for total company revenue in 2024 remains the same at down 2% to 5%, which implies higher base business revenues of approximately $1.3 billion compared to our prior guidance as Atmus is now excluded from future quarters."
},
{
"speaker": "",
"content": "We are increasing our forecast for heavy-duty trucks in North America to 255,000 to 275,000 units in 2024 compared to our prior guide of 245,000 to 265,000 units, though We do still expect softening in the second half of the year."
},
{
"speaker": "",
"content": "In North America, medium-duty truck market, we maintain our prior guidance of 140,000 to 150,000 units, down 5% to flat from 2023, consistent with our prior guidance, our engine shipments for pickup trucks in North America are expected to be 135,000 to 145,000 in 2024, down 5% to 10% from 2023 as we prepare to launch our model year 2025 in the fourth quarter. In China, we project total revenue, including joint ventures, to increase 3% in 2024, consistent with our prior guidance."
},
{
"speaker": "",
"content": "We project a range of down 5% to up 10% in heavy- and medium-duty truck demand and expect a range of down 5% to up 5% in demand in the light-duty truck market. We expect replacement demand to be in the range -- to be the biggest driver, but the effect may be weakened by a sluggish economy and potentially slower export demand."
},
{
"speaker": "",
"content": "The short-term shifts in the market share that I noted earlier are expected to normalize as we progress through the remainder of the year. In India, we project total revenue, including joint ventures, to increase 9% in 2024, primarily driven by strong power generation and on-highway demand, consistent with our prior guidance."
},
{
"speaker": "",
"content": "We expect industry demand for trucks to be flat to up 5% for the year. For global construction, we project down 10% to flat year-over-year, up from our previous guidance of down 5% to 15%. We continue to expect weak property investment and slowing export demand in China. We project our major global high-horsepower markets to remain strong in 2024."
},
{
"speaker": "",
"content": "We are raising our guidance for global power generation markets to be up 10% to 15% compared to our prior guidance of about 5% to 10%, driven by continued increases in the data center and mission-critical markets."
},
{
"speaker": "",
"content": "Sales of mining engines are expected to be down 5% to up 5%, consistent with our prior guidance. While a smaller market for us, we continue to anticipate demand for oil and gas engines to decrease by 40% to 50% in 2024, primarily driven by decreased demand in North America."
},
{
"speaker": "",
"content": "For aftermarket, we've maintained our guidance of down 5% to up 5% for 2024, as we are through the inventory management efforts and destocking that happened throughout the industry in the second half of 2023."
},
{
"speaker": "",
"content": "In Accelera, we expect full year sales to be $450 million to $500 million compared to $354 million in 2023, consistent with our prior guidance. We are ramping up electrolyzer manufacturing capacity and capability to deliver orders to our customers as well as expect continued growth in electrified components."
},
{
"speaker": "",
"content": "In summary, coming off a strong first quarter, we are maintaining our sales growth outlook for the year of down 2% to 5% as stronger demand in our base business has offset the removal of Atmus for future quarters from our guidance. We have also revised our forecast for EBITDA to be in the range of 14.5% to 15.5% compared to our previous guidance of 14.4% to 15.4%, reflecting stronger North America heavy-duty truck and power generation markets, which more than offsets the loss of profitability of Atmus."
},
{
"speaker": "",
"content": "In addition, we are taking steps to reduce cost, optimize our business and position Cummins for continued success in 2024. We are in a strong position to keep investing in the future, bringing new technologies to customers and returning cash to our investors. During the quarter, we returned $239 million to shareholders in the form of dividends, consistent with our long-term plan to return approximately 50% of operating cash flow to shareholders."
},
{
"speaker": "",
"content": "In addition, we reduced the overall Cummins share count by 5.6 million as we completed the Atmus share exchange, which will be more fully reflected in the average share count in the second quarter and beyond."
},
{
"speaker": "",
"content": "I am impressed and grateful for the commitment of our employees and leaders around the world for delivering for our customers and generating strong financial performance at the same time. Our results further enhance Cummins' ability to keep investing in the future growth, bringing sustainable solutions that will protect our planet for future generations and returning cash to our shareholders."
},
{
"speaker": "",
"content": "I look forward to discussing our long-term strategy further in our upcoming Analyst Day on May 16 and now let me turn it over to Mark."
},
{
"speaker": "Mark Smith",
"content": "Thank you, Jen, and good morning, everyone. We delivered solid first quarter revenue and profitability and generated positive operating cash flow. Given the strength of first quarter results and our improved outlook, we've raised our full year expectations for 2024 after adjusting for the separation of Atmus. First quarter revenues were $8.4 billion, down 1% from a year ago. The separation of Atmus in mid-March resulted in a year-over-year sales decline of around 1% to our -- to Cummins consolidated sales."
},
{
"speaker": "",
"content": "Our underlying revenues increased in North America and Latin America and were offset by weaker demand in China and Europe. EBITDA was $2.6 billion or 30.6% of sales for the quarter. We completed the tax-free full separation of Atmus in March, which resulted in a onetime gain on the divestiture of $1.3 billion, net of transaction costs and other expenses. First quarter results also included $29 million of restructuring expenses. This compares to first quarter of 2023, which included $18 million of costs related to the separation of Atmus."
},
{
"speaker": "",
"content": "To provide clarity on operational performance and allow comparison to prior year, I am excluding the onetime gain and the costs related to the separation of Atmus as well as the restructuring expenses in my following comments. Financial results of Atmus through March 18 are included in our first quarter consolidated sales and EBITDA. EBITDA was $1.3 billion or 15.5% of sales for the quarter compared to $1.4 billion or 16.3% of sales a year ago. The lower EBITDA percentage was driven by investment in new products and capabilities and lower sales volumes."
},
{
"speaker": "",
"content": "Now let's look into more detailed by line item. Gross margin for the quarter was $2.1 billion or 24.5% of sales compared to $2 billion or 24% even last year. The improved margins were primarily driven by favorable pricing and operational improvements, especially in the Power Systems business. Selling, administrative and research expenses increased by $72 million, driven by higher research costs as we continue to bring to market new products and capabilities to support future profitable growth, particularly the development of the HELM product line within the Engine business."
},
{
"speaker": "",
"content": "Joint venture income of $123 million increased $4 million from the prior year, primarily due to increased earnings in the Power Systems segment. Other income was $21 million, a decrease of $50 million from a year ago. The decrease in other income is driven by the relative negative impact of foreign currency revaluation and lower gains on investments related to company-owned life insurance compared to a year ago. Interest expense was $89 million, an increase of $2 million from the prior year, driven by higher outstanding, long-term borrowings related to the bond issuance we completed in February."
},
{
"speaker": "",
"content": "The all-in effective tax rate in the first quarter was 8.7%, mainly due to the tax-free gain on the separation of Atmus. All in, net earnings for the quarter were $2 billion or $14.03 per diluted share, which includes the net gain related to the separation of Atmus of $1.3 billion or $9.08 per diluted share and restructuring expenses of $29 million or $0.15 per share."
},
{
"speaker": "",
"content": "Just to reinforce what Jen said, full impact of the lower share count from the Atmus separation will be seen in future quarters since the diluted share counts counted on a weighted average basis. All-in operating cash flow was an inflow of $276 million compared to an inflow of $495 million in the first quarter last year. Now let me comment on segment performance and our guidance for 2024."
},
{
"speaker": "",
"content": "As a reminder, prior guidance for 2024 assume that the operations of Atmus would be included in our consolidated results for the full year. Components segment revenue was $3.3 billion, a decrease of 6%, while EBITDA, excluding costs related to the separation of Atmus, increased from 14.6% of sales to 14.8% driven primarily by improved performance within Cummins [indiscernible]. For Components, we've updated the guidance for the segment following the separation of Atmus and expect 2024 revenues to decrease 9% to 14% and EBITDA margins in the range of 13.5% to 14.5%."
},
{
"speaker": "",
"content": "Our latest guidance reflects an increase in both revenues and EBITDA margins after adjusting for the separation of Atmus. For the Engine segment, first quarter revenues were $2.9 billion, a decrease of 2% from a year ago. EBITDA was 14.1%, a decrease from 15.3% a year ago as the benefit of pricing offset by lower volumes and higher research costs. 2024, we now project revenues for the Engine business to be down 5% to flat, an improvement of 2% at the midpoint from our prior year projections, reflecting a revised outlook in the North American truck markets and stronger-than-expected demand from our construction customers."
},
{
"speaker": "",
"content": "2024 EBITDA is projected to be in the range of 12.7% to 13.7%, an increase of 20 basis points at the midpoint due to higher volumes. In the Distribution segment, revenues increased 5% from a year ago to $2.5 billion. EBITDA decreased as a percent of sales to 11.6% compared to 13.9% of sales a year ago as aftermarket sales, particularly to industrial customers declined from the record levels that we experienced a year ago."
},
{
"speaker": "",
"content": "We expect 2024 distribution revenues to be flat to up 5% and EBITDA margins to be in the range of 11.5% to 12.5%, an increase from the prior guide of 3% for revenues and a modest improvement to margins for the full year. Power Systems segment revenues were $1.4 billion, an increase of 3% and EBITDA increased from 16.3% to 17.1% of sales driven by higher volumes, particularly in the power generation markets, improved pricing and operating improvements, all of which contributed to a strong trend of improving performance in that segment."
},
{
"speaker": "",
"content": "2024, we now expect Power Systems revenues to be flat to 5%, up 3% at the midpoint and EBITDA has also increased to be approximately 16% to 17%, up 80 basis points from our previous guide. Accelera revenues increased 9% to $93 million, driven by increased electrolyzer installations. Our EBITDA loss was $101 million compared to an EBITDA loss of $94 million a year ago as we continue to invest in the products and capabilities to support future growth."
},
{
"speaker": "",
"content": "In 2024, our guidance is unchanged. We expect revenues to be in the range of $450 million to $500 million and net losses to be in the range of $400 million to $433 million consistent with our prior guide."
},
{
"speaker": "",
"content": "As Jen mentioned, given the strong performance in the first quarter and the outlook in our key regions, end markets, we are adjusting the full year company guidance, and we project company revenue -- consolidated company revenues to be down 2% to 5%, consistent with the prior year guidance despite the separation of Atmus."
},
{
"speaker": "",
"content": "Company EBITDA margins are now projected to be approximately 14.5% to 15.5%, up 10 basis points from prior guidance, all of which excludes the net gain related to the separation of Atmus and the restructuring expenses. Our effective tax rate is expected to be 24%, excluding the tax-free gain related to Atmus and other discrete items. Capital investments will be in the range of $1.2 billion to $1.3 billion, unchanged from our outlook 3 months ago as we continue to make critical investments in new products, capacity expansion to support future growth."
},
{
"speaker": "",
"content": "In summary, we delivered solid sales, profitability and positive cash flow in the first quarter. We do still expect moderation in some of our key markets in the second half of 2024, but we have raised our expectations of our own performance relative to our prior guide. We took some steps to reduce costs in the fourth quarter of 2023 and continue to identify ways to streamline our business going forward leaving us well positioned to navigate any economic cyclicality and continue investing and delivering strong financial performance."
},
{
"speaker": "",
"content": "Our priorities in 2024 for capital allocation are unchanged. We will reinvest for growth, plan to raise the dividend and reduce debt. Thank you for your interest today, and I look forward to seeing some of you in person in New York at our upcoming Analyst Day."
},
{
"speaker": "",
"content": "Now let me turn it over to Chris."
},
{
"speaker": "Christopher Clulow",
"content": "Thank you, Mark. [Operator Instructions] Operator, we're ready for our first question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Steve Volkum (sic) [ Steve Volkmann ] with Jefferies."
},
{
"speaker": "Stephen Volkmann",
"content": "I think I'd like to start off with power gen, if we could. That business seems to be going well. So sort of 2 things I'm curious to hear about exactly kind of what you think your position is in the data center market. How much of your business is data centers?"
},
{
"speaker": "",
"content": "And then how are you thinking about increasing capacity over the next, whatever, few quarters or years, however, that's going to play out? What should we be thinking about in terms of capacity additions and your ability to kind of grow that business over time?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Great. Thanks, Steve. And as you heard in the guidance, we're projecting the power gen business to be up 10% to 15% for the year, and data center, mission-critical is really the driver of that. And we've had a very strong demand from data center customers, have had historically a strong position in that market, and that market is obviously growing. We're sold out on our 95-liter through 2025 right now. And I mentioned the launch of the new Centum product, which uses our 50 and 78-liter engine. So that's providing additional solution to those customers. And then, of course, we're continuing to look at capacity of the 95-liter and how we plan to support what we think will be continuing strong and growing market."
},
{
"speaker": "Stephen Volkmann",
"content": "So sorry, do you have any concrete plans to increase capacity of 95 yet? Or is that still in process?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes, we do have concrete plans to increase the capacity that we have in place to-date for the 95-liter."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jerry Revich with Goldman Sachs."
},
{
"speaker": "Jerry Revich",
"content": "I wonder if I just ask the cadence of earnings over the course of this year, nice to see an upwards revision to both top line and margins. Mark, can you just talk about where the quarter came in versus your expectations because obviously, the quarter was light versus where the consensus was set up, and I'm just wondering how the quarter developed versus your internal plan. And what's the cadence of the acceleration that you folks are seeing to raise the guidance higher?"
},
{
"speaker": "Mark Smith",
"content": "Yes. I think to be fair to everyone involved to all of you on that side of the fence and all of us here, there's a lot of moving parts with the separation of Atmus. So from my perspective, in total, we came in, in line with our expectations and when you adjust for the mid-quarter separation of Atmus, I think we're by and large in line."
},
{
"speaker": "",
"content": "I would say, as someone pointed out, the Distribution business margins a little bit lower, certainly lower than last year. We see those at the bottom end of the range in Q1 and improving from here, largely driven by what we've seen as a pullback on parts sales, particularly in the industrial off-highway applications."
},
{
"speaker": "",
"content": "So that's the 1 area. It's not new. It's been there for a couple of months, 2 quarters. But otherwise, I'd say we feel good about the gross margin improvement year-over-year. As you can see from our announcements and our comments, we're continuing to look at ways to streamline our organization, make us more efficient where we can. So overall, in line, Jerry, but expecting Distribution in particular to pick up in its margins going forward."
},
{
"speaker": "",
"content": "We've always expected -- probably we were expecting this a little bit last year, to be fair, and it didn't materialize. But we are expecting heavy-duty truck production to decline in the third quarter, in particular, and you've probably heard that from other industry participants. I think the Engine business and Components will feel some of that in Q3, probably Q4 Power Systems and Distribution shouldn't see any significant volatility in revenues."
},
{
"speaker": "",
"content": "And really, the momentum is to the up on Power Systems going forward and into next year, clearly. And Distribution. As you know, it's more than half parts and service and quite predictable and reliable. We just had a little bit of a mix shift with the lower parts, but we think that's temporary."
},
{
"speaker": "Jerry Revich",
"content": "Super. And can I just ask from a bigger picture standpoint, so new regulations 2027 will have embedded warranties essentially. What does that mean for your parts market share. Is that an opportunity when that field population increases for you folks to have higher engine parts market share because of that warranty dynamic on the new regulations, how significant is that opportunity?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean, as you noted, there's a requirement starting with the EPA 2027 regulations for longer emissions warranty for heavy-duty 10 years or 450,000 miles, most of that application is going to mile out. So it's essentially what our 5-year extended warranty that some customers are already purchasing."
},
{
"speaker": "",
"content": "And then that will mean that everybody will need that warranty that will be embedded into pricing on those engine systems and then, of course, we'll drive customers to genuine part throughout that period, which will provide some further benefit to us."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Nicole DeBlase with Deutsche Bank."
},
{
"speaker": "Nicole DeBlase",
"content": "I'm going to ask mine together because they're related. So and they're both around Power Systems. So I think in the guidance, you guys are embedding full year margins below 1Q levels. I think it's a lumpy business, but if I look back historically, it's more common that the second half is higher. And then similar question on growth, the comps [ reduced ] slightly in the second half, but your full year growth guidance is, for an outcome less than the growth you saw in the first quarter. So if you could address both of those items."
},
{
"speaker": "Mark Smith",
"content": "We do tend to see some seasonality on revenue in the fourth quarter, a little bit in the second half. But I think the point of your question is essentially right, Nicole, there's positive momentum there. We've been raising the guidance as the performance is improving."
},
{
"speaker": "",
"content": "There is some modest variation depending on how the parts flow in that business. But overall, our messages, we're confident in the business and the improvements that we have Jenny Bush and her team have really worked hard on over the last 18 months. And if we get more revenue, we're confident we'll be able to turn that in higher earnings. But there's nothing dramatically structurally different. Going forward, we expect improvement over time."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of David Raso with Evercore ISI."
},
{
"speaker": "David Raso",
"content": "May 16, the meeting, can you just give us some expectations around the meeting? I think particularly around the margins. I think people are just trying to figure out the operating leverage in the company in the last couple of years, maybe not quite the margins people were expecting. Even the guide today, it was nice to see the power gen margin increase. But overall, the relative increase in earnings relative to the increase implicit in the sales guide. Still not that tremendous. So I'm just curious if you can sort of tee up a little bit what should we expect May 16. not trying to steal the thunder of the meeting but just to level set..."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. Well, obviously, I won't tell you what we're going to tell you specifically, but certainly, you can expect us to talk about overall strategy for the company where we think we're at against some of the 2030 goals that we shared in our last Analyst Day and certainly talking about revenue and margin expectations and what the drivers for that will be within that. So I think you'll hear more about that for sure, David, at our Analyst Day."
},
{
"speaker": "David Raso",
"content": "Okay. And 1 quick one. The JV income in the first quarter was up year-over-year, but you're still guiding the year down. And I'm just trying to make sure we know why is it down? Is it China not continuing some of the improvement? Is there other parts of the royalty income? I know it's a pretty lumpy line item within the JV income. If you can help us with that would be great."
},
{
"speaker": "Mark Smith",
"content": "Yes. I think you're exactly right, David. There's really 2 moving parts of the operating performance, which generally tends to move in line or better than the market rate. And then we get very lumpy tech fees from the joint venture back to Cummins consolidated results as new products are launched and last year was a particularly strong period of new product launch, [indiscernible] certain development milestones. So the tech fees are going to be down, particularly in the Engine business primarily and that's offsetting any assumptions around the market growth."
},
{
"speaker": "",
"content": "I will say it's -- there was some truck OEM build increases in the Q1, but that was more on expectations or hopes about going forward, we're still waiting for clearer signs of momentum as China, as you know, is the biggest driver of the earnings there. But it's really lower tech fees, which were a big at last year -- a little bit in components, mostly in the Engine business."
},
{
"speaker": "Christopher Clulow",
"content": "One quick add there, David. And we also have built in our plan the launch of the battery joint venture later on this year post approval. So that will have some losses as well as that comes back online in the second half."
},
{
"speaker": "Mark Smith",
"content": "Which is embedded in Accelera."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes, we're expecting that. We have final regulatory approval for that battery JV. So we're expecting that's going to start flowing in Q2."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Angel Castillo with Morgan Stanley."
},
{
"speaker": "Angel Castillo Malpica",
"content": "Just back to the Power Generation segment. I think you raised your guidance to 10% to 15% versus a 5% to 10% previously. Can you just talk about the price versus volume mix makeup of that versus prior expectations? Is this a matter of getting better production than you kind of anticipated? Or is pricing growing and just kind of what are you seeing from that perspective?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So there's a couple of dynamics to keep in mind in that market. So first of all, as I articulated, the order board is pretty long. And so some of the work to improve price cost in response to inflation and performance of the business takes some time to play out. So we're starting to see stronger pricing leverage come into that market. And then we're continuing to, of course, drive improvements in the Power Systems business and efficiency in manufacturing and supply chain. And I noted the launch of the new products that we've also designed to be able to sell at some higher margins. So there are some favorable dynamics that have been happening in the power gen market compared to historically where we would have been in margin performance."
},
{
"speaker": "Angel Castillo Malpica",
"content": "That's very helpful. And along the lines of new products, just you talked about your X15 diesel engine that's coming out for kind of ahead of the emissions regulations. Can you give us a little bit more as to what you kind of expect in terms of guardrails around pricing and margin potential improvement. I know you typically run emission cycles when you get kind of the opportunity to reset and recover some of that margin. So as we think about maybe not necessarily specifically to any given year, but those projects -- or those products and kind of the implications to your price and margins as those get rolled out?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So certainly, like in past emissions regulations, our goal is to deliver incremental value to the customer, to have margin improvement associated with that. You will see with the 27 EPA regulations, we already talked about the emissions warranty dynamic. You will also see added content, in particular, after-treatment system to meet those regulations has notable additional content."
},
{
"speaker": "",
"content": "And then you will also have the warranty dynamic that we always have as we launch new products where we began at least to launch to accrue at a higher rate from a warranty perspective until the product is out in the market, and we've demonstrated warranty. So those are the moving parts that you'll see. We have not yet shared specific numbers on what we expect around exact pricing for those products."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Tami Zakaria with JPMorgan."
},
{
"speaker": "Tami Zakaria",
"content": "So I wanted to understand the margin guide a little better. It seems like excluding Atmus, which probably -- which was a headwind separating that out is becoming a headwind, but you sort of raised the full year guide by about 10 basis points, expecting better margins in Engines and Power Systems. So just to get a sense of what's really driving this improved margin expectation? Is it higher volumes? Or is it more cost savings? Or is it more price/cost? So any color there would be helpful."
},
{
"speaker": "Mark Smith",
"content": "Good question. You're right that the Atmus separation is a little bit dilutive to margins. So yes, good that you picked up on that. It's really volume and a little bit of cost reduction activity. Those are the 2 primary drivers."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Rob Wertheimer with Melius research."
},
{
"speaker": "Robert Wertheimer",
"content": "My question is going to be around your competitive positioning in the 2027 EPA from what you can see today. There's a bunch of questions we get on whether there's a prebuy on what the cost increase would be and maybe the warranty should be stripped out of that, I'm not sure."
},
{
"speaker": "",
"content": "And there may also be more subtle things that you guys would understand better than most of us around how the standards can be met, whether having an additional nat gas where you guys do pretty well can offset other emissions and so forth. So that's the general question. Price increase, whether share gain and whether there's any subtleties around your mix in your early preparedness that will help you in 2027 transition?"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. Great. Thanks for the question. And we are investing, as we've talked about in the new HELM engine platforms. And we're in a unique position because of our scale to continue to invest in what will be a market-leading engine solutions to meet those future regulations."
},
{
"speaker": "",
"content": "And so we expect that, that will provide some advantage for us as we go into those regulations. There will be a dynamic we think that's going to play out in the '25 and '26 time period as end customers anticipate a major regulation change and what that will mean to them."
},
{
"speaker": "",
"content": "And so we expect that's going to drive some things beyond the normal cycle in the U.S. truck market. And then as we go into 2017, there'll be some period of uptake, but we think we're well positioned. Obviously, our position in medium duty has continued to strengthen, and we'll have a next-generation 15-liter natural gas that will go into the market later this year that is of high interest to some of our customers that have sustainability ambitions and see this as the best way, most cost-effective and reliable way to meet those ambitions and then we'll have a new high-efficiency 15-liter platform and 10-liter platform as well. So we're excited about our position with those products and really focused on the execution of development and launching them into the market."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Noah Kaye with Oppenheimer."
},
{
"speaker": "Noah Kaye",
"content": "Just sticking with the EPA 2027 for a minute here. If the final rules continue to provide nice crediting of hydrogen trucks. And just given your offerings in this space, wondering if you started to see more of a pickup for hydrogen fuel cell or whether most of sort of the Accelera inbounds at this point are primarily both."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So if you look beyond even the '27 into the EPA announced the Phase 3 greenhouse gas regulation, which is going to really start to shape the industry as we get into 2030 and beyond, no major surprises for us with that regulation, but it is really an unprecedented level of ambition and assumptions around 0 emissions vehicle penetration. And so the industry and the government is going to have to work really closely together for that to be successful."
},
{
"speaker": "",
"content": "So to your question, one of the things -- there are a few things that we're pleased about in the regulation. One is it actually recognizes hydrogen engines as a zero-emission solution. So we believe that, that will create a space for hydrogen fueled engine that hydrogen fuel cells still are a good solution over time, but the adoption rate on that is likely to be -- take some time, I would say. And then the EPA also did commit to work to streamline hybrid powertrain certification. So hybrid engines, we think, may be an attractive solution because the infrastructure availability is going to be a challenge."
},
{
"speaker": "",
"content": "So that's another thing that we're looking at closely. So there's still some engine-based solutions. Yes, we're seeing an uptick today in more of the battery electric powertrain as I noted, and of course, electrolyzers, fuel cells are still at pretty low level."
},
{
"speaker": "Noah Kaye",
"content": "Yes, makes sense. And then you mentioned that you got regulatory approval for the JV. So just can you lay out for us kind of the game plan on how spending for the gigafactory should proceed over the next couple of years? And what you may be doing at this point in terms of lining up supply and demand for the factory, at least your [indiscernible]"
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. I mean the partners have been working together ahead of getting the final regulatory approval we announced that we selected a site earlier this year. So we'll be -- we're getting a site ready in Mississippi, just outside of Memphis to kind of see and really starting the work to prepare for supply chain and building the plant. We -- now that we have regulatory approval, we believe we'll be able to close and finalize the entity in this quarter."
},
{
"speaker": "",
"content": "And then we'll have phased investment as we build the plant and work towards start of production in 2027. And then we're, of course, sharing this investment of a 21-gigawatt hour plant across the partners and have this design that will allow us to phase in new lines and scale up the plant and production rates based on how we see the industry developing, and we're still feeling really good about how we're positioned in the market together with LFP cell that will be designed specifically for the commercial vehicle market and have the ability to leverage some of the incentive money that's available here to help enable adoption in our commercial vehicle market."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jamie Cook with Truist Securities."
},
{
"speaker": "Jamie Cook",
"content": "So sorry, I'm managing through like 7 calls. I hope this hasn't been asked. But Mark, the question is to you, I guess, understanding you have your guys' Analyst Day coming up this month. I'm just looking at Cummins and thinking, okay, perhaps there's a cost story there, you have market share gains that should be helping you maybe less spend on Accelera. I'm just wondering, as you think about margins over the medium term, do you think there's an opportunity to structurally improve incremental margins? Or as you think about sort of the next couple of years, it is more so taking these actions to hit Cummins' historic targeted incremental margins?"
},
{
"speaker": "",
"content": "And then my second question would be, and if this is addressed, I apologize. Can you just talk to the visibility you have across like in terms of backlog across your portfolio, in particular, for the engine side and the Power Systems side."
},
{
"speaker": "Mark Smith",
"content": "So I heard you we will explicitly address incremental margins in May. You will not miss that for all who are asking, very appropriate, at center of mind -- or top of mind for us clearly. So you will hear that very, very shortly, I guess."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. And Jamie, good to have you back. We're, of course, working and you're seeing the improvement in the Meritor business as we do the integration and Accelera as we ramp up. Revenue, we'll talk more about that. In terms of color on the market, we're seeing continued solid demand in the heavy-duty market because of the high backlogs that have been built up, still a lot of strength in the vocational market."
},
{
"speaker": "",
"content": "Truckload's been down for some time. And so we are still anticipating and hearing from our OEM customers that second half will have some weakening, and that's baked into our revised guidance, which is down, but not as far down as previous guidance. Power gen, I noted earlier, we've sold out the 95-liter through '25. We're looking at capacity there and how we can take that up as well as with the new Centum launch, being able to sell some of our other engines into that market as well."
},
{
"speaker": "",
"content": "So pretty -- really strong feeling very good about power gen, feeling good about medium-duty and vocational on-highway. It's really the -- it's the truckload, fleet customers in the heavy-duty market. That's the one that we're watching closely and still anticipating that it's going to soften before we enter the next uptick in their cycle."
},
{
"speaker": "Mark Smith",
"content": "Yes. And then what you heard maybe earlier was some industry consensus building about '25 and '26 ahead of 2027. So our baseline assumption today is that this is not as sharp or as steep as normal cyclical downturn. That's an assumption, not a fact, but that's what we've baked into our outlook for this year. China is the 1 where we're still -- we're waiting for more momentum probably."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jeff Kauffman with Vertical Research."
},
{
"speaker": "Jeffrey Kauffman",
"content": "I was just curious your thoughts. It's apparent that the downturn, I think a lot of us feared in '24 on the heavy-duty engine side isn't going to be as bad as originally feared. I know ACT Research has taken up their forecast. You did mention some weakness beginning in 3Q, but are we taking from what would have been otherwise prebuy in '26 if we have a better '24? Or do you think the 2 are unrelated?"
},
{
"speaker": "Jennifer Rumsey",
"content": "I'm not sure that they're related. I mean, we're really watching what's going on with production rates with backlog with some of the spot rate dynamics in the market. And if you look at some of the freight carriers out there, they've been challenged now for the last 18 months."
},
{
"speaker": "",
"content": "And so that's what's driving our outlook, but fair. I mean we -- because of the -- it's really the supply chain dynamic that has made this cycle so different and even unpredictable. It certainly held up better and longer than we had forecast, and we are still expecting to see some softening in the second half."
},
{
"speaker": "Jeffrey Kauffman",
"content": "Well, congratulations."
},
{
"speaker": "Operator",
"content": "Our last question comes from the line of Chad Dillard with Bernstein Research."
},
{
"speaker": "Unknown Analyst",
"content": "This is Federico filling in for Chad. I would like to double click on the R&D intensity and how to think about this on the medium-term basis."
},
{
"speaker": "Christopher Clulow",
"content": "Sorry, can you repeat that? I don't think we got the first part."
},
{
"speaker": "Unknown Analyst",
"content": "Sorry. We would like to double-click on the R&D intensity and how to think about this on a medium term basis."
},
{
"speaker": "Jennifer Rumsey",
"content": "Yes. So we are -- as you know, we've taken up our R&D investments. We noted that in our comments because we're making investments, in particular in these new fuel-agnostic engine platform. So we're at an elevated level of R&D for those new platform investments. And those products are beginning to launch and really will launch through the '26 and '27 time period. And then, of course, we're at a period of investment in the Accelera business as we work to launch new products and ramp up revenue there as well."
},
{
"speaker": "Operator",
"content": "Thank you. I'd like to turn the floor back over to Chris Clulow for closing comments."
},
{
"speaker": "Christopher Clulow",
"content": "Thanks, everybody, for your participation today. That concludes our teleconference. Really appreciate the interest. And as always, the Investor Relations team will be available for questions after the call. Have a good day."
},
{
"speaker": "Jennifer Rumsey",
"content": "Look forward to seeing many of you in person in a couple of weeks."
},
{
"speaker": "Operator",
"content": "This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
cms | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, everyone, and welcome to the CMS Energy 2024 Year End Results. The earnings news release issued earlier today and the presentation used in this webcast are available on CMS Energy's website in the Investor Relations section. This call is being recorded. After the presentation, we will conduct a question and answer session. Instructions will be provided at that time. If at any time during the conference you need to reach an operator, please press the star key followed by zero. Just a reminder, there will be a rebroadcast of this conference call today beginning at 12 PM Eastern Time running through February 13th. This presentation is also being webcast and is available on CMS Energy's website in the Investor Relations section. At this time, I would like to turn the call over to Mr. Jason Shore, Treasurer and Vice President of Investor Relations."
},
{
"speaker": "Jason Shore",
"content": "Thank you, Harry. Good morning, everyone, and thank you for joining us today. With me are Garrick Rochow, President and Chief Executive Officer, and Rejji Hayes, Executive Vice President and Chief Financial Officer. This presentation contains forward-looking statements, which are subject to risks and uncertainties. Please refer to our SEC filings for more information regarding the risks and other factors that could cause our actual results to differ materially. This presentation also includes non-GAAP measures. Reconciliations of these measures to the most directly comparable GAAP measures are included in the appendix and posted on our website. And now, I'll turn the call over to Garrick."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Jason, and thank you everyone for joining us today. In the words of James Brown, I feel good. CMS Energy. Twenty-two years of consistent industry-leading financial performance. Every year for over two decades. You can count on us to deliver. We do that through our simple but powerful investment thesis, coupled with disciplined execution across our electric and gas businesses. We take our legacy of service and excellence seriously at CMS Energy. We play to win every day. We have a lot to celebrate about 2024, and today, I will highlight a few key successes, among many, to demonstrate how we deliver for all of our stakeholders year in and year out. First, our work to improve customer reliability. Our five-year reliability roadmap, which we filed in 2023, set bold commitments to improve service to our customers. To never have more than 100,000 customers disrupted per event and have service restored within 24 hours. And we are making progress. In 2024, we restored power to over 93% of customers within 24 hours, compared with 87% in 2023. And the average customer experienced 21 fewer power outage minutes. And although there is still more work to do, it is clear the investments are making a meaningful difference. I'm also pleased with the work on the electric supply side. In November, we filed our 20-year renewable energy plan. This critical long-term filing highlights the thoughtful changes we will make to our generation portfolio as we transform our system for more renewables and a diversified mix that includes nine gigawatts of solar and four gigawatts of wind over the next two decades. This filing details to the commission our commitment to leading the clean energy transformation and achieving the target established in Michigan's 2023 energy law. Most importantly, it demonstrates our commitment to diversify the energy portfolio and invest in supply infrastructure to serve our customers with reliable and clean energy in the most affordable manner. And, of course, our gas business continues to grow. I'm extremely proud of our coworkers' efforts to build and replace infrastructure that ensures a safe, reliable, and clean natural gas system. The system has proven invaluable to customers throughout the year and even more recently in the extreme cold experienced in January. I could give many more examples, and some are listed on this slide, which speak to the winning program at CMS Energy and are further proof points of our investment thesis in action, ensuring you can count on us to deliver value for all stakeholders every year. On slide five, we've highlighted our five-year $20 billion utility customer investment plan, up $3 billion from our prior plan. A significant and needed increase designed to deliver better customer service through improved reliability both in distribution and supply, driven largely by our reliability roadmap. As we bolster our electric distribution system and by investments in our supply portfolio as we expand our renewable pipeline to meet the energy law. This plan supports 8.5% rate-based growth through 2029. In addition to the robust customer investment plan, we have growth drivers outside traditional rate base. These are important and sometimes overlooked, so let me spend a moment here. The financial compensation mechanism, which allows us to earn on PPAs, grows during the five-year period, offering approximately $20 million of incentives by the end of the decade and continues to grow thereafter as we secure additional PPAs. There's more than $60 million per year of incentives through our energy efficiency programs, enhanced by the energy law. We also expect incremental earnings from our non-utility business NorthStar Clean Energy, as we continue to see attractive pricing from capacity and energy sold at Dearborn Industrial Generation, or DIG. I want to take a moment to highlight the long runway of customer investments, which are incremental to our five-year plan, giving us confidence in our financial performance and continued growth of our company. Slide six shows the detailed filings we expect over the next ten years and beyond, which will be incorporated into future five-year updates. On the slide, you can see key investments in the electric distribution system to improve reliability for our customers through rebuilds, undergrounding, hardening, and technology. $10 billion of opportunity not in the five-year plan. In the middle of the slide, renewable energy plan. An ambitious and thoughtful plan to achieve 60% renewables by 2035, as required by the energy law, and in response to significant load growth in our service area, providing for additional wind and solar resources. $10 billion of opportunity not in the five-year plan. And finally, the 2026 integrated resource plan filing, which will shore up the intermittency of renewables, build out battery storage, and deploy clean energy required under the energy law. The modeling for this filing is underway and will provide additional customer investment opportunities. So altogether, well over $20 billion that is not in the five-year plan. Now let's talk about our formula to keep rates affordable for our customers to accommodate these needed investments. You know our track record. You've heard me share in the past about our deliberate and sharp focus on taking cost out. Whether it is episodic cost savings through plant closures, renegotiating PPAs, operating our plants better than the markets, leveraging the CE Way for process improvement, the use of digital technologies to improve efficiency, or strong economic development. I'm confident in our ability to keep bills affordable while delivering on the needed customer investments, ensuring every dollar is maximized and adds value. Speaking of economic development, I've said it before. Michigan is in a renaissance. Growth. Our five-year plan now incorporates the significant economic development we are seeing with upwards of 2% to 3% annual load growth. We feel really good about the quality of growth we see materializing across our service area in the state. Data centers and manufacturing load. Well, we see a nice mix coming to the state. The manufacturing growth brings with it jobs, supply chains, commercial activity, housing starts, and residential growth, which allows us to couple customer investments with affordability as we spread fixed costs over a larger customer base. We're committed to growing Michigan, and we are pleased with what we've contracted and the now nine gigawatt pipeline of opportunities not yet in the plan. We work hard every day to win our customer's business, and we are honored when businesses see the value in investing in our state and our service area. Jumping to Michigan's regulatory environment, we continue to see a strong and supportive energy policy to ensure timely recovery of investments and incentives above and beyond stated ROEs, as well as constructive regulatory planning mechanisms like renewable energy plans, integrated resource plans, and investment recovery mechanisms that streamline the rate case process. In 2024, we delivered successful outcomes in our electric rate case, settled our fourth consecutive gas rate case, and saw support for our distribution investments through the Liberty audit. For 2025, we expect a constructive outcome in our electric rate case with an order by the end of March. Our gas rate case is in the early innings, but we expect good support for the needed investments to keep our system safe."
},
{
"speaker": "Rejji Hayes",
"content": "And as I shared earlier, the renewable energy plan with an expected outcome in late Q3 of 2025 is something to look forward to given the large amount of renewables needed to meet the energy law and the growing demand we're seeing across our service area. Now onto the financials. We delivered adjusted earnings per share of $3.34 for the high end of our guidance range. For 2025, as you might expect, we are raising our 2025 guidance off 2024 actuals from $3.52 to $3.58 to $3.54 to $3.60, which represents 6% to 8% growth, and we continue to guide toward the high end. We also continue our long-standing tradition of compounding off actuals, providing our investors with a higher quality of earnings. Longer term, we continue to guide toward the high end of our adjusted EPS growth range of 6% to 8%, which implies and includes 7% up to 8%. Our dividend policy remains unchanged. We continue to target a dividend payout ratio of about 60% over time. With that, I'll hand the call over to Rejji."
},
{
"speaker": "Rejji Hayes",
"content": "Thank you, Garrick. And good morning, everyone. As Garrick highlighted, we delivered strong financial performance in 2024, with adjusted net income of $998 million, which translates to $3.34 per share and towards the high end of our guidance range. The key drivers of our 2024 financial performance included constructive regulatory outcomes, a solid beat at NorthStar, cost performance fueled by the CE Way, a variety of non-operational countermeasures which more than offset the many challenges we saw throughout the year. For the second year in a row, we experienced significant weather-related financial headwinds, primarily in the form of mild winter temperatures in the first and fourth quarters. In fact, for our records in 2024, we had the warmest winter in the last 25 years, based on heating degree days. Yet despite these challenges, we managed to offset the weather-driven headwinds without compromising our commitments to our customers, communities, or coworkers. To elaborate on the strength of our financial performance in 2024, on slide eleven, you'll note that we met or exceeded all of our key financial objectives for the year. To avoid being repetitive, I'll just note that we successfully invested $3.3 billion as per original guidance to make our electric and gas system safer, more reliable, and cleaner on behalf of our three million customers at the utility. We managed to do this while funding the business in a cost-efficient manner largely through operating cash flow, well-priced bonds at the utility, and tax credit transfers in the inaugural year of this new financing vehicle. This funding strategy enabled us to maintain our solid investment-grade credit metrics and associated ratings as affirmed by each of the rating agencies over the course of the year, most recently by S&P in December. Moving to our 2025 EPS guidance, on slide twelve, you'll note the rebasing of our 2025 adjusted EPS guidance off of actuals. For additional clarity, our 2025 adjusted EPS guidance increased by $0.02 per share on the low and high ends of the range commensurate with the amount by which our 2024 adjusted EPS of $3.34 exceeded the midpoint of last year's EPS guidance. Our increased 2025 EPS guidance implies 6% to 8% growth with continued confidence toward the high end of the range as Garrick noted. As you can see in the segment details, our EPS growth will primarily be driven by the utility providing $4.01 to $4.05 of adjusted earnings as we plan for normal weather, constructive rate case outcomes, and earned returns at or near authorized levels. At NorthStar, we're assuming an EPS contribution of $0.18 to $0.22, which incorporates a planned maintenance outage at DIG, offset by ongoing contributions from NorthStar's clean energy business. Lastly, our financing assumptions remain conservative at the parent segment with the expectation of approximately $1.3 billion of new holdco long-term debt and up to $500 million of equity to support the increased capital plan at the utility. Our 2025 guidance also assumes the absence of liability management transactions. To elaborate on the glide path to achieve our 2025 adjusted EPS guidance range, you'll see the usual waterfall chart on slide thirteen. For clarification purposes, all of the variance analysis herein are measured on a full-year basis relative to 2024. From left to right, we'll plan for normal weather in this case amounts to $0.39 per share of positive variance given the expected absence of the atypically mild winter temperatures experienced in 2024. Additionally, we anticipate $0.21 of EPS payout attributable to rate relief by the residual benefits of last year's successful gas rate case settlement and the expectation of constructive outcomes in our pending electric and gas rate cases. Outside of the general rate cases, we also expect to see earnings contributions from our renewable investments as construction of these projects progress. As always, our rate relief figures are stated net of investment-related costs such as depreciation, property taxes, and utility interest expense. As we turn to the cost structure in 2025, you'll note three cents per share of positive variance due to the anticipation of continued productivity driven by the CE Way. We also expect a healthy reduction in operating expenses attributable to the closure of our remaining coal units midyear, which will be largely offset by increases to vegetation management and other electric reliability-related cost categories, all of which align with our pending electric rate case. Lastly, in the penultimate bar on the right-hand side, you'll note a significant negative variance which largely consists of the reversal of select countermeasures in 2024 and expected capital cost associated with the aforementioned parent financings. We're also including the usual conservative assumptions around weather-normalized sales and taxes among other items. In aggregate, these assumptions equate to $0.37 to $0.43 per share of negative variance. As always, we'll adapt to changing conditions throughout the year to mitigate risks and deliver our operational and financial objectives to the benefit of customers and investors. On slide fourteen, we have a summary of our near and long-term financial objectives. As Garrick noted, from a dividend policy perspective, we're targeting a payout ratio of about 60% and anticipate remaining in that area over the course of our five-year plan. Given the elevated cost of capital environment and the breadth and depth of customer investment opportunities before us, we continue to believe that it is prudent to retain more earnings to fund growth. From a balance sheet perspective, we continue to target solid investment-grade credit ratings and will continue to manage our key credit metrics accordingly as we balance the needs of the business. As such, we intend to resume our at-the-money, at-the-market, or ATM acquisitions program in the amount of up to $500 million in 2025 as mentioned earlier. We expect this level of equity issuance to trend down in the outer years of our plan as we increase the size of our tax credit transfer program, given the substantial renewable build-out underway in accordance with Michigan's energy law. Lastly, we also expect select large multiyear economic development projects to begin coming online in 2025, yielding approximately 1% weather-normalized load growth for the year with run-rate assumptions of 2% to 3% in the outer years of our plan as other large projects come online. Slide fifteen provides a look into the historical performance and estimated growth of NorthStar's DIG facility with upside potential beyond 2026 as capacity prices in zone seven continue to increase. Given the rising cost of new entry, we have updated potential range of outcomes accordingly. As you can see in the bars on the far right-hand side of the chart, we remain bullish on the opportunities in the bilateral market for DIG and will continue our strategy of layering in contracts over time. Slide sixteen offers more specificity on the funding needs in 2025 at the utility and the parent. The only additional financings I've mentioned for the year are the planned debt issuances at the utility, which we anticipate being a little over $1.1 billion. It is also worth noting that we have not assumed the issuance of any junior subordinated notes, also known as hybrids, in our 2025 financing plan or in our five-year plan, which offers a potential opportunity if we see attractive price points in the market. Needless to say, we'll remain opportunistic throughout the year. On slide seventeen, we have refreshed our sensitivity analysis on key variables for your modeling assumptions. As you'll note, with reasonable planning assumptions and our track record of risk mitigation, the probability of large variances from our plan is minimized. Our model has served and will continue to serve all stakeholders well. Our customers receive safe, reliable, and clean energy at affordable prices. Our diverse and battle-tested workforce remains committed to our purpose-driven organization, and our investors benefit from consistent industry-leading financial performance. And with that, I'll hand it back to Garrick for his final remarks before the Q&A session."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Rejji. Finish where I started. And with James Brown. I feel good. But I can't hold a tune. So instead, I'll fix like this. Twenty-two years. Twenty-two proof points of consistent industry-leading financial performance. Providing you with predictability and strong growth compounding off actuals, which very few do in our sector. Providing you with a higher quality of earnings. We had a great 2024, remain confident in our strong outlook for 2025 and beyond. As we continue to execute on our simple investment thesis and make the necessary and important investments in our system, we will maintain customer affordability. With that, Harry, please open the lines for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you very much, Garrick. The question and answer session will be conducted electronically. If you would like to ask a question, please do so by pressing the star key followed by the digit one on your touch-tone telephone. If you're using a speaker function, please make sure you pick up your headset. We'll proceed in the order you signal us, and we'll take as many questions as time permits. If you do find that your question has been answered, you may remove yourself from the queue by pressing the star key followed by the digit two on your touch-tone telephone. And we'll now pause for just a second. Our first question today will be from the line of Julien Dumoulin-Smith with Jefferies. Please go ahead. Your line is open."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Hey. Good morning, team. Nicely done. Thanks again for the time. Appreciate it."
},
{
"speaker": "Garrick Rochow",
"content": "Hey. Morning, Julien."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Let me kick it off here. Hey. Good morning. Thank you. Look. Let me just kick it off on something a little bit more timely here. Just with respect to the permitting, you guys have a lot going on the renewable front. I'd love to hear your thoughts about the ability to execute in this environment. You guys specifically have wind in your outlook. I'm just curious to get your thoughts here given some of the backdrop here on the ability to execute, and especially given the permitting regime has been something of a conversation in recent times in your geography. Then I'll pivot back to some of the financials."
},
{
"speaker": "Garrick Rochow",
"content": "Well, the team is doing some amazing work, and from a pipeline perspective, both on wind and solar. And I'll just give you some context of that before I jump into kind of the administration kind of federal administration piece. We just finished up a wind project in late last year which was very successful. We got two large solar projects underway. A Muskegon solar project's 250 megawatts. Just announced this last week, another 360 megawatts we're building in Southwest Michigan. And so and this team's got along the pipeline. So this whole permitting thing, here's a secret to it, and it's not much of a secret. It's being on the ground. Right? It's with the locals and the local townships, local communities to get accepted for the projects and the tax dollars that come with those projects. It's working with landowners. That's been our success. And so when it comes to specifically wind in this administration, that's particularly aimed at federal lands. We're not doing anything offshore, and we're not doing anything on federal lands. It's all private. And that's where our point of success is. And so we do see we do see an opportunity for future wind projects. In many cases, it's been repowering. It's expansion within existing parks. And there's a couple new projects that are underway and under consideration. But I feel good about our ability to build out these renewables. And then remember always that this renewable energy plan is an iteration. So if I gotta make an adjustment in a year, we'll do that. And that's what gives me a lot of confidence about our future and ability to continue to deliver on this important customer investment agenda."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Awesome. Excellent. Thank you for that. I know that other folks are kinda curious to understand exactly how that gets implemented, if you will. But pivoting back to the business, I mean, obviously, very nicely done here. Thank you for the updates on the low growth front. I mean, can you speak a little bit to what the legislation you know, does and especially could do prospectively? You kind of alluded it in broader terms. Can you speak a little bit more specifically in terms of what the contribution is in the 2% to 3% and what the big moving factors could be, especially subsequent legislation, which is fairly recent, right, in terms of what's reflected in that 2% to 3%?"
},
{
"speaker": "Garrick Rochow",
"content": "You're assuming are you talking about state legislation? Just to clarify your question, Julien."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Yeah. Yeah. Yeah. Oh, yeah. Apologies. Yeah. I'm thinking about the sort of the data center avenue. And to what extent is that reflected in that 2% to 3%? And, again, is it just a little bit too nascent given recently some of the stuff materialized?"
},
{
"speaker": "Garrick Rochow",
"content": "So I wanna be really clear about our sales growth, and this is exciting piece because it's evident in our renewable energy plan that we filed in November. It's part of our five-year plan that we're talking about today. This 2% to 3% load growth is not a pipeline. It's not hypotheticals. This is stuff that contracted. We have a high confidence that we're building substations to support. Some of this load starts to come on in 2025 and then continues out throughout 2029 in this five-year plan. So there's a lot of there's a high degree of confidence about this 2% to 3%. That's the important piece. And then if you look forward, there's a nine gigawatt pipeline. And there were several quarters ago, I talked about that pipeline. It was smaller, so grown, and it shifted a little bit to more data centers. It's about 65% data centers now. The rest is manufacturing. And that's in part due to this legislation passing, the sales and use tax. So that passed in end of the year. The governor just signed it mid-January, and so we're starting to see a nice uplift there. And you hear, like, you've heard Microsoft acquiring land. We're working with other hyperscalers as well. And so and you've also heard about a semiconductor project in Genesee County. There's a lot of energy here. No pun intended. A lot of excitement about the sales growth here. Both what we've secured in that pipeline. And so I'm excited about Michigan."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. Julien, all I would add to Garrick's comments is you think about the 2% to 3%, just to give you additional specificity, we've got multiple projects embedded in that. I'd say six or seven larger ones, and it's well diversified. So data centers are represented in that mix. But, again, there's a lot of non-data center activities we've talked about for some time, just given the attractiveness of Michigan. Remember, it's not just competitive rates. We've also got, obviously, good fiber network. We've got really good access to fresh water, which is attractive for a lot of these manufacturing businesses because they do include water in their processes. And we've got a lot of energy-ready sites because we've been doing the hard work for many years now, not just over the past couple of years. So we are well prepared to welcome these opportunities into Michigan, and the opportunities embedded in that 2% to 3% in our five-year plan, those are either signed or imminently signed. So again, there's not a whole lot of beta around those opportunities. The one thing I would circle back to on your question about the permitting is that as Garrick noted, all of the projects we're executing on are on private lands, and as I understand it, you know, the private lands are also to some extent in the crosshairs a bit. But I think that that's also centered on wetlands associated with private property. Again, none of our projects are situated in wetlands that could be subject to federal regulations. So, again, to Garrick's comments, we feel very good about our fact panel, respect to permitting and the associated build-out of renewables over time."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Alright. Excellent, guys. I'll leave it there. See you guys soon. Alright? All the best."
},
{
"speaker": "Rejji Hayes",
"content": "Take care, Julien."
},
{
"speaker": "Operator",
"content": "The next question will be from the line of Jeremy Tonet with JPMorgan. Please go ahead. Your line is open."
},
{
"speaker": "Jeremy Tonet",
"content": "Morning, Jeremy."
},
{
"speaker": "Rejji Hayes",
"content": "Hi. Good morning. Just wanted to dive in a little bit if I could with regards to, I guess, how you feel about the regulatory environment in Michigan. There's been, you know, some concern in the marketplace with recent orders and figured that it would be good just to hear from you guys how you think about things these days."
},
{
"speaker": "Garrick Rochow",
"content": "Jeremy, you like sausage? I mean, I love breakfast, so I gotta tell you this. I gotta tell you this. Like, a breakfast burrito, an egg scramble, I love seasoned sausage. The reality is, like, I don't like how sausage is made. No one wants to see how sausage is made. Right? And I think that's the that's the challenge. Everybody's getting wrapped around the axle about the Michigan regulatory environment, and that's just the nuances of the mark of the environment. You got the pluses and deltas. Everybody's paying attention to it, but the bottom line is the bottom line is we get constructive outcomes. 2022, 2023, remind you of 2024. Like, successful electric outcome. It consist you know, fourth consecutive gas settlement. We'll get a constructive outcome in this electric rate case. And so like, yeah, there's this push and pull that goes on within the regulatory environment, I'm not here ringing my hands. Like, I'm we like, our job is to sweat the sweat the small stuff. That's what we do. We sweat the small stuff. We work to we work the commission process. And we get constructive outcomes. And so when we're out there talking about 6% to 8%, toward the high end, this consistency and predictability that our investors can count on is because we sweat it. Day in and day out. So bottom line, we work through all that at the commission. And we get to good outcomes. And I think that's the bottom line, Jeremy."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Sausage. Understood. Just wanted to go if I could pivot to DIG for a second here. It seems like I think you mentioned outage. I'm just wondering, how much of a headwind that is for per EPS this year. If you could quantify that."
},
{
"speaker": "Garrick Rochow",
"content": "Well, first of all, I'll let Rejji walk through the numbers on that, but the teams did this were just like any major outage, we do these every seven, eight years. Teams prepared, ready to execute, materials are all there. And so we've talked about this last year, and this is part of the plan this year, and it's there's some renewables that are part of the mix that help with the EPS numbers and contribution from NorthStar."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. I think Garrick summarized it well, Jeremy. So, yeah, we'll probably lose about a little less or rather a little more than 50% of DIG's contribution in prior years, but that will be offset by contributions from existing operating assets. Remember, we do have a thermal generation fleet beyond DIG. We also have existing renewable projects such as the Aviator Project and others. And then we also do have some multiyear projects that are underway that we expect to achieve commercial operation data COD in the second half of this year. And so it's a combination of additional contributions from new and existing operating assets, and so that should offset DIG's contribution this year."
},
{
"speaker": "Jeremy Tonet",
"content": "Right. I guess I was just thinking. I mean, guidance might have been even higher if not for this turnaround. But understood your points there. That's what we thank you."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. I mean, outages are reality of the business. So, unfortunately, this year, we'll have a modest DIG, David. But in the subsequent years, we expect to see additional growth, which we highlighted on slide fifteen in the materials."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Thanks."
},
{
"speaker": "Operator",
"content": "The next question today will be from the line of Michael Sullivan with Wolfe Research. Go ahead. Your line is open."
},
{
"speaker": "Michael Sullivan",
"content": "Morning, Mike."
},
{
"speaker": "Garrick Rochow",
"content": "Hey. Good morning."
},
{
"speaker": "Michael Sullivan",
"content": "Hey, Garrick. I didn't eat breakfast, so you're making me making me a little hungry. I have sausage."
},
{
"speaker": "Garrick Rochow",
"content": "I usually eat before the weekend. Like, I can't treat myself. All the time. I gotta wait for the weekend."
},
{
"speaker": "Operator",
"content": "There you go."
},
{
"speaker": "Michael Sullivan",
"content": "Actually, I wanted to start with Rejji just on the financing side. So do you mind just maybe bridging us a little bit from the $3 billion CapEx increase to will you increase on the equity side? Because it seems like maybe a little bit less than what we would have otherwise expected in terms of equity need. How much is maybe tied to tax credit transferability? Any additional color there would be helpful."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. Happy to provide some information on that, Michael, and appreciate the question as always. So as you may recall, in the past, we've talked about this sensitivity between every dollar of capital investment funded by about thirty-five to forty cents of common equity at the holdco. And that's about where we are if you just think about the glide path from this vintage we've just rolled out today of a five-year plan versus a prior. And so to give you specific numbers, we're up $3 billion vintage over vintage of aggregate CapEx. And so that implies about another $120 million or so of equity. The prior plan had up to $350 million of equity starting this year, and so you add $120 on top of that. You start to get that $500 million range. And that's what we expect from an equity issuance perspective over the next two to three years. And then as we get to the outer years of this plan, it does step down, and that's why I said on a long-term basis, the average will be about $450. And what you see is we do have we're expecting about $85 million or so roughly of tax credit monetizations this year, but that will step up over the course of this five-year plan as we execute on more renewable projects to comply with the energy law. And so we expect over $700 million of tax credit transfers in aggregate over the course of this five-year plan, and that compares favorably versus the expectations in the prior five-year plan, which was closer to over a little over half a billion. So that tax credit ramp-up or that tax credit transfer ramp-up is really what's driving down the equity needs in the outer years of the plan. And I would say in the front of the plan, pretty directly consistent with our historical sensitivity between CapEx and equity needs."
},
{
"speaker": "Michael Sullivan",
"content": "Okay. That's really helpful. And second question, I'm gonna stick with you here, Rejji. In terms of the liability management side. How do you think about if there's more to potentially do if necessary? I know you didn't bake it into the plan, but if weather is mild again for the second or third year in a row, are there more levers to pull on that front? And then maybe if I could also tie in, like, again, where you're conservative without baking in any hybrid issuances. Like, is that available to you currently, you think? And just wanted to be really conservative? Yeah. Just trying to think about where you have some of the flex."
},
{
"speaker": "Rejji Hayes",
"content": "Absolutely. And so I would say with respect to liability management, certainly, that was a very helpful tool in the toolkit over the course of 2024 and 2023, I'd remind you. And so we did lean into those. I think the benefits are several fold. I mean, obviously, we wanna peg them to weather. And so we'd have to see what weather does over the course of the year if we were gonna go down that path because we view opportunities like that as transitory like weather. So we would wanna peg it peg them to weather. But I'd say given our utilization of those over the past couple years, I'd say there's certainly more opportunities there, but we'd have to see where interest rates go. I mean, right now, it certainly makes the environment hospitable because rates have remained range-bound and fairly high, which creates the discounts on extinguishments that drive the gains. But, again, we have to see where weather trends and needless to say, going on year eight here at CMS. And as we've said before, you know, we don't discriminate when it comes to the cost structure, and so we look broadly, whether that's tax planning, whether that's operational O&M related flags, whether that's a CE Way. We will continue to look throughout the cost structure and execute on levers wherever we find them. And that's why we've been successful for so many years now. It's just staying paranoid identifying risk, quantifying risk, and making sure we have opportunities that exceed the risk. And so that's what we'll do going forward. That's the playbook, and I don't see us deviating from that. Transitioning to the question around hybrid, certainly, that's an opportunity as I think we may have talked about in the past. The real limitations there is, obviously, we'll see where market conditions are, but it seems like there's pretty good depth and appetite for junior subordinated note paper in the market. We saw some issuances recently and at pretty interesting levels. And there was quite a bit of activity last year, I think, catalyzed by Moody's increasing the equity credit they ascribed to hybrids in Q1 of last year. So certainly an opportunity. And we were doing those long before that was that became a thing. And so I'd say it represents less than 10% of our book capitalization. There's a threshold by S&P at 15%, and so that gives us about $3 billion of additional capacity to do hybrids. And so, again, it's a tool in the toolkit. We'll be opportunistic. We see the right pricing, and that can allow us to do both credit and EPS accretive deals from a financing perspective versus plan, we'll certainly look to do that."
},
{
"speaker": "Michael Sullivan",
"content": "Really appreciate it. Very helpful. Thank you."
},
{
"speaker": "Rejji Hayes",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question will be from the line of Andrew Weisel with Scotiabank. Please go ahead. Your line is open."
},
{
"speaker": "Andrew Weisel",
"content": "Morning, Andrew."
},
{
"speaker": "Rejji Hayes",
"content": "Good morning, everyone. You covered a lot of areas. Just one quick I wanted to clarify on the dividend. The pace of the increase has decelerated, past couple of years. Wanted to just understand the payout ratio for 2025 should be right around your target at 61% based on the midpoint of guidance. You obviously tend to beat the guidance midpoint as we all know. So my question is looking to 2026 and beyond, how should we think about the dividend growth? I understand it's a board decision. Rejji, I think you made a comment about wanting to retain more earnings to finance growth. How should we think about the pace of dividend growth relative to earnings going forward starting in next year?"
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. I appreciate the question, Andrew. And I'll take a walk down memory lane, because as you may recall, when we sold EnerBank, in 2021 in at the risk of sounding self-serving, boy, is that transaction aged well. We increased the growth rate at that time, and that's when we started going toward the high end to 7%, 8%. We just thought it was prudent to decouple the dividend per share growth at that time from the EPS growth. Also, we did have to rightsize it because we went up to, like, 65% payout, which we thought was not comparable versus our growth year peers. And so at that point, we've been on this sort of glide path of DPS growth. It was initially sort of low 6%. It's now sort of 5% to 7% toward the low end. And that has made a lot of sense as we glide path down to a 60% payout ratio. And just frankly, again, to your comment and my comment in my prepared remarks, retain more earnings so that we can redeploy those earnings into the utility growth and rate-based growth. And so that will be our MO. As I look in the outer years, again, we'll probably have pretty consistent dividend per share increases. And so you'll see that growth kinda being the low 5% year over year. And I still think we'll be no. I think I anticipate us being sort of in that sort of low sixties, high fifties range for some time. And to your comment, we'll obviously have to confirm that our board is supportive of that year in and year out as we always do. But it should be, you know, around 60%. Again, it may be sort of high fifties or thereabouts, but I think that, again, is the most prudent use of capital in the current environment because we've got a breadth and depth of CapEx backlog that really warrants significant. So support from a funding perspective, and we just don't think it makes sense to sort of recycle the capital through the external markets. Why not just retain more and redeploy it into the business? So that's gonna be our MO for some time. That helpful, Andrew?"
},
{
"speaker": "Andrew Weisel",
"content": "It is. I certainly don't disagree. I just wanted to make sure you're comfortable going into the fifties, and it sounds like you are. Thank you very much."
},
{
"speaker": "Rejji Hayes",
"content": "Yep."
},
{
"speaker": "Operator",
"content": "The next question will be from the line of Nicholas Campanella with Barclays. Please go ahead. Your line is open."
},
{
"speaker": "Nicholas Campanella",
"content": "Morning. Morning."
},
{
"speaker": "Rejji Hayes",
"content": "Hey. I just wanted to ask just a follow-up to Jeremy's question a little bit further on, like, NorthStar and the big opportunities. Just you've outlined some of the potential upside there, but to the extent that you have, just better bilateral opportunities that come down to pipeline that are incremental to that. Is that still just a further extension of the 6% to 8%, or would you kind of reevaluate, you know, at that time? Thanks."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. I'm gonna use three words, Nick, with which I think you're well familiar and you know, our bias is always to strengthen the length in the plan. And so while there certainly may be additional opportunity with the roughly 25% open margin that we highlighted in the outer years of the plan, which could be we've contracted at really attractive rates. Just given the tightening we continue to see in zone seven. You know, it just gives us additional opportunity to strengthen the length of the plan. And I think it's worth reminding folks, and Garrick highlighted this in his prepared remarks. I mean, remember, we compound off of actuals year in and year out. So you really wanna make sure that you've got enough support to do that because it gets harder every year by definition. And so, again, that's been our bias for some time, and that would be the intent. As you can see on slide fifteen too, yes, there's open margin, there's a tightening market, and there's additional opportunity, but it's also important to know we did realize a good portion of that in this plan. And so you can see in that bar that says 2026 through 2029, we've stepped up the earnings power of DIG pretty handsomely by, again, contracting at really attractive rates. So there's still additional opportunity on the outside looking in, but we didn't realize a good portion of that this plan. Let me stop there and see if there's any further questions beyond that."
},
{
"speaker": "Nicholas Campanella",
"content": "No. Hey. That's helpful. And then I just my only follow-up on the REP, like, I know it's early, but just is this something that you expect to take a full distance, or is there a settlement potential opportunity in there too?"
},
{
"speaker": "Garrick Rochow",
"content": "We'll always look for settlement opportunities. This renewable energy plan would be more similar to the integrated resource plan. We've had success in settling integrated resource plans. And so, again, I would look for settlement opportunities in that renewable energy plan. But at the latest, it'll go into the Q3 of the year. And, again, it's a good plan. Got confidence in taking the whole way if need be."
},
{
"speaker": "Nicholas Campanella",
"content": "Alright. Thanks a lot. See you soon."
},
{
"speaker": "Garrick Rochow",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question will be from the line of Durgesh Chopra with Evercore. Please go ahead. Your line is open."
},
{
"speaker": "Durgesh Chopra",
"content": "Hey, team. Good morning. Thanks for the discussion today."
},
{
"speaker": "Garrick Rochow",
"content": "Hey. Good morning, Garrick. All my other questions have been answered. Just one big picture question on tariffs. You know, they if, you know, China tariffs and in fact, now as you know, when they stay on for a prolonged period of time, just thinking about how it impacts you, especially given you have a considerable amount of renewable investment in the plan. So when we talk to your supply chain, how you're dealing with that, just, you know, any color you could share, that would be great. Thank you."
},
{
"speaker": "Garrick Rochow",
"content": "Really, the team's done great work. We've really done our homework here. So just let me talk through some numbers. So when we look at direct spend across our supply chain, and we looked at it both Canada, Mexico, and China. It's a little over 5% direct that it's coming from one of those three locations in the world. When we look at indirect spend, so indirect, you're going with a company that might be US-based, but they have a spend in either, again, Mexico, Canada, or China. It's a well, again, a little over 5%. So we're talking about 10% to 12% of the overall supply chain mix. And so it's small in the context, so that but to your point, we're actively working to mitigate that. And that's one, we've bumped up our supply stock a bit. Two, we've looked at how to migrate to other vendors that are US-based that's a way to deal with it as well. So that's the supply chain. So I got great confidence in our ability to execute the capital plan and keep bills affordable for our customers. Now the other piece is in electric and natural gas, so let me talk about that. Homework we've done as well. Because there as part of MISO, there are you know, Canada is part of the MISO mix. But remember this, given our natural gas plants. We're typically putting energy into the market. Great heat rates. Got low cost of incoming natural gas, and that's a nice hedge. Save our customers over a couple hundred million dollars this year. And we'll continue to set a hedge from what if there is if there's any volatility or an increase in electric prices in the market. So really positioned well there. And then gas. We bought last year, and this was a high for us, we bought about 6% of our gas from Canada. Again, and that was at a high. And so remember, we have seven interconnects. And so I've got six other interconnects that I can leverage for US gas, be able to mitigate that. So, again, I feel like I'm in a really good spot there or the company's in a really good spot from a tariff perspective for natural gas. And then finally, and I imagine we'll get this question over time, when we look at it in some detail, is that often you start to think about other industries. And so often with Michigan, with our rich heritage on automotive, the question comes up, well, tariffs, how do they impact the automotive industry? And I'll remind all our investors that a little over 2% of our gross margin is in the automotive space. In tier one and tier two. So we've got a very diversified service territory. Which helps mitigate some of that risk that might show up for the automotive industry. And so a lot of detail there, a lot of data. You can tell we've done our homework. But till like, we can we can really manage and mitigate the impact to our customers. I know Rejji wants to get on into this too."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. Durgesh, all I would add to Garrick's dissertation is that for the avoidance of doubt, we actually do not directly source any material from China. So as Garrick noted, we may have second or third derivative exposure, like I think most global and diversified businesses on the planet do, but again, we do not directly source any material from China. And the only other thing I mentioned is that we are obviously using the place in the CE Way when we work with our vendors. And we do have operating reviews with our vendors, and we are working very actively with them to ask them the same questions you're asking us. What are they doing to mitigate the risk of tariffs? We're making sure that our contracts with our vendors, particularly those who do have second or third derivative exposure to some of these locations that are in the crosshairs, that there's the appropriate level of risk transfer or risk sharing in our contracts. So we are doing work with our vendors just to make sure we've got the right level of visibility on the manufacturing footprint and what and make sure we have clarity on what they're doing to mitigate these risks."
},
{
"speaker": "Durgesh Chopra",
"content": "Wow, guys. That's really comprehensive. Appreciate all the detail. And actually just prompted a follow-up question that I was just curious about. Is there a way to think about your equipment and your supply chain, how much of that is domestic versus international because my top process is this is just not China, Canada, right? This is this might be the, you know, the European Union might be next year. You know, you know. So just I would think about domestically versus internationally, sourcing equipment and other things."
},
{
"speaker": "Garrick Rochow",
"content": "Well, Durgesh, hopefully, what you heard from our early responses, again, we sweat the details. Right? So our investors don't have to worry. I mean, that's the big message here. But just going back to those numbers, like, from a again, Canada, Mexico, China, and certainly, Rejji clarified that the China piece you know, we're talking about and indirectly, about 10% to 12% where there might be materials that are coming from those three countries. And so, again, most of it's US-based, which gives us a great deal of confidence in our ability to execute the plan."
},
{
"speaker": "Rejji Hayes",
"content": "Yeah. Durgesh, all I would add is that we do not principally source most of our materials domestically. You know, some of them are internationally sourced, but most of them are domestic. And, again, I think the key, really, operationally, is, you know, it's really important to have a diversified vendor base, and we've done that quite a bit on the solar side. We're sourcing domestically a lot of solar to derisk. We've been doing that for many years now, not over the past couple months, last several years. We've also broadened our footprint to sourcing from Southeast Asia with respect to solar modules, and that's been really helpful as well. So, again, we've really taken an all-the-above approach to make sure we're well diversified and not subject to over-indexing or over-concentration in any particular area."
},
{
"speaker": "Durgesh Chopra",
"content": "Perfect. Thank you, guys, and congrats on the update here."
},
{
"speaker": "Rejji Hayes",
"content": "Thanks."
},
{
"speaker": "Durgesh Chopra",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question will be from the line of David Arcaro with Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "David Arcaro",
"content": "Hey. Thanks so much, Clint."
},
{
"speaker": "Garrick Rochow",
"content": "Hey, David."
},
{
"speaker": "David Arcaro",
"content": "Was curious on maybe the broader kinda Michigan backdrop for supporting data centers. And I was curious, is there excess capacity as you see it in Michigan or in your own fleet of on the generation side, you have extra, like, buffer to absorb data center projects and some of this load that you're seeing?"
},
{
"speaker": "Garrick Rochow",
"content": "Well, first, first start with Michigan. Michigan's been very supportive. Both in the sales and use tax. And as Rejji mentioned in his earlier comments, we've worked closely with regional and state economic development organizations to help locate data centers as well as manufacturing facilities in Michigan. The biggest piece that we do in our economic development team does is help in the placement. And so there's not tons of excess transmission capacity out there, but there is there is advantages to where you're located in the state, and we help along with the transmission provider, locate and try to position those across the state. And in some cases, it does require transmission build-out. Requires distribution build-out. We try to make that small, that we're able to keep the cost down, but also so we can do it in the time frames that are expected. From a supply perspective, we feel good about our supply mix. We're continuing that renewable energy plan incorporates that 2% to 3% growth. We're building up those additional renewables to meet the energy law, but also for that sales growth. We do our integrated resource plan, we're gonna again, look at the needs there. So we have these filings to be able to build that out. But remember, out of the last IRP, integrated resource plan, we're at a surplus. And so we've been able to leverage that as well to be able to attract these businesses in Michigan. And so, again, I feel good about our ability to place them here. And have the supplier resources to meet that. And the final thing I'll add to it as well is remember, these loads don't come out all at once. And so there's timing piece and we work with those companies. We know those timing pieces. And so, for example, we've talked about this. We know that switch, the data center, wants to be full load by 2026. Well, we're building that. We're constructing that now. They've they bring a little load on the 2025. And we'll have it on by 2026. And so we know all those, whether it's manufacturing, or whether it's data centers, and so we can stage those and make sure we have the what's the physical distribution and transmission, but also the supply resources to be able to meet their needs."
},
{
"speaker": "David Arcaro",
"content": "Gotcha. Thanks. That's helpful. And then maybe a quick question just going back to the rate case. I know it's late in the process, but are there opportunities here to still settle broadly or individual pieces before the finish line?"
},
{
"speaker": "Garrick Rochow",
"content": "I'm always open to settlement. You know that. But, again, times the clock is ticking on this one, and we've had the PFD, and I would just offer this. Staff is staff is a really constructive starting position on this. And I just as a reminder, like, these are staff professionals. They do their homework. They done a lot of due diligence in this case. They put it in testimony. It's a, you know, a nice constructive starting spot, which I have a lot of confidence in that. And then you also add our experts. Who bring best practices and bring benchmarking to that. And so there's a nice blend that should occur between staff's position and the company's position. But bottom line, I have a lot of confidence we're gonna get to constructive outcome. Whether it be settlement, or probably more likely, through a final order in March. We'll get to a constructive outcome. It'll be good for all stakeholders."
},
{
"speaker": "David Arcaro",
"content": "Okay. Great. For all the updates."
},
{
"speaker": "Garrick Rochow",
"content": "Yeah. You bet, David."
},
{
"speaker": "Operator",
"content": "As a reminder, if you would like to ask any further questions, please dial all one now? Please go ahead. Your line is open."
},
{
"speaker": "Garrick Rochow",
"content": "Good morning, everyone. Thank you."
},
{
"speaker": "Durgesh Chopra",
"content": "Good morning."
},
{
"speaker": "Rejji Hayes",
"content": "The hey. Quick clarification on the long-term opportunities. When you put the numbers $10 billion on the reliability roadmap, $10 billion on the electric the REP rather. Are those opportunities that are simply outside the plan, I. E. Year six through ten or those opportunities that might come into the five-year plans."
},
{
"speaker": "Garrick Rochow",
"content": "Right now that $20 billion plus of opportunities is outside or incremental to the five-year plan. As those filings progress, it's an opportunity to bring them into the five-year plan. Or, to your point, add them in years six through ten. But it as you can see, it's a rich a rich opportunity. From an investor standpoint, but they're really needed customer investments, needed from a reliability and resiliency system as we see higher wind speeds, as we see more frequent storms, and higher customer expectations. We need to make those investments in the electric distribution system for our customers. And then the other one is in just in terms of the energy law, we have to have renewables in place 60% by 2035. Those are needed investments for cleaner air in compliance with this with the law as well as supply growth that we are seeing across the state or supply demand, I should say, that we've seen across the state that we referenced. And then finally, important investments in our gas system. To ensure the safety of natural gas gas system. Now that's not on the slide, but that's another important piece of the of the five-year and then the tenure."
},
{
"speaker": "Durgesh Chopra",
"content": "Okay. Great. And then the 2% to 3% electric growth, if you end up realizing that type of growth, is there a chance that you could get off of that kinda one-year rate case cadence, maybe extend it to two years. Is that a possibility as you've run them numbers, if you get that electric demand growth up."
},
{
"speaker": "Garrick Rochow",
"content": "We're confident that we're gonna see that. So again, I go back. So you used the word if, and I just wanna make sure I'm we're really clear about this. These are contracts. These are things where we're like, if I take, like, Corning, you know, $900 million investment, 1,100 jobs, know, we're bringing on the elect we're building the substation now, bringing electric to serve them, and like, these are being realized. I just wanna give that level of confidence. Again, our approach there's occasion where we stayed out for a year on a rate case. Our strategy is really to be in there annually to do smaller type increases, to have an active dialogue with the commission, that's where we see the best outcomes and successful outcomes for our customers. And so I would anticipate that annual rate case cadence continues going forward."
},
{
"speaker": "Durgesh Chopra",
"content": "Okay. Great. No. That's all very helpful. You answered most of my other questions. Appreciate it."
},
{
"speaker": "Garrick Rochow",
"content": "Yeah. Thank you."
},
{
"speaker": "Operator",
"content": "With no further questions queued, I will now turn the call back to Mr. Garrick Rochow for some closing remarks."
},
{
"speaker": "Garrick Rochow",
"content": "Thanks, Harry. I'd like to thank you for joining us today. I look forward to seeing you on the road this year. Take care. And stay safe."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. We thank everyone for your participation."
}
] |
cms | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, everyone, and welcome to the CMS Energy 2024 Third Quarter Results. The earnings news release issued earlier today and the presentation used in this webcast are available on CMS Energy's website in the Investor Relations section. This call is being recorded. After the presentation, we'll conduct a question-and-answer session. Instructions will be provided at that time. [Operator Instructions]. Just a reminder, there will be a rebroadcast of this conference call today beginning at 12:00 p.m. Eastern Time running through November 7. This presentation is also being webcast and is available on CMS Energy's website in the Investor Relations section. At this time, I would like to turn the call over to Mr. Jason Shore, Treasurer and Vice President of Investor Relations."
},
{
"speaker": "Jason Shore",
"content": "Thank you, Harry. Good morning, everyone, and thank you for joining us today. With me are Garrick Rochow, President and Chief Executive Officer; and Rejji Hayes, Executive Vice President and Chief Financial Officer. This presentation contains forward-looking statements, which are subject to risks and uncertainties. Please refer to our SEC filings for more information regarding the risks and other factors that could cause our actual results to differ materially. This presentation also includes non-GAAP measures. Reconciliations of these measures to the most directly comparable GAAP measures are included in the appendix and posted on our website. And now, I'll turn the call over to Garrick."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Jason, and thank you, everyone, for joining us today. At CMS Energy, we deliver year-over-year for all stakeholders. We do that through our investment thesis. This is simple but powerful model coupled with our disciplined execution sets us apart in the industry and has delivered more than two decades of industry-leading financial performance. Typically, I walk through that investment thesis. But today, I want to offer three differentiators at CMS Energy providing confidence and visibility as we continue to strengthen and lengthen our 6% to 8% EPS growth. First, Michigan's clean energy law. This law is great for our customers, the planet, and our investors. It ensures we have the right legislation in place to move from coal to clean, providing certainty for the investments we need to make in renewable energy and it gives us the flexibility to either own the assets or utilize a power purchase agreement doing what is best for our customers. Now, here's what's unique. Earning a financial compensation mechanism approximately 9% on a power purchase agreement, no other state that I'm aware of has this provision and then add to it requirements for battery storage and an increased incentive on energy efficiency. There is a lot in this law, very little of which is in our five-year investment plan, providing a strong tailwind and we believe we can do this important work affordably for our customers. The flexibility in the law that allows for ownership or power purchase agreements both within Michigan and outside of Michigan provides more options for customers and ensures we can utilize lower cost energy. Furthermore, it provides us the ability to replace existing, outdated, and above market power purchase agreements with new renewable assets, which keeps costs affordable for customers. Our 20-year renewable energy plan or REP that we'll file next month will detail our clean energy investments and plans to achieve the targets set by Michigan's clean energy law. This filing will show the renewable assets needed above and beyond our 2021 integrated resource plan as well as the additional renewable assets needed to meet increasing sales demand and growth in the state. As I shared before, Michigan's clean energy law is great for all stakeholders. It provides the flexibility we need to find the most cost effective clean energy for our customers. The second item I want to highlight is our commitment to customer reliability. I'm very proud of the comprehensive plan we have laid out in our five-year $7 billion electric reliability roadmap. This plan details our actions to move to second quartile reliability performance or SAIDI by the end of the decade through targeted investments in our electric grid, needed investments for our customers because we have recorded some of Michigan's highest wind speeds over the last five years. We are seeing more frequent storm activity. This plan is deliberate and comprehensive and improves reliability in the short-term and built in long-term resiliency and it does it proactively versus reactively. This plan means we will begin serious efforts to underground more of our distribution wires, better align with Midwest peers, and replace more than 20,000 poles with those designed for more extreme weather. It also means investing in grid technology for more automation and machine learning to speed up restoration in weather events. We're also one of the first utilities East of the Mississippi is file a comprehensive wildfire mitigation plan, which lays out the investments needed to prepare for climate change. These customer investments are based on Electric Power Research Institute, EPRI best practices and will bolster our distribution system to a level of performance our customers expect, particularly as the economy continues to electrify. And our plans have been supported. I am pleased with the recent outcomes from the Michigan Public Service Commission and the Liberty storm audit, which highlights the vastness of our system, the billions of dollars and decades needed to improve it and the importance of these strategic investments. And our customary benefit when we improve the system proactively versus reactively, making these investments in the system now means we can do it at a 40% to 70% lower cost compared to when we do this work following an outage. Better service, lower customer cost, this is a great story. The third point I want to make today is the nice tailwind of economic development we are seeing in our service area. I'm excited and encouraged about the true renaissance underway in Michigan. The big story across the industry is sales growth brought by data centers. We're seeing the same and we're happy to talk more about data centers. Our story is different and in my opinion, better. In Michigan, we are seeing a manufacturing renaissance bolstered by onshoring, unique state attributes, and the inflation reduction and the CHIPS and Science Act. And we love manufacturing growth because it brings jobs, supply chains, commercial activity, housing starts and residential growth where there is greater benefit for the state. We recently updated this slide to highlight several new and diversified examples. Corning expanding and investing up to $900 million and bringing nearly 1,100 jobs to the state, this is the sort of growth we like to see significant Michigan investment in job growth. Saab has expansion plans for an integration and assembly facility. Saab is new to the state but adding to the nearly 4,000 businesses engaged in defense and aerospace work in Michigan. Two new examples among many that speak to the diversified manufacturing growth we are realizing over 700 megawatts of signed contracts in 24 months and growing. Our economic development pipeline continues to look promising with over 6 gigawatts of load looking to either move to or expand in our state, 60% of which is manufacturing. As I mentioned earlier, our renewable energy plan will conservatively reflect our updated load growth forecast based on the strong economic development tailwind we are experiencing. We work hard every day to win our customers business and we are honored when businesses see the value in investing in our state and our service territory. So let's take a look at the regulatory calendar for the year. As I shared last quarter, our financial related regulatory outcomes are known for the year given the constructive March electric rate order in the approved gas rate case settlement. This positions us well as we navigate the last quarter of 2024. Gas rates were effective October 1 and we plan to file our next gas rate case in December of this year. In our current electric rate case, we saw a constructive starting position by staff. We saw support for further underground, wildfire mitigation, and the continuation of the investment recovery mechanism. I do want to point out that the mechanism for storm recovery and the investments outlined in the electric rate case and in the Liberty storm audit are important for our customers. That probably goes without saying. However, it may require that we go to a fully adjudicated order to get the best outcome for our customers. Know that we are confident with where we are in the process, the quality of our filing, and the proactive nature of the investments we are making to improve reliability for our customers. If we go the full distance, we expect the order in March of 2025. Now, let's spend a moment on the results. For the first nine months, we reported adjusted earnings per share of $2.47, up $0.41 versus the same period in 2023, largely driven by the constructive outcomes in our electric and gas rate cases. Given our confidence in the year, we are reaffirming all our financial objectives, including this year's guidance range of $3.29 to $3.35 per share with continued confidence toward the high end. We are initiating our full year guidance for 2025 at $3.52 to $3.58 per share, reflecting 6% to 8% growth off the midpoint of this year's range. And we are well-positioned, just like 2024, to be toward the high end of that range. It is important to remember that we always rebase guidance off our actuals on the Q4 call, compounding our growth. This brings you a higher quality of earnings and differentiates us from others in the sector. And like we've done in previous years, we'll provide a refresh of our five-year capital and financial plans on the Q4 call. With that, I'll hand the call over to Rejji."
},
{
"speaker": "Rejji Hayes",
"content": "Thank you, Garrick, and good morning, everyone. On Slide 9, you'll see our standard waterfall chart, which illustrates the key drivers impacting our financial performance for the first nine months of 2024 and our year-to-go expectations. For clarification purposes, all of the variance analyses herein are in comparison to 2023 both on a year-to-date and a year-to-go basis. In summary, through the third quarter, we delivered adjusted net income of $736 million or $2.47 per share, which compares favorably to the first nine months of 2023, largely due to higher rate relief, net of investment costs, and solid performance at Northstar. From a weather perspective, the third quarter offered favorable weather versus the prior year to the tune of $0.10 per share, largely due to a warm September. The strong third quarter weather for the electric business more than offset the mild weather experience in the first half of the year, thus equating to $0.05 per share of positive variance year-to-date. As mentioned, rate relief net of investment costs, one of the key drivers of our year-to-date performance resulted in $0.18 per share of positive variance due to constructive outcomes achieved on our electric rate order received in March and the residual benefits of last year's gas rate case settlement. From a cost perspective, our year-to-date financial performance was largely driven by lower service restoration expense despite a sizable weather system that impacted our service territory in early August. Our favorable variance in this regard has been fueled in large part by cost efficiencies in our storm response efforts. In fact, even though our volume of outages has increased by approximately 10% in 2024 versus the comparable period last year, our restoration cost per interruption has decreased by over 10%, all while restoring customers at a faster rate than the prior year. These achievements and our storm response efforts are just another example of our lean operating system, the CE Way, driving daily productivity in the business. Quite simply, our workforce uses the tools of the lean operating system to deliver more value to customers with less resources every day. That is the essence of the CE Way, and this favorability and service restoration expense coupled with cost performance throughout the business provided $0.02 per share of positive variance versus the comparable period in 2023. Rounding out the first nine months of the year, you'll note the $0.16 per share of positive variance highlighted in the catch all bucket in the middle of the chart; the primary sources of upside here were related to solid operational performance at Northstar and a tax related benefit, among other factors. Looking ahead, as always, we plan for normal weather, which equates to $0.14 per share of positive variance for the remaining three months of the year, given the mild temperatures experienced in the last three months of 2023. From a regulatory perspective, we'll realize $0.09 per share of positive variance, largely driven by the aforementioned electric rate order received from the commission earlier this year and the constructive outcome achieved in our recently approved gas rate case settlement, which went into effect on October 1, as Garrick noted. On the cost side, we anticipate $0.15 per share of negative variance for the remaining three months of 2024; in large part due to additional funding support for select cost categories that have trended above budgeted levels for the majority of the year, such as insurance premium and IT-related expenses. Closing out the glide path for the remainder of the year, in the penultimate bar on the right-hand side, you'll note a significant negative variance, which largely consists of the absence of select one-time countermeasures from last year and conservative assumptions around non-utility performance among other items. In aggregate, these assumptions equate to $0.25 to $0.31 per share of negative variance. In summary, we remain well-positioned to deliver on our 2024 financial objectives to the benefit of customers and investors. As such, we are reaffirming our full year guidance range of $3.29 per share to $3.35 per share with a continued bias toward the high end. Moving on to the balance sheet. On Slide 10, we highlight our recently reaffirmed credit ratings from S&P in August. We continue to target mid-teens FFO to debt on a consolidated basis over our planning period to preserve our solid investment-grade credit ratings as per long-standing guidance from the rating agencies. As always, we remain focused on maintaining a strong financial position, which coupled with a supportive regulatory construct and predictable operating cash flow generation supports our solid investment-grade ratings to the benefit of customers and investors. Moving on to our financing plan on Slide 11. I'm pleased to report that we've completed all of our planned financings for the year at levels favorable to plan and ahead of schedule, which leaves us with ample liquidity for the remainder of the year and beyond. I'll bring to your attention a relatively modest increase to our 2024 planned financings at the utility given the need to rebalance the rate-making capital structure in accordance with the recent regulatory outcomes and attractive pricing at issuance. It is also worth noting that we remain opportunistic should we see a cost-efficient opportunity to pull ahead some of our 2025 financing needs. As I've said before, our approach to our financing plan is similar to how we run the business. We plan conservatively and capitalize on opportunities as they arise. This approach has been tried and true year in and year out and has enabled us to deliver on our operational and financial objectives, irrespective of the circumstances to the benefit of our customers and investors, and this year is no different. And with that, I'll hand it back to Garrick for his final remarks before the Q&A session."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Rejji. CMS Energy over two decades of consistent industry-leading financial performance. We remain confident in our strong outlook this year and beyond as we continue to execute on our simple investment thesis and make the necessary and important investments in our system while maintaining customer affordability. With that, Harry, please open the lines for Q&A."
},
{
"speaker": "Operator",
"content": "Thanks very much, Garrick. [Operator Instructions]. Our first question is from the line of Shar Pourreza with Guggenheim Partners. Please go ahead. Your line is now open."
},
{
"speaker": "Shar Pourreza",
"content": "Hey guys, good morning. A - Garrick Rochow Hey, good morning, Shar. I heard you didn’t like our hold music. I heard that was a thing today."
},
{
"speaker": "Shar Pourreza",
"content": "Oh, God, it was on hold, no matter, but it's okay."
},
{
"speaker": "Garrick Rochow",
"content": "Hey, I like your choices. Yes, Metallica, but you don't have AC/DC. If you would have brought a little AC/DC, I'd have been there. What's your question today? There you go. There you go."
},
{
"speaker": "Shar Pourreza",
"content": "So just, Garrick, on the data center demand, obviously, everyone is mentioning it to kind of the degree, Michigan has obviously started to emerge as a favorable data center environment with some of the hyperscalers doing some land acquisitions there, Grand Rapids to be exact. Do you have sort of existing grid capacity to onboard kind of the new customers with that kind of an interconnection lag? What are you seeing on the ground? And do you need sort of a new tariff structure to move ahead? We've seen some interesting proposals coming out of Ohio, a lot of back and forth there. So a big question, but how do you think about those?"
},
{
"speaker": "Garrick Rochow",
"content": "Michigan in our service territory, specifically you referenced Grand Rapids and that's been our service territory, is a great place for data centers and investment in Michigan. The temperate climate, the fiber infrastructure and to your point and really the point of your question here is we have the electric infrastructure to be able to serve. And so we work closely with data centers and other manufacturing customers to meet their timelines for the ramp-up and load. And so that makes us advantageous to locate a data center or as I highlighted in my prepared remarks, really manufacturing, there's been a lot of manufacturing growth that's shown up here. And so that's what's exciting about Michigan. I guess, the other thing is, too, when they look to our clean energy law, they can see a path to that growing clean energy, the renewables and then the clean energy standard by 2040, which is also attractive to the data center components. But I would highlight, too, just what I don't want to lose in this conversation is manufacturing growth. That's really where we've seen the true renaissance. We've seen a lot of opportunities show up there that will show up in our renewable energy plan as well, to serve our customers. And from my -- just going to the question on the tariff, you'll recall, we've already filed ex-parte type filing to move the data centers to what we call our GPD rate. That's a better reflection of the cost to serve, and we are working collaboratively with the commission to see if another rate structure is needed for data centers that would ensure our residential customers are not left subsidizing data centers."
},
{
"speaker": "Shar Pourreza",
"content": "Got it. Any timing on that, Garrick?"
},
{
"speaker": "Garrick Rochow",
"content": "We would expect that we continue to make progress. I mean, like I said, the ex-parte filing has already been approved. And so we're in a good position there from a cost of service perspective. We'll continue to work with the commission. I would expect that to take place over the next six months to a year."
},
{
"speaker": "Shar Pourreza",
"content": "Okay. Perfect. And then just lastly, in terms of your takeaways from the storm and resiliency audits this year. Is your commitment to cutting outages supported by the current distribution plan? Or would you look to update the DSP to incorporate some recommendations from the audit? Or does it just inform you better to move the $1.5 billion incremental CapEx you're identified into base plan? Thanks."
},
{
"speaker": "Garrick Rochow",
"content": "This -- this audit that was completed -- we call it the Liberty audit because that was the company that was performing the work is really balanced and supportive. I mean, you could see that in the context of the support of the work that we need to do, the capital investments and free trimming to be able to continue to enhance reliability and provide better service and as in my prepared remarks, share, we can do that at a lower cost. So better service, lower cost when we do things proactively versus reactively, and so we have our five-year capital plan, that $7 billion plan that's comprehensive and very deliberate and focus. And we'll take the Liberty audit results, and we'll look to incorporate that in that plan. And I'll remind you, that's a $7 billion plan; $5.5 billion of it is incorporated into the capital plan. And so there's opportunity there to work more of that capital in, of course, with the support of the Public Service Commission staff and commission."
},
{
"speaker": "Shar Pourreza",
"content": "Fantastic. Thank you, guys so much. Remember, Garrick, Guns N' Roses next time. Thanks. Appreciate it."
},
{
"speaker": "Garrick Rochow",
"content": "AC/DC. AC/DC."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Jeremy Tonet with JPMorgan. Please go ahead. Your line is now open."
},
{
"speaker": "Jeremy Tonet",
"content": "Thank for taking my questions here. Just wanted to start off, if you could walk us through a bit more, I guess, on DIG, given everything that we're seeing on the generation site needs their capacity needs. Just with contracts rolling off and how you think about, I guess, the trajectory there going forward?"
},
{
"speaker": "Garrick Rochow",
"content": "NorthStar business, and I'll get to the big piece, continues to perform well. But frankly, I'd expect that. It's a small piece of the earnings mix. But they need to perform, and we expect them to perform, and that's exactly what they're doing, both from an operational and a financial perspective. And of course, DIG is an important part of that mix or Dearborn Industrial Generation. And we continue to see strength both in the capacity markets and the energy markets, and we are securing those bilateral contracts throughout time, and they continue to be above our plan and our expectations. And so it's a great story, and we continue to be a tailwind in our overall expectations around 6% to 8% EPS growth."
},
{
"speaker": "Rejji Hayes",
"content": "Jeremy, this is Rejji. All I would add is we've been -- Jeremy, just to provide a bit more of a financial lens to Garrick's good comments. As you know, we've had a good 25% to 30% open margin in the outer years of our plan. And so we'll provide an update on our Q4 call, as we always do around the levels at which we're pricing capacity contracts in that bilateral market. And as you know, we'll bring in a new year in our next five-year plan, and that will have even more open margin. And we continue to see reverse inquiry at levels well in excess of what we've historically realized from a capacity price perspective. And so we're usually around $3 to $3.50 per kilowatt month. We're now seeing 5 and 6 handles in reverse increase. So still a really robust opportunity. And unsurprisingly, it's just because of the real nice tactical we're seeing with just supply being reduced in Zone 7 through retirements and upward pressure on the demand curve. So we don't see any reason why that should abate anytime soon."
},
{
"speaker": "Garrick Rochow",
"content": "And one thing I'll remind you, Jeremy, too, it's not linear as well. We do have outages to maintain the system out there. So that's an important piece to remember, particularly as we go through the long-term plan."
},
{
"speaker": "Jeremy Tonet",
"content": "Right. That makes sense. I don't want to get too far ahead of myself there. But maybe just thinking about growth in general, we're seeing some of your peers talk about higher sales forecast and even some kind of lifting the expected long-term EPS CAGR expectation. And just wondering how you guys think about this given the incremental opportunities you see in front of you. I'm expecting strengthening and lengthening but just wanted to double check there."
},
{
"speaker": "Garrick Rochow",
"content": "Let me offer some comments, and I'm sure Rejji is going to want to jump into this as well. And we provided those differentiators, those tailwinds to give visibility and to instill confidence. And that's what we have. We have confidence about the ability to strengthen and lengthen that 6% to 8% EPS growth. But I want to be clear, what our investors expect is that we continue to deliver year after years. That's 21 years; we've now industry-leading or consistent industry-leading financial performance, time and time again. And then compounding off actuals, which gives you a better quality of earnings, that's what our investors inspect, that's what we expect and that's what we deliver. And so by providing some insights to those tailwinds, I just -- you get some idea of the momentum and how we can again strengthen our confidence in delivering this and just doing it year after year, exactly what our investors expect. But certainly, Rejji, I'm sure we want to walk in and offer some commentary on this as well."
},
{
"speaker": "Rejji Hayes",
"content": "Jeremy, all I would add to Garrick's comments is that when you think about the components of what will drive long-term growth, Garrick walked through in great detail in his prepared remarks, the opportunities on the capital side, whether it's through the capital investments and/or earning on PPAs in the context of new energy law, and that's going to be decades of financial opportunity, investment in PPAs again, the opportunities to improve the reliability and resiliency of our electric distribution, infrastructure that's decades of spend and investment opportunity to the benefit of customers and investors. And then in the gas business, which we didn't talk about as much on this call, but there's still a significant level of investment to be made to continue to harden that system, reduce future methane emissions and continue to keep it safe in the lab, particularly with pending regs coming out from FEMSA. And so a lot of investment opportunity and when the upward pressure that you alluded to on the demand side that will create the headroom among other benefits to facilitate and enable that investment to come to fruition. And so we see a really nice glide path to deliver on that differentiated 6% to 8% growth for many years, compounding off of actuals. And so we're not going to get ahead of our Q4 disclosure, and that's when we update our five-year plan, but we still feel very good about our ability to strengthen and lengthen that growth to Garrick's comments."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. That makes sense. That’s helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question today will be from the line of Ross Fowler with Bank of America. Please go ahead. Your line is now open."
},
{
"speaker": "Ross Fowler",
"content": "Good morning, Garrick. Good morning, Rejji. How are you?"
},
{
"speaker": "Garrick Rochow",
"content": "Good morning, Ross."
},
{
"speaker": "Ross Fowler",
"content": "Congratulations on the quarter, another solid one as we've all come to expect from CMS. So just a couple of questions. I think you've talked about the 2.5 gigawatts of storage target in the state. How do you think about -- could that change is sort of battery tax credit shift? Or does the cost of that change? Or is there just a lot of support for this at the state level versus what's going on at the federal level potentially after next week, how do you contextualize that's investment going forward?"
},
{
"speaker": "Garrick Rochow",
"content": "Let me offer the two mechanisms that we have to consider what I'd call supply type assets. One is the renewable energy plan, which we'll file here November 15 in that range around that date. And that will lay out some of the renewable energy assets we need, both -- it will build off the foundation of our 2021 integrated resource plan, but then there's two tranches as I see it of additional renewable energy, that will show up in the terms of meeting the 50% standard of renewable assets for 2030 as well as 60% for 2035. That's really tranche one. And then there was additional renewable assets as a result of economic development and growth, the demand growth that we've seen. So that's a nice piece of work, a nice tailwind. There will be some reference to storage in there as part of that. But where more of the storage will play out is in our 2026 integrated resource plan. That's where we look at the capacity mix. That's where we look at the reliability of supply. That's where we'll look at those important components. In the degree, there's additional tax incentives or benefit that will play out in that process and that selection process. I do anticipate that there's going to need to be quite a bit of storage on the system, maybe even more than what is referenced in the law, but that's certainly a nice pathway to get things started with the certainty of the legislation. So hopefully, that's -- that's helpful."
},
{
"speaker": "Rejji Hayes",
"content": "Yes, Ross."
},
{
"speaker": "Ross Fowler",
"content": "Yes, Garrick, thank you. Sorry, Rejji. Go ahead."
},
{
"speaker": "Rejji Hayes",
"content": "Yes. Ross, sorry. I've been a little slower the drawn a couple of my comments. So pardon me. The only thing I would just add and it sounded like you're alluding to when you talked about next week, a potential repeal of the IRA and the implications of that on tax credits. Is that the thrust of the second part of your question? Or did I miss it?"
},
{
"speaker": "Ross Fowler",
"content": "Yes. Yes. Just as that -- where can we contextualize that versus the state incentives that are kind of pushing this?"
},
{
"speaker": "Rejji Hayes",
"content": "Yes. So I dare not wager or speculate as to the outcome on next week. I think that's a fool's errand and I think it's too difficult to call. But I do think it still remains a low probability that you see a repeal of the IRA. Because the reality is, one, you need a pretty sizable red way to just repeal the legislation. But even if you did want to hypothesize that that could take place, I think there's also a reality that the number of red states have benefited significantly from the legislation getting passed. I heard a stat the other day from one of the CEOs in our state who suggested about that 75% of the benefits of the IRA have accrued to red states. And so I think, again, even if you saw Red Wave significant enough, to, which I still think is a fairly remote probability to repeal the legislation. I still think there'll probably be a real significant discussion off-line about whether it would make sense from an economic perspective to go and undo all those benefits accruing really nationally, but again, more concentrated towards red states. So I still think it's a low probability event. And that said, and if it did happen, again, even if you wanted to take sort of that really remote probability come into fruition, we still have to comply with the law, to Garrick's comments, albeit it might be at a higher cost. But again, we still have to comply with the law in Michigan."
},
{
"speaker": "Ross Fowler",
"content": "Yes. Perfect. Makes sense. Rejji, you just seem more coffee this morning. So grab a cup of coffee."
},
{
"speaker": "Garrick Rochow",
"content": "Will do, yes."
},
{
"speaker": "Ross Fowler",
"content": "The next question I had, just kind of back to Jeremy's question a little bit on NorthStar and capacity auctions. I mean, MISO has sort of adopted a lot of the PJM changes around the VRR curve. So certainly, it seems like that will also go higher in next year's capacity auction at least that would mirror what happen at PJM. So do you sort of hold off on some closing down some of these open positions further out on capacity until you see what that auction clears out, so you have a better idea? Like I'm just trying to figure out the timing of how you work that through."
},
{
"speaker": "Garrick Rochow",
"content": "Our process has been with DIG to just layer these in over time. That's really a de-risking mechanism for us. And certainly, the sometimes where we might strike at a price point that's a little lower than the future, but there are times where it's going to strike at a price point that's a little higher than the future. And so we've had that approach. It really de-risks and becomes a predictable source of earnings by taking that -- these bilateral contracts or just kind of layer in minimum over time."
},
{
"speaker": "Ross Fowler",
"content": "Basically sense ties into this [indiscernible]. Thanks, guys, another solid quarter."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question today is from the line of Julien Dumoulin-Smith with Jefferies. Please go ahead. Your line is now open."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Hey, good morning, team. Guys, thank you so very much for the time. Appreciate it. Good to see you all guys. Get that coffee going."
},
{
"speaker": "Garrick Rochow",
"content": "Keep it going."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "So to the extent -- thinking of which -- you guys had this pretty big swing in the cost number in that waterfall slide, you talked about that minus $0.15 last quarter, that was a plus 9. You mentioned in your prepared remarks, insurance and IT. Can you speak a little bit on exactly what's going on? Is there a pull forward going in there as well that's timing intra year. I mean is there a wildfire impact that's impacting insurance? I'm just trying to understand what are the big pieces?"
},
{
"speaker": "Rejji Hayes",
"content": "Yes, Julien, it's Rejji. I appreciate the question, and let me provide a little bit more color on that. And so we have a number of cost-related line items that we track throughout the year. We obviously have expectations going into the year and budgeted levels for across every cost category. And through the course of the year, some of those line items track ahead of budget and not in a good way, so higher than budget. And so we countermeasure that largely through the CE Way and other cost reduction initiatives. And in some cases, as we get to Q4, and we don't think we'll have sufficient countermeasures to offset that. There are times will just sort of fund those cost categories at levels that we anticipate at the end of the year. And so sorry, I said differently, we have a level of countermeasures as well as Q3 weather help that have given us enough contingency to fund those cost categories to levels that we anticipate than being at the end of the year. And so we're just funding those costs. Insurance was one example. We had IT-related costs that were trending a little ahead of budget. Another one is we also have some regulatory assets that are or liabilities that are amortizing that are at higher levels in the prior year associated with our EV programs and others. And so it's a hodgepodge of cats and dogs that were just trending ahead of budgeted levels. And so that's really what we're funding there. And that's why you see that big increase in the Q4 year-to-go expectations versus where we were in our Q2 call. Is that helpful?"
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Yes. So basically said differently, you would have been holding off on funding some of it into 2025, you realize that you have the ability to do so, so you pull them back forward."
},
{
"speaker": "Rejji Hayes",
"content": "Yes, I wouldn't call them a pull ahead. To be clear, these are not expectations of costs that we'll have in 2025 that we're trying to de-risk. These are costs that we are incurring right now and the actuals we have seen in the first nine months of the year in excess of what we've budgeted. And so we're applying some of the contingency that we've accumulated through countermeasures, NorthStar outperformance and just point old-fashioned, good weather in September and applying that contingency to just fund those cost estimates for the end of the year. So these are just 2024 funding and just basically updating our forecast to reflect the economic reality we're seeing across those cost categories."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Wonderful. Thank you guys very much. Good job there."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Travis Miller with Morningstar. Please go ahead. Your line is now open."
},
{
"speaker": "Travis Miller",
"content": "Hi. So on the REP, you've touched on this a couple of times, but the -- anticipating that sales growth number going up. As you were going through that process, not to front run this too much for the next couple of weeks. But as you're going through the process, did you have enough visibility in terms of sales growth from data centers and what you mentioned on manufacturing some of those kind of 24/7 type loads to be able to incorporate, again, some of the stuff you touched on in terms of storage and perhaps other renewable technologies. Can we -- will we see that in this REP or is that something to look more for in the IRP?"
},
{
"speaker": "Garrick Rochow",
"content": "The short answer is yes, but let me explain more. In the renewable energy plan, we'll start out with the base or the foundation is really the 2021 integrated resource plan, which you'll remember calls for 8 gigawatts of solar and we've built some renewables as part of that as well. So that's the foundation. The first piece will -- the 2021 IRP did not get us to 50% renewables by 2030 or the 60% number by 2035. So there's some renewables that will have to be constructed or through a PPA with an FCM, that will have to happen. That's tranche one. The second tranche is specifically because there's additional sales expected as a result of economic development. And so we forecast that out over 20 years, and so we do have visibility to it. But we have to have certainty around it as well. So these are items that we are -- have high confidence around, and we have signed contracts around. This is not the pipeline or some hypothetical numbers. It's -- again, a reflection of what's coming to the state in terms of -- so we have to answer question directly, yes, visibility of that. That will also drive additional renewable assets or purchase power agreements to meet that need as well. So if you continue to follow that down, I expect it to be a mix of solar and wind that will make that up. And then, of course, we'll talk about more details of that at EEI as we file that. So that's part one. The second part that I would also is the IRP. And remember, renewable energy plan just deals with energy. You have to deal with the capacity; you have to do with the reliability of supply. You also have the opportunity to accommodate additional sales growth. That will show up in the integrated resource plan as well. So I assume it's two mechanisms -- two opportunities where we'll see those tailwinds of again, ownership of assets, investments to deliver clean energy on behalf of our customers or through a PPA with the financial compensation mechanism."
},
{
"speaker": "Rejji Hayes",
"content": "Hey Travis, this is Rejji. All I would add is that if you look at Slide 6 in our presentation today, you can see on the left-hand side of the page, and Garrick spoke to some of this in his prepared remarks, there's a raft of opportunities we've seen from an economic development perspective. And I think we've got eight or so listed on the page. Only two of those are in our current five-year plan, Goshen and Ford. The rest of these are additive to our plant. So that offers some breadcrumbs as to the additional opportunities we're seeing. And I will tell you that some of the opportunities that are pretty high in probability that we're still not quite in the plan yet are likely going to be coming to fruition in the coming months. And so there's a lot of opportunity that we've already seen since we rolled out last year's five-year plan. And so at this point, that's well stale. And so again, you'll see that update in our REP. You also see it in the five-year plan that we roll out in Q4 next year in addition to the IRP, as Garrick noted. So you get some visibility on Slide 6 today. And again, we're looking forward to talking about more opportunities in the coming months."
},
{
"speaker": "Travis Miller",
"content": "Okay. That's great. I appreciate all that detail. And then one more for me on different subject. The Liberty audit, would you anticipate on the regulatory side, the potential for putting in regulators to put in some kind of performance mechanism or some kind of metrics to meet before you get approval for the additional CapEx or operating costs?"
},
{
"speaker": "Garrick Rochow",
"content": "I anticipate that we'll take the Liberty audit findings and weave them into our five-year reliability plan, which will, of course, enhance that plan, provide opportunities for additional capital investments to again address reliability for our customers proactively offering better service and lower cost. So that will be part of it. I anticipate there will be additional tree trimming or operation and maintenance expect that we've woven into the plan as well as part of this Liberty audit. And as the commission -- one of the actions that the commission has already taken is a performance-based ratemaking that's focused on reliability work. And so I anticipate that's woven into this work as well. I don't think it holds us up from making these important investments. And we're making them now and seeing good performance improvement in terms of reliability and we just need to continue to do that important work."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Michael Sullivan with Wolfe Research. Please go ahead. Your line is open."
},
{
"speaker": "Michael Sullivan",
"content": "Hey everyone, good morning. I think it's been asked a couple of times now, but just to level set us for load growth and what's coming in the REP. My recollection is you have historically talked about 2% -- less 2% energy efficiency and you're kind of flat is kind of your base case today? And then, it sounds like you're excited about all this kind of new load growth, but what's actually going to be reflected in the REP is going to be pretty conservative and not some big shift change? Is that a fair characterization?"
},
{
"speaker": "Rejji Hayes",
"content": "Michael, good morning. It's Rejji. Thanks for the question. So just to level set, our current five-year plan that we rolled out in the fourth quarter this year, had about 0.5% of electric load growth on a five-year compound annual growth rate basis. And you're right, that number is always inclusive of energy waste reduction. And so if you wanted to gross that up, you could think about that as about 2.5% growth. And again, net of energy efficiency, 0.5%. We expect pretty significant upward pressure on that growth rate in the IRP -- sorry, from the REP, renewable energy plan, filing that we'll publicize in the coming weeks. And then we'll get another kick at the can, obviously, in the IRP filing about a year later. And again, between that, you'll get more color on the loan growth assumptions embedded in the five-year plan that we rolled out in the fourth quarter of next year. And so again, you should see pretty material upward pressure. We do plan conservatively, guilty as charged. But we do also want to reflect the reality of what we're seeing because remember, this is a component in our rate proceedings. And so you will see, again, upward pressure on that -- those load growth assumptions. And to Garrick’s comments, we do really try to incorporate whether it's data centers, industrial companies; we try to incorporate those in the plan when they're close to being signed or effectively signed and moving forward. We really try not to speculate if we've seen some momentum across the state, but it's not coming to fruition. That's not something we'll put in our plan. So we're conservative from that perspective. But again, the takeaway here is that you'll see upward pressure on our historical growth estimates in this next cut."
},
{
"speaker": "Michael Sullivan",
"content": "Okay. So significant upward pressure, but conservative. I got it. And then just shifting over to the electric case, I also just kind of wanted to level set there. So it sounds like you are going to probably adjudicate this mainly because of the storm mechanism because this is kind of a first go around for that? And what specifically are you asking for? And where is staff on that with respect to the storm specifically?"
},
{
"speaker": "Garrick Rochow",
"content": "Rejji will walk through the numbers in a moment. Let me just start out by saying staff's position as a constructive starting point. And as I shared in my prepared remarks, there's a number of things that have been supported in SaaS position. But there are some distribution investments for our customers that have, I would say, been left on the table. And we're focused on improving reliability. We know we can do that, offer better service. We're proving that out by our five-year plan, and we can do that at a lower cost, doing it proactively versus reactively. And so in addition to the storm recovery mechanism, which you referenced, which is also referenced in the Liberty audit as well. But we're also focused on those distribution investments to offer better service for our customers. And so there's a bit of advocacy we are doing on behalf of our customers. So we can make those investments to improve service. That is also a component which may push us into an adjudicated order. But I'll remind everybody, I'm open to settlement. It's just going to have to have -- it's going to have to continue to be more than where the staff is currently at. But Rejji, just share with Mike where things are at from a cost perspective."
},
{
"speaker": "Rejji Hayes",
"content": "Yes, so, Michael, the mechanics of the storm restoration tracker that we're proposing in our pending rate case. And if memory serves me, DTA is proposing a similar structure. We're essentially trying to take the five-year average of service restoration expense and put in the equivalent of a true-up mechanism where there's a 50% share for investors with customers. In the event our level of service restoration expense is above or below what's embedded in our rate case. So to give you a specific numerical example, if we had $130 million of service restoration expense in rates and a year in which we incurred $150 million of actuals, $10 million of that would be absorbed by shareholders. So we'd have $10 million of hurt flowing through our P&L and $10 million would be established in a regulatory asset that we would recover at a later date. And so customers would fund that portion of it. And if we saw the numbers go the other way, you would assume a commensurate level of regulatory liability and so on. And so it's -- as we see it, that provides good alignment of incentives between investors and customers with a mechanism like that, and we will limit a lot of the volatility we've seen in our P&L over the last several years because the levels of service restoration expense embedded in rates have been well below actuals now for the last several years and counting. And so that's the spirit of it and have to spend more time offline on that if need be."
},
{
"speaker": "Garrick Rochow",
"content": "And just to offer some numbers, our staff is at $170 million at a 9.5% ROE, 49.9% equity ratio. And our rebuttal position, we're at $277 million at 10.25% ROE, 50.75% equity ratio. So a little bit of cost of capital difference there as well. But I wanted to just make sure, Michael, you had the revised position of the company."
},
{
"speaker": "Michael Sullivan",
"content": "Okay. That's great color. Just real quick, staff on the storm specifically though, are they outright against it or they're just looking for a different structure than what you just…"
},
{
"speaker": "Garrick Rochow",
"content": "They're not supportive of it, but again, not supportive, but we expected that. Just like the investment recovery mechanism, it had to go to the commission. And we anticipate some mechanism like this will require the commission to weigh in on. And so it's not a surprise we're to ask that. And again, if we're going to go after that, it's going to go likely to a full order."
},
{
"speaker": "Michael Sullivan",
"content": "Okay. Thanks for helping [ph] me through all that. I appreciate it."
},
{
"speaker": "Garrick Rochow",
"content": "You’re welcome. Have a great day, Mike."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Andrew Weisel with Scotiabank. Please go ahead. Your line is open."
},
{
"speaker": "Andrew Weisel",
"content": "I was also going about -- hi, I was also going to ask about settlement. I guess I appreciate the detail there. I guess if there were to be a deal to be made, what would be the window for that? Or is it a relevant to where that happens?"
},
{
"speaker": "Garrick Rochow",
"content": "Yes. We're in that window now. And so -- and really up to a final order as the window of opportunity for us. And so -- and we'll look -- again, we'll look, I'm always open to settlement. I've said that in calls before. If we can make things work for our customers and for all stakeholders, I mean that's a good place to be. There's just a couple of things in this case that may force us into a full order, and we just want to make sure everyone on the call is aware of that."
},
{
"speaker": "Andrew Weisel",
"content": "Yes. Understood. New tools are often a policy question. So I understand that completely. The other question I wanted to ask about the CapEx update. I understand we'll have to be patient on the numbers. But the two things I wanted to ask about. Number one, just qualitatively, it sounds like there's going to be a lot of things going into that. There's always a business as usual update, but you've got spending around the REP. You got spending around the Liberty reliability audit, you've got the electric reliability roadmap with stuff going in there, plus you've got sort of a step change in demand growth from data centers and manufacturing, what I'm getting at is, should this be a meaningfully bigger increase than what we've seen in recent years? And if so, how should we think about financing that? You previously talked about up to a $350 million per year of equity in 2025 and beyond. I'm guessing there might be an upside bias to that given all the pieces that I just mentioned. How should we think about a rule of thumb about incremental equity needs per incremental dollar of CapEx? Thank you."
},
{
"speaker": "Garrick Rochow",
"content": "Rejji and I'll tag team this one, but I want to remind you that many of the tailwinds that we described in this call come as a result of approval of the renewable energy plan or approval of the IRP. And so although we'll file it in November of this year, fast-forward 10 months. So it's going to be in late Q3 of 2025 before we see where the commission is at with that. And so I wouldn't expect some of that good work to show up until our Q4 call at the end of 2025, early part of 2026. And then you'd have the same cycle for the IRP, which would start in 2026 and then play out in 2027. So I see these as tranches that go over time over the five years. Clearly, there's some tailwinds here, but they show up at different points in time. But I'll turn it over to Rejji to offer some additional color."
},
{
"speaker": "Rejji Hayes",
"content": "Yes, I think that's exactly right, Andrew. I mean the governors we've talked about and when we prepare our capital plan, our affordability balance sheet and an operational feasibility. Can we get the work done and those remain governors. But the fourth governor at this point is the pacing to Garrick's comment. And so just the time for the commission to review the REP, the time for the load opportunities to materialize. Yes, we signed contracts, we interconnect these opportunities, but it takes a while for build-out of a manufacturing facility or data center. So the pacing is going to certainly dictate when we'll be able to bring in all of this additional capital opportunity and see the load materialize, which effectively will fund those capital investment opportunities. So that's really the fourth governor at this point. But you will see upward pressure for sure in the $17 billion five-year CapEx number we've provided at this point. So without a doubt, but it will be pacing before you see the material bump, but I feel very good about the underlying earnings growth and rate base growth that will come from the next vintage. With respect to equity, as you know, and as you stated, we have said no equity obviously in 2024. And then up to $350 million starting next year and we've said that's a pretty good run rate for the current $17 billion capital plan and the sensitivity I'll share with you as you think about incremental capital going into the plan and what that might drive in terms of incremental equity needs. As a general rule of thumb is for every dollar of CapEx we invest at the utility, we usually fund it with around $0.35 to $0.40 of common equity, and that has been tried and true for some time. Now what's interesting over the last, I'll say, two years to three years is that we've seen downward pressure that sensitivity in terms of the equity needs, and it's really been driven by a few things. One, obviously, we just continue to generate substantial cash flow in the business, because of the forward-looking test year and the rate construct of Michigan. So I'll give an example, our prior five-year plan of $15.5 billion of capital generated about $12.5 billion of operating cash flow over a five-year period in aggregate. This current vintage is $17 billion. We expect $13.2 billion of cumulative operating cash flow generation, vintage over vintage. So almost $1 billion of increased vintage over vintage. And so just good cash flow generation. That's one. Number two, the ability to monetize tax credits afforded to us through the IRA, that's another big driver of liquidity and effectively a new source of equity that's helping our metrics and then just offering another layer of liquidity to fund our capital plan. So that's also helpful and we did our first tranche this year, about $90 million of dispositions, and we did that at levels better than planned, meaning the discount to par was better than we thought it would be. And so I anticipate us doing more of that over time. And then the last one is just -- I feel like a broken record when I say this is, we do plan conservatively. And so for the debt we're going to issue at the holding company, we're assuming it's straight debt with no equity credit, but we've been known to issue subordinated notes or hybrids in the past. Those get now a greater level of equity credit from Moody's, as you know, and so we're at 50% now. And so if we start to see pricing for those types of securities improve over time, that creates an opportunity also to put downward pressure on that sensitivity because obviously, if we see pricing comparable to what our debt assumptions are in our plan, then we can do hybrids at a level that's credit accretive and EPS accretive to plan. And so those all create opportunities for us to really minimize the equity needs as we increase the capital in our five-year plan."
},
{
"speaker": "Andrew Weisel",
"content": "Okay. That's extremely helpful details there. Thank you very much. So just to be clear on the CapEx numbers, though, so we should not expect numbers related to the REP or IRP but we should expect upside to CapEx related to reliability and the demand and economic development. Is that maybe a fair way to put it?"
},
{
"speaker": "Rejji Hayes",
"content": "Yes. You certainly won't see the full magnitude of opportunities associated with the REP. And the other reason I'm qualifying the comment a little bit, Andrew, is that you start to earn on PPAs effective mid-this year, and so we'll assume additional PPAs going forward. And so we'll start to see that opportunity associated with the renewable energy plan scale every year because we're doing PPAs for renewables every year. We'll probably start to layer in some of the capital investment opportunities in outer years of the plan. And so you'll see some of that weaved in and you'll definitely see your comment reliability and resiliency. But again, the lumpier opportunities associated with the energy law, you won't see until really starting in the 2026 vintage of our five-year plan."
},
{
"speaker": "Andrew Weisel",
"content": "Okay. Appreciate you are clarifying. I guess, maybe I needed some coffee this morning as well or some early Halloween candy perhaps. Thank you guys."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. And for our next question, we'll move to the line of Angie Storozynski with Seaport. Please go ahead. Your line is open."
},
{
"speaker": "Angie Storozynski",
"content": "Thank you. Thanks for squeezing me in. So I just have one question. So when I look at your current supply stack on the system, I mean, how much of it is imports from like self-generation versus the imports from the grid. And I understand that the MISO dispatches assets, et cetera. But I'm just debating how much of spare capacity that you have of your own right now? I mean, if I were to be an industrial customer or hyperscaler, how much could you offer me in megawatts right now?"
},
{
"speaker": "Garrick Rochow",
"content": "Well, let me offer you this and then we'll talk a little bit about the mix from MISO and the like. After our 2021 integrated resource plan, we were along from a capacity perspective. And there was a couple of things. One, we kept additional assets available to us as part of the settlement. We acquired the Covert Generating facility was 1.2 gigawatts. In the meantime, since 2022, when that was approved, we've also built out renewable assets, both wind and solar, and both here some PPAs as well as some owned assets. And so that's actually put in a position where we've been long and we've been able to accommodate a lot of sales growth. And then, as a reminder, we have the mechanisms, both the renewable energy plan and the integrated resource plan with some flexibility in those because we look at them -- two years on a renewable energy plan basis every three to five on an integrated resource plan, but we can pull it up and adjust those as needed to be able to accommodate the additional growth. The third piece with these hyperscalers is working with them because they're not going to all come on immediately. And they have plans and when they want to ramp up. That's also true with manufacturing. And so they may need a starting load in 2026, but their full ramp-up doesn't get out to 2028, 2029, 2030. And so there's a lot of work that we do with the customers to make sure we get that right. And so there's a lot of flexibility we have to make sure the supply and demand stack match up nicely and we can grow Michigan in the state. Now, we do leverage MISO to be able to do that. And if you look at our total mix, it's about 46%, 40-ish, 5% that we either have through PPAs or through purchase off market. Remember those PPAs act as both capacity and energy as well in that mix. And then the rest is self-generated."
},
{
"speaker": "Angie Storozynski",
"content": "But again, I'm just -- again, I'm debating it myself, if I were to cite like a big industrial facility or a data center, I would probably care about the speed to power, right? So this initial availability of megawatts would probably matter to me. So you're saying you are long tower even right now. So even, say, the next, say, 24 months, there is spare capacity that you could allocate to such a user?"
},
{
"speaker": "Garrick Rochow",
"content": "The short answer is yes. And we work closely with customers to be able to do that. I'll give you a real example. And it just hit the press today, we talked about in Q1, but we couldn't name the company. Switch, which is an existing data center in Michigan, is expanding by 230 megawatts. They want to be up by full load in 2026. We're able to do that. We're able to deliver that, as the electric infrastructure, both with our transmission partner and the distribution infrastructure as well as ensuring we have the supply. And so that gives you a little nature of our ability to deliver on that. And as we other -- entertain other hyperscalers or other manufacturing, again, we work with them closely to match up the ramp-up schedule. I gave the example of Corning as well in my prepared remarks. Corning wants to out low down by the first quarter of 2025. We're constructing the substation right now. We will deliver that. But again they want to ramp up. They go from a small amount of megawatts up to 90, 95 megawatts. That quarter is over a year. And so we pace that along with that company. So those are two real examples, real work going on in the state and just gives you an idea of how we work with customers to grow Michigan and grow in our service territory."
},
{
"speaker": "Angie Storozynski",
"content": "And what if there is like a very big site, let's say, a gig of eventual capacity? I mean, is this something that you feel comfortable accommodating. I mean, it is obviously, that would probably require a large -- well, two large combined cycle gas bonds to be built. How do you think about those sort of very big projects? Would you prefer to have smaller sites? Or is there, from like a risk perspective, do you think comfortable accommodating the big loads like that?"
},
{
"speaker": "Garrick Rochow",
"content": "We welcome growth in Michigan. I mean there's nothing better than create jobs. And we've got a constructive -- I mean, we're doing a lot of onshoring. It is truly a manufacturing renaissance. We're certainly open for data centers as well. And we work with those customers, large sites, small sites, to create opportunity for all stakeholders in the state. And so it doesn't -- we don't back away from a gigawatt load. Some of those are on one site; some of those are across multiple sites. And it's really, again, working with that company on their ramp-up schedule and when do we need to provide that and match that supply/demand mix. We've been doing this for 135 years. I used to be -- I started out my business -- in the business, I should say, on the supply side. So I get this. And that's what we do as a load serving entity; we have the mechanisms within the construct to be able to do that with success."
},
{
"speaker": "Angie Storozynski",
"content": "And just to make sure. And how do you, for example, ensure that this load actually materializes like when we look at power companies, like they have those take-or-pay contracts. How do you ensure that if you make the investments, actually the load will happen?"
},
{
"speaker": "Garrick Rochow",
"content": "One of it is contractually, but it's also, as I shared in my earlier remarks, making sure we've got a good -- from a rate design perspective, a cost of service model. That's how we operate in the State of Michigan. And so that makes sure that the other customers aren't subsidizing that work. And as I shared, we're working closely with commission and commission staff with data centers to see if there's additional rate compact or construct to be able to further ensure that residential customers aren't subsidizing or putting the bill for the data centers."
},
{
"speaker": "Operator",
"content": "Our next question will be from the line of Anthony Crowdell with Mizuho. Please go ahead. Your line is open."
},
{
"speaker": "Anthony Crowdell",
"content": "Hey, good morning, team. Thanks for squeezing me in. And I know it's a tough morning with Shar telling you what music to listen to and Ross telling you what to drink. So I'll keep it quick. Just I apologize. I think it's up to Mike Sullivan's question, the low drills update. Will we get that on the fourth quarter call on when you file the IRP, just when is the most up-to-date of the load growth."
},
{
"speaker": "Rejji Hayes",
"content": "Anthony, this is Rejji. Yes. So you will get a load forecast update and the renewable energy plan that we'll file in the coming weeks, and you will also -- we will also have a load growth update a few months later, that's supporting the five-year plan that we'll roll out on our fourth quarter call in the first quarter of 2025 as we always do. So you'll get a couple of bites of the cherry from a load growth perspective. And as Garrick noted in his earlier comments, you'll also see a load growth update about a year from then, maybe 1.5 years in the context of our IRP filing. So we'll have an iterative process for load disclosure. And again, as I said earlier, I expect upward pressure certainly on current estimate of 0.5%. That would certainly go up and it will likely accrete beyond that. So looking forward to sharing those with you in the coming weeks and months."
},
{
"speaker": "Anthony Crowdell",
"content": "Great. And then just lastly, one of the earlier questions, you talked about how the financing needs of the company. Also, I think the amount of equity now maybe 30% to 40% for every dollar spent. You also mentioned tax credits were going to be instrumental. Has the company quantified what we could assume for transferability over the next five years?"
},
{
"speaker": "Rejji Hayes",
"content": "So the latest number I'll guide you to is what we have embedded in our five-year plan, Anthony, and that's a little over $0.5 billion. But again, I expect that number to increase over time just based on the quality of the execution and also the anticipation of more renewable ownership should allow that number to accrete. And so this current plan has $0.5 billion in aggregate over five years. And again, as we provide an update on our five-year plan on our fourth quarter call and Q1 of next year, I'll provide a revised number, and I'd be surprised if that number doesn't continue to increase. Is that helpful?"
},
{
"speaker": "Anthony Crowdell",
"content": "Perfect. Thanks for taking my questions and see you in Hollywood."
},
{
"speaker": "Garrick Rochow",
"content": "Yes, see you in Hollywood"
},
{
"speaker": "Operator",
"content": "We have no further questions in the queue at this time. So I would now like to hand the call back over to Mr. Garrick Rochow for any closing remarks."
},
{
"speaker": "Garrick Rochow",
"content": "Thanks, Harry. And I'd like to thank you for joining us today. I look forward to seeing you at EEI, take care and stay safe."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. We thank everyone for your participation."
}
] |
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{
"speaker": "Operator",
"content": "Good morning, everyone, and welcome to the CMS Energy 2024 Second Quarter Results. The Earnings news release issued earlier today and the presentation used in this webcast are available on CMS Energy's website in the Investor Relations section. This call is being recorded. [Operator Instructions]. Just a reminder, there will be a rebroadcast of this conference call today beginning at 12:00 p.m. Eastern Time running through August 1. This presentation is also being webcast and is available on CMS Energy's website in the Investor Relations section. At this time, I would like to turn the call over to Mr. Jason Show, Treasurer and Vice President of Investor Relations."
},
{
"speaker": "Jason Shore",
"content": "Thank you, Harry. Good morning, everyone, and thank you for joining us today. With me are Garrick Rochow, President and Chief Executive Officer; and Rejji Hayes, Executive Vice President and Chief Financial Officer. This presentation contains forward-looking statements, which are subject to risks and uncertainties. Please refer to our SEC filings for more information regarding the risks and other factors that could cause our actual results to differ materially. This presentation also includes non-GAAP measures. Reconciliations of these measures to the most directly comparable GAAP measures are included in the appendix and posted on our website. And now I'll turn the call over to Garrick."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Jason, and thank you, everyone, for joining us today. Our proven investment thesis, which delivers 6% to 8% adjusted earnings growth and affordable bills for our customers has been durable for more than two decades because we focus on what matters. Today, I'm going to highlight two key areas of our thesis. First, Michigan's strong regulatory environment. Built on a solid constructive framework, much of which is codified in Michigan law, 10-month forward-looking rate cases, important financial and fuel recovery mechanisms increased energy waste reduction incentives just to name a few attributes. This robust framework supports Michigan's position as a top-tier regulatory environment and provides supportive incentives for needed investments to make our electric and gas systems safer, more reliable and resilient and cleaner. And second, our continued commitment to affordable bills for our customers. As I've said before, we work both sides of the equation. We make important investments and we keep customer build affordable. I consider our use of the CE Way, our lean operating system, one of the best in the industry. This approach limits upward pressure on customer bills. It is critical in the delivery of our investment plan. And we continue to see a long runway of cost-saving opportunities well into the future, delivering industry-leading results for all our stakeholders. From a regulatory perspective, we're off to a strong start for the year. As you can see on Slide 4, our regulatory calendar is mostly complete. We received a constructive order in our electric rate case in March, filed our new electric rate case in May and settled our gas rate case earlier this month, the fourth consecutive settlement in our gas business, four consecutive settlements in gas, yet another proof point highlighting the strong regulatory environment in Michigan. We're very pleased with our recently approved gas settlement, which calls for a $62.5 million of effective rate relief, a 9.9% ROE and a 50% equity ratio. We plan to follow our next gas rate case in December of this year. Outside of rate cases, our upcoming 20-year renewable energy plan or our EP filing in November is the only major remaining filing for the year. Let me pause there for a moment. Midway through the year. our financial-related regulatory outcomes are known. This is a great place to be. I also want to talk about our formula to deliver customer affordability as we make important investments. Long-term filings, like our renewable energy plan detail the significant planned investments that support safe, reliable, clean and affordable energy for our customers. As we shared previously, we see more investment opportunities as we make the transition to renewables and clean energy. In addition to the $17 billion of needed customer investments in our 5-year capital plan, our electric reliability road map and natural gas delivery plans highlight important investments well beyond within our financial plan. Now that's a long way of saying we see a long runway of necessary and important customer investments. These investments must be balanced with a laser focus on customer affordability. We take seriously our ability to create capital headroom to make those investments through continued use of the CE Way, which provides over $50 million of annual customer savings. Renegotiating over market PPAs in retiring our coal facilities, which together provide well over $200 million in savings as we transition toward cleaner resources. Capitalizing on economic development opportunities, particularly in manufacturing, which brings jobs and significant mission investments, spreading fixed costs over a larger customer base, benefiting all customers. Lastly, leveraging our best-in-class energy waste reduction programs to help customers reduce bills. This is a formula that works for everyone, continuing to strengthen the system with important investments while keeping customer bills affordable. Now let's look at the results and outlook. For the first half, we reported adjusted earnings per share of $1.63, up $0.18 versus the first half of 2023, largely driven by the constructive outcomes in our electric and gas rate cases. We remain confident in this year's guidance and long-term outlook and are reaffirming all our financial objectives. Our full year guidance remained at $3.29 to $3.35 per share with continued confidence toward the high end. Longer term, we continue to guide toward the high end of our adjusted EPS growth range of 6% to 8%, which implies and includes 7% up to 8%. With that, I'll hand the call over to Rejji."
},
{
"speaker": "Rejji Hayes",
"content": "Thank you, Garrick, and good morning, everyone. On Slide 7, you'll see our standard waterfall chart, which illustrates the key drivers impacting our financial performance for the first six months of 2024 and our year ago expectations. For clarification purposes, all of the variance analysis herein are in comparison to 2023, both on a year-to-date and a year-to-go basis. In summary, through the first half of 2024, we delivered adjusted net income of $485 million or $1.63 per share, which compares favorably to the comparable period in 2023, largely due to higher rate relief net of investment costs. And while we have seen some glimpses of favorable weather, particularly in June, overall weather continues to be a headwind through the first half of the year, equating to $0.05 per share of negative variance and that figure includes the warm winter weather experience in our service territory in the first quarter, which I'll remind you, have the second lowest number of heating degree days in the past 25 years. As mentioned, rate relief, net investment-related expenses, one of the key drivers of our first half performance resulted in $0.13 per share of positive variance due to constructive outcomes achieved in our electric rate order received in March and last year's gas rate case settlement. From a cost perspective, our financial performance in the first half of the year was negatively impacted by heavy storm activity, including a notable weather system that impacted our service territory in late June resulted in $0.03 per share, a negative variance versus the comparable period in 2023. Rounding out the first six months of the year, you'll note the $0.13 per share of positive variance highlighted in the catch-off bucket in the middle of the chart. The primary sources of upside here were related to solid operational performance at NorthStar and higher weather-normalized electric sales. Looking ahead, as always, we plan for normal weather, which equates to $0.20 per share of positive variance for the remaining half of the year, given the mild temperatures experienced in the final six months of 2023. From a regulatory perspective, we'll realize $0.12 per share of positive variance, largely driven by the aforementioned electric rate order received from the commission earlier this year and the constructive outcome achieved in our recently approved gas rate case settlement, which Garrick summarized earlier. Closing out the glide path for the remainder of the year, as noted during our Q1 call, we anticipate lower overall O&M expense at the utility driven by the usual cost performance fueled by the CE Way and the residual benefits from select sustainable cost reduction initiatives implemented in 2023 such as our voluntary separation plan, among others. Collectively, we expect these items to drive $0.09 per share, a positive variance for the remaining six months of the year. Lastly, in the penultimate bar on the right-hand side, you'll note a significant negative variance, which largely consists of the absence of select onetime countermeasures from last year and the usual conservative assumptions around weather-normalized sales and nonutility performance among other IOs. In aggregate, these assumptions equate to $0.35 to $0.41 per share of negative variance. In summary, despite a challenging first half of the year, we are well-positioned to deliver on our 2024 financial objectives to the benefit of customers and investors. Moving on to our financing plan. Slide 8 offers more specificity on the balance of our planned funding needs in 2024, which at this point are limited to debt issuances at the utility. I'll bring to your attention a relatively modest increase to our 2024 planned financing of the utility. Specifically, we are now planning to issue approximately $675 million in the second half of the year versus the implied estimates in our original guidance of $500 million to rebalance the rate-making capital structure at the utility in accordance with recent rate case outcomes. Although not highlighted in the table on the slide, I'm pleased to report that we have completed all of our planned tax credit sales for the year at levels favorable to our plan and ahead of schedule. I'll also reiterate that we have no planned long-term financings as apparent in 2024, but remain opportunistic should we see a cost-efficient opportunity to pull ahead some of our 2025 financing needs. As I've said before, our approach to our financing plan is similar to how we run the business. We plan conservatively and capitalize on opportunities as they arise. This approach has been tried and true year in and year out and has enabled us to deliver on our operational and financial objectives, irrespective of the circumstances to the benefit of our customers and investors, and this year is no different. And with that, I'll hand it back to Garrick for his final remarks before the Q&A session."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Rejji. CMS Energy, 21 years of consistent industry-leading financial performance. I have confidence in our strong outlook this year and beyond as we continue to execute on our simple investment thesis, and make the necessary and important investments in our system while maintaining customer affordability. With that, Harry, please open the lines for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. Our first question today comes from the line of Jeremy Tonet of JPMorgan. Please go ahead. Your line is open."
},
{
"speaker": "Jeremy Tonet",
"content": "Just wanted to turn towards DIG for a little bit here if we could. And just wanted to get updated thoughts with regards to recontracting overall and just, I guess, the outlook in this environment, given kind of trends in power prices?"
},
{
"speaker": "Garrick Rochow",
"content": "I would suggest, Jeremy, it's consistent with what we shared in the past, energy and capacity markets that upward pressure continues to be a ripe opportunity and we continue to strike nice bilateral contracts to secure managing capacity prices well above our plan. And so again, it's a good opportunity to continue to do that. And as we've shared in the past, this just continues to strengthen and lengthen our financial performance."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Thank you for that. And then it seems like halfway through the year, CMS is in a pretty good position overall. Just wondering any thoughts, you could share with regards to, I guess, how weather is looking in impacts for 3Q as it stands right now and really getting towards, I guess, cost management thoughts and whether there might be in a position to pull forward costs to further derisk the future outlook and how you think about all of that?"
},
{
"speaker": "Rejji Hayes",
"content": "Jeremy, it's Rejji. I appreciate the question. I would say weather outlook looks fairly good for Q3, but obviously, early days. And I will just say, personally, I don't give a lot of credence to 2-month and 3-month outlooks. I'm much more focused on the 10 days ahead, which appear to be a bit more accurate. And so, we always remain paranoid about weather. And just based on year-to-date, weather has not been all that kind. And so, we'll continue to execute on cost performance-related initiatives. We've had some good success over the last several years in executing on cost management over the course of the year, and we'll continue to do that through Q3. As I mentioned in the first quarter call, it's still premature to start thinking about pull aheads for 2025. I'd say historically, even in the best of years, where weather was really helpful in the first couple of quarters, we still didn't think about flexing up or pull ahead or any of those types of derisking mechanisms until we got deeper into Q3 and had a real good outlook on the fourth quarter. So hopefully, more to talk about from a 2025 derisking perspective next quarter. But at this point, it's too premature to get into that."
},
{
"speaker": "Garrick Rochow",
"content": "And if I could just add to that, Jeremy, part of the call here in my prepared remarks, I talked about the confidence. Confidence comes from the fact that we're executing on the CE Way. We've done that historically. We typically have been at a run rate of greater than $50 million on an annual basis. We see that continuing. There are a number of things that we did in 2023 in terms of -- already Ready shared in his prepared remarks, voluntary separation, contract control as those continue to yield benefit in the year. And also, we're flying a lot of digital solutions, everything from work in the field to automate work, all the way into the office, things like work management that continue to provide additional cost savings in the year. So again, confident as I shared in the call here earlier, and delivering guidance for the year."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Appreciate it. And then if I could just wrap with thoughts on opportunity to service data centers going forward here, and I guess, the interplay with regards to legislation in Michigan, whether that comes to fruition and how that might impact the pace of such type of development."
},
{
"speaker": "Garrick Rochow",
"content": "Jeremy, you know us well enough the Hayes-Rochow team here. We're pretty conservative in our approach to financials. And as I shared in the Q1 call, we want to make sure it's signed on the dotted line, you might say, before we talk about it. So, we don't inflate our sales forecast. I would just say that there's a lot of interest in both manufacturing and data centers in the state as I shared in the Q1 call, seeing a lot of manufacturing growth. That continues into Q2. We saw data centers, we talked about one that we signed in Q1, 230 megawatts. There continues to be strong interest in the state, both the hyperscalers and also, we're seeing some growth in what I call, midscalers from a data center perspective, those continue to move forward regardless of legislation in the state. And so, the sales and use tax piece will continue in the conversation in the legislature. But again, it's a bit of Jerry on top of Sunday, you might say."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Shahriar Pourreza of Guggenheim Partners. Please go ahead. Your line is open."
},
{
"speaker": "Shahriar Pourreza",
"content": "So, I know you guys noted previously that the FCM mechanism could be incremental sort of in the new generation not in plan. As we're kind of getting closer to the November rep filing, any thoughts on where demand is headed and how maybe CMS would be positioned for upside there. So, any thoughts on incremental CapEx versus the PPA options? Have you started to embed any higher load growth in your assumptions?"
},
{
"speaker": "Garrick Rochow",
"content": "Sure. I was really hoping for a rate design question."
},
{
"speaker": "Shahriar Pourreza",
"content": "It's coming. That's my follow-up."
},
{
"speaker": "Garrick Rochow",
"content": "Let's talk about this. We definitely see as a part of this energy law, additional upside. That shows up in ownership of asset that shows up in the financial compensation mechanism, both those are true. Let me talk about how they'll play out, though. We're going to file this our renewable energy plan in November, it's a 10-month process. So, we'll know in 2025, kind of latter half of the year, what that looks like. And so, in our 2026 capital plan, you'll see what that means, our 2026 financials both from an FCM perspective as well as what might the ownership mix looks like. And so that's where it will play out. In addition to that, that's probably a portion of the story because in 2026, we'll also file our integrated resource plan, which we'll talk about some of the reliability pieces and some of the work to deliver the capacity component of that. So, between '26, '27, '28, I think that's when you'll see the capital impact as well as the financial compensation mechanism play out in terms of our financials. And I will say this, we've seen some good economic growth in the state. That will show up in our renewable energy plan. We're definitely seeing a greater need than was in our original 2021 IRP. So, I'll leave it at that. And certainly, that will provide additional upside opportunity in terms of capital growth in addition to the energy law."
},
{
"speaker": "Shahriar Pourreza",
"content": "And then just a quick follow-up, and I obviously dedicate this to Garrick. Just on the rate case filing on the electric side, obviously, it's in the early innings. It's kind of more of a '25 event. The provisions and sort of the mechanisms like the IRM and DR remain unchanged. I guess do you feel there would be sort of an opportunity for settlement after testimony given this is kind of a less complex case. I guess, how are you sort of thinking about settlement path versus the prior litigated path? And is there anything, and I dedicate this to you, any of the rate design stuff in there that can cause some contention?"
},
{
"speaker": "Garrick Rochow",
"content": "I set myself up for that one, didn't I? [indiscernible] here on this call. I will always look for settlement opportunities. I'm also very confident in our team. We put a great case together, and we can go to full distance, just as we did this year in our March order. And so, when I think about this electric rate case, there's some things that have to be figured out to really get some context around the opportunity for settlement. One, I think it's really important to understand that electric cases are more complex than gas cases. So, for example, we had less than 10 intervenors in our gas case. We have a little over 20 in our electric case. That's not abnormal, it's just, it's a more complex case. There's more interested party so we have to navigate through that. I also think it's important to find where staff is and where the Attorney General are at in this case. That will come in September. These are important points to know in the context of settlement opportunity. But I understand that, I am very confident in this case. It is focused on electric reliability. That's well aligned with what the customers are asking for, what the commissioners and the staff are asking for and what I've committed to do and so this case has great capital investments and undergrounding has important work hardening the system and automated transfer reclosures technology on the system. There's important work in O&M and tree trimming, our number one cause of outage and other important maintenance work across the system. We're going to leverage the infrastructure recovery mechanism, we'll certainly look for -- we're going to try another store mechanism in this case as well. And so, we feel confident in our ability to get the very constructive outcome, just given how well aligned we are across commission staff as well as our customers. So hopefully, that gives you some context on the case. Now on rate design, let me just talk a little bit about rate design. Specifically, data centers are not at our economic development rate. We had ex-parte filing that made an adjustment in that, that was approved. And so, in the meantime, they are an industrial rate. We thought our GDP rate and what that does is a better balance, both capacity and energy cost, the cost to serve those customers. The commission as well as the utility has been looking and exploring at the opportunity specific data center rate. But in the interest of time, the GDP is a good proxy for that in our mind. And so well suited from a rate design perspective, from a data center perspective. I also said GDP, I think that's the wrong thing. I was hoping for something different there. Maybe that was -- but GPD is what I meant -- sorry about that Shahriar I had my eyes on the economic [indiscernible] it's election time. I have my mind on other things like what's going to happen with our economy."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Michael Sullivan of Wolfe Research. Please go ahead. Your line is open."
},
{
"speaker": "Michael Sullivan",
"content": "I just wanted to go back to the data center legislation discussion. I think on the last call, you talked about a 230-megawatt data center coming in 2026. Was that contingent on the legislation or your understanding is still moving forward? And are there any other examples of that? Or is everyone else [indiscernible] weighted inflation?"
},
{
"speaker": "Garrick Rochow",
"content": "It was not contingent. That one is still moving forward, that's the signed piece. And that's -- I guess that's my point. What we hear from data centers, it's more important about how fast can you get transmission here, how much cash can you build that conversion from transmission distribution to substation, how fast can you get supply here, and we're able to do that. And so many of those mid scalers and hyperscalers continue to make forward steps regardless of the progress on the sales new stack. And just to give you a little context, at the end of the spring session, the legislature was focused on the state budget. In the words of our governor, we've got to fix the damn road, and we got to fund schools, right? And so those are important things, too. I don't want -- we want smart kids in the state. So those are important things underway. That conversation on data centers and the sales tax will continue into the fall. Now we're in elections. So, it will be difficult for me to predict how fast that will move or it could happen to [indiscernible]. And so, we'll continue that conversation in the state. But again, it's not stopping things for moving forward, Michael."
},
{
"speaker": "Michael Sullivan",
"content": "And is that like a good proxy for how long it takes new load to come on to your system about two years with that one being 2026?"
},
{
"speaker": "Garrick Rochow",
"content": "There's a number of variables there, Mike. So, in the case of that data center, what we talked about is they're bringing on load by 2025, 2026, and where they're located on the system makes a big difference. And so able to accommodate that. Depending on where the data center is located from a property perspective makes a difference. Just as far as how far do we have to extend lines, is it greenfield? there's all kinds of variables that go into it, but we're in that two to three years cycle. And again, even if you're at the tail end of that cycle, data centers are moving quickly, and that doesn't seem to be holding them up too much."
},
{
"speaker": "Michael Sullivan",
"content": "Okay great. And then separately, just kind of sticking with legislation. I think there were some comments a few months ago from the PSC chair about rate case time lines being a bit impressed these days. Are you hearing any chance of legislation coming up that would revert back to 12 months per cycle from -- and just a general sense for rate fatigue in the state in light of those comments?"
},
{
"speaker": "Garrick Rochow",
"content": "The short answer is no. As you know, what makes Michigan great is much of the regulatory environment is set in law. So, 10-month forward-looking rate cases is in the law, financial compensation mechanism, energy efficiency incentives are in the law. And we just went through that law. We just opened and it was just signed here last November, and we're hearing nothing in terms of holding that law back up or looking at different traditions. Now we continue to always have a constructive dialogue with the commission and the staff. And so, I do think there are opportunities right, in terms. And so, I'll give you one example, just one example of probably many you could think about. We have a great process for an integrated resource plan and a renewable energy plan that lay out an energy supply portfolio. So, we get it preapproved and then it flows into rate cases. It really streamlines rate cases. What if we could do the same thing on the distribution system, wouldn’t that be great? Let's build a 5-year reliability road map. Wait, we've already done that. Let's do that. Let's approve that and then have that flow into rate cases. That could really streamline the process. And it's done in the right way, you can potentially see a path where you could stay out for a period of time, again, done in the right way. And so, the kind of the nature of Michigan's constructive regulatory environment, let's explore that. Let's see if there's opportunities there to -- even for the bolstered Michigan constructive nature."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Andrew Weisel of Scotiabank. Please go ahead. Your line is open."
},
{
"speaker": "Andrew Weisel",
"content": "Just two quick ones. First, C&I weather-adjusted volumes were down in the quarter, it's a bit of a reversal from the first quarter. I know the first quarter was extremely mild weather. So those numbers are probably a little bit goofy. But any commentary on the underlying trends and the near-term outlook for the rest of this year, maybe early thoughts on 2025?"
},
{
"speaker": "Rejji Hayes",
"content": "Sure, Andrew. This is Rejji. I'll take, and I appreciate the question as always. Yes, we did see a little bit of a pullback in Q2 versus Q2 of last year for weather normalized sales for electric. I will always caveat and I think you alluded to it that it's a very imperfect science, and the team does a really good job trying to pull these numbers together with real accuracy. But again, it's very difficult to get real precision here. Just so everybody is grounded residential for the quarter versus Q2 of 2023, which is slightly up about 0.1%. And commercial down about 1 point, industrial down about 2 points, excluding on low-margin customer and an all-in blended was down about 1 point and so that is to your comment, unfavorable from the trends we were seeing in the first quarter. But I would say, on a year-to-date basis, the trend remains quite good, and we continue to be surprised for the upside really across all customer classes because our assumptions were incredibly conservative as they always are for the year. And so, we are outperforming across every customer class, what our initial expectations were that were embedded in our original guidance. And so, we are still seeing non-weather sales upside. I'll also note, as I've said before, that we had energy waste reduction incorporated into all of those numbers that you're seeing. And so, you should always add 2% to each of those customer classes because we're delivering the 2% reduction across every customer class year-over-year, and we've been doing that now really since the '08 law or thereabouts. And so, another way to think about those numbers I just quoted that you should add or gross up 2% across each of those, if you want to get the underlying economic conditions. So, we still remain quite good. And then we still remain quite pleased rather with the results. And then when you think about it on a year-to-date basis, where is up about 1 point. Commercial is up over 1%, industrial down about 1 point and all in is up about a little over 0.5%. So again, all things considered, particularly when you gross up for energy waste reduction, we think conditions in Michigan remain quite good really across all customer classes. Was that helpful?"
},
{
"speaker": "Andrew Weisel",
"content": "Yes. Good reminder on the efficiency. And yes, we all know that you're conservative. Next, an operational question. You noted there was some heavy storm activity in the quarter, what kind of score or grade would you give yourself in terms of restoration efforts? Reliability is obviously a big focus for you. You talked about that in your comments, what would you say went well? What could have gone better? And how does this fold into your efforts as part of the electric rate case and the audit?"
},
{
"speaker": "Garrick Rochow",
"content": "So, we're seeing a number of great improvements as a result of the investments we have made to date. More needs to be done along those lines. And so, in fairness, I'd give ourselves a B in the context, there's more needs to be done for our customers. And that's evident in the rate case filing that we're doing. Where we've worked a lot, this year is reducing the size of the outage. And so, we've put in a lot of fusing. So, what I mean by that is you have less customers impacted when the tree comes down the line, that's an important work. We've more than doubled our free trimming work over the last three years. That's also provided a benefit when we trim treating there, we see a greater than 60% reduction in the number of outages. You may ask why not 100% because we still see trees outside the right way that impacts our performance. But I would also put it into context, Rejji talked about the last week of June, and there was a larger event in June, but there was a lot more smaller events which we would anticipate. We're trying to shrink the size, which makes restoration easier, but a lot of pockets throughout the state. We brought in a number of resources. We leverage a lot of our existing union resources to be able to respond to that, and we have good response from that perspective. We measure in terms of restoring our customers within a 24-hour window. We want to have all customers restored within a 24-hour window. And last year, in 2023, we're at 90% within a 24-hour window. This year, we're upwards of 95%. And so that shows the directional improvement. Now the year is not done. We've got a lot of work to do. and we'll continue to make some important investments throughout this year. And again, this electric rate case shows the path for more. So hopefully it gives us some context. I know Rejji wants to add to it as well."
},
{
"speaker": "Rejji Hayes",
"content": "Andrew, all I would add to Garrick's good comments on the operational side is really applying a financial lens. And I would give us about a B+ on the financial side because through utilization of the CE Way, we've done a really good job reducing unit cost in our actual service restoration. And we're seeing at this point over $40 million of avoided costs. Now needless to say, I talked about negative variance attributable to overall service restoration costs versus last year. However, the cost would have been decidedly higher as in the problem-solving we've done throughout the year. And so, we're contracting third parties more efficiently. We're using more automation to reduce manual inspections and definitely leveraging the tools of the CE Way to really execute on storm restoration much more efficiently than we have in the past. And so, in addition to all the operational feat that Garrick highlighted, will also apply a really thoughtful financial lens as well as to make sure that we're bringing customers back online as quickly as possible and as quickly as possible and as cost efficiently as possible. So, I'd be remiss if I didn't add that as well."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Julian Dimelo Smith [Indiscernible] of Jefferies. Please go ahead. Your line is open."
},
{
"speaker": "Unidentified Analyst",
"content": "Garrick, what are you put in your -- when are you putting yourself in the ring here for VP given all the political conversation here, right? Now you want to fix them growth."
},
{
"speaker": "Garrick Rochow",
"content": "And here's Rochow. I don't know. I don't know if it has a ring to it. Look I'll give it a try."
},
{
"speaker": "Unidentified Analyst",
"content": "Anyway, I -- look, you guys are really -- you got your front foot forward here for sure. Look, you favorably have pulled back on O&M savings here you're talking about leaning in, being in a good position against near-term and longer-term targets you issued more debt, I think it was $675 million versus the $500 million to rebalance your equity ratio. What's driving this level of outperformance? But I just want to try to clarify like the debt signaling as well as just overall the commentary, especially considering the O&M factor that you flag here. Like typically, you lead with costs, but I'm wondering what other factors there are."
},
{
"speaker": "Rejji Hayes",
"content": "Julian, it's Rejji. I appreciate the question and welcome back. Really good to hear your voice. Let me start with a few of the just premises or working assumptions you offered up in the question. And so, let me start with the debt at the utility, just for factual purposes. And so, we are planning to issue about $675 million in the second half of the year at the utility as part of our financing plan. It was initially $0.5 billion and so we've slightly increased, and that's really just because of our rate case outcomes, which had modestly lower equity levels, and so we'll have more debt at the operating company. And so, I just want to make sure that, that was abundantly clear. And obviously, we'll look to execute on that financing as cost-efficiently as possible, and we'll be thoughtful about maturity profile as well. The outperformance has been, obviously, we always try to deliver on the cost performance side. But as I mentioned in my prepared remarks, rate relief net of investments has been helpful getting constructive orders the electric rate order in early March, the gas rate case last year, we're still seeing the residual benefits from that. And so that's really what's helped us in the first half of the year. And also, though it's embedded in that catch-all bucket, as I noted in my prepared remarks, NorthStar has really outperformed. They had a really soft comp in the first half of 2023, just given last year's plan was a bit more back-end loaded. And there were also some outage-related issues at DIG, given a transformer issue. And so, this year, they've really gotten out of the gate pretty strong. DIG is up about $0.05 year-over-year, and we're seeing the residual benefits from some solar projects that came in late last year. And so, I'd say it's a combination of rate relief net of investments, outperformance at NorthStar as well as some cost performance, as you alluded to, offset by mild weather conditions, which have hurt the top line as well as storms, as we talked about in the prior question. So, I'd say it's a combination of all of that, which gives us just good confidence going into the second half of the year."
},
{
"speaker": "Unidentified Analyst",
"content": "And Rejji, just to follow-up on that real quick. A lot of that dynamic with NorthStar, some of it is true up there. You talk about outages year-over-year. You should -- in theory, some of that should have been expected, the solar in service mean I'm curious, the outperformance here. I mean, is this more of a true-up? Or is there sort of a compounding effect across the subsequent years? How do you think about the leading indicators there?"
},
{
"speaker": "Rejji Hayes",
"content": "Yes, good question. NorthStar on plan. We anticipated a front-end loaded year for all of the reasons you noted. So, a good portion of NorthStar's performance was on plan. But I will say DIG did surprised a little bit to the upside in the first quarter because operationally, not only are they executing very well, but they're also executing on a lower unit cost basis, which drives a little bit of additional margin there also opportunities for off-peak margin that the team has capitalized on. So, I'd say it's a combination of being on plan because it was a front-end loaded plant at NorthStar, but also so operational efficiency, which we've seen. So that's really the thrust of it at NorthStar."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Durgesh Chopra of Evercore. Please go ahead. Your line is open."
},
{
"speaker": "Durgesh Chopra",
"content": "Good morning. Thanks for taking my question. Just -- all my other questions have been answered. I just wanted to see if there's an update on the performance-based ratemaking dotted here coming out of the legislation last year. Where do we stand there? Can you just update us on that, please?"
},
{
"speaker": "Garrick Rochow",
"content": "Sure. That's been a very constructive dialogue. As I've shared in the past, it started really wide in the number of metrics. And then through good dialogue, it was narrowed down to a nice four benchmarkable metrics. It's grown a little bit to accommodate some storm provisions. However, there's still a constructive dialogue underway here in July and August, there's filings to be able to navigate that. There's a few things we still want to work through and get -- Dot the Is and Check the Ts on you might say. And then I expect that this is going to play out over several rate cases. And so, it's not going to be implemented here immediately. I think it just speaks to the constructive dialogue we have in Michigan here. A lot of good interveners and filings that go back and forth to really make sure it's going to be a productive ratemaking mechanism."
},
{
"speaker": "Durgesh Chopra",
"content": "Got it. So just kind of the framework of this would be a potential earnings uplift. And then on the downside, a potential penalty on certain metrics. And then when did you say this could go into effect? This is a '25 Item, '26? Just any thoughts there?"
},
{
"speaker": "Garrick Rochow",
"content": "I would put it several rate cases away, so over maybe a year or two years out from an implementation perspective. Again, that's my view, just what I see of the world. The intent is for it to be symmetric. And so, there's upside opportunity and downside opportunity. The downside opportunity is market about $10 million at this context, which is manageable in the context of the year. That means the upside opportunity is roughly that same amount. And at least that is proposed currently."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. Our next question is from the line of Travis Miller of Morningstar. Please go ahead. Your line is open."
},
{
"speaker": "Travis Miller",
"content": "Very high level on electric demand. I wonder if you could elaborate on how it's trending versus your 2021 IRP and how, as you had mentioned earlier in the call, how that would affect potentially the renewable energy plan filing here. They're trending higher or lower and how does that impact the REP?"
},
{
"speaker": "Garrick Rochow",
"content": "Yes. It's definitely trending higher based on all the economic development activity that is, again, not speculating on that, that is signed or -- and we're out building substations and there's transmission being built to serve these customers. And so, in our renewable energy plan filing, you should anticipate that there's additional sales reference there above and beyond our 2021 IRP."
},
{
"speaker": "Travis Miller",
"content": "And is it fair to make the leap then that you would need more renewable energy on that same percentage basis as what's in the lot?"
},
{
"speaker": "Garrick Rochow",
"content": "Yes, generally speaking."
},
{
"speaker": "Travis Miller",
"content": "Okay. And then also, obviously, a lot to talk about in the media about Palisades. From your perspective, is it accurate that you're seeing development moving forward on that plant? And then if so, would you be interested in either implementing that in your plan in terms of the capacity and energy and/or signing a PPA?"
},
{
"speaker": "Garrick Rochow",
"content": "Palisade is making forward progress in the state. From a state budget perspective, another $150 million was allocated toward the forward direction of the facility. We're having public meetings that are going on right now on site. So again, forward steps and moving forward that plant. Now I remind you that a PPA has already been struck for the offtake from the Palisades facility that goes to a co-op in Michigan and a co-op in Indiana. So, it's already spoken for. Now we did -- it's good for Michigan that Palisade is returning. And we, at CMS Energy, do not see any adverse impact as a result of Palisade coming back."
},
{
"speaker": "Operator",
"content": "Our next question today is from the line of Nick Campanella of Barclays. Please go ahead. Your line is open."
},
{
"speaker": "Nick Campanella",
"content": "Just one for me today. So, I know, Rejji, you said you would be opportunistic in your prepared remarks around financing and potentially pulling things forward from '25. I'm just cognizant that you do have kind of you start to issue equity in 2025. And maybe you can just kind of give us some more color? Are you just kind of talking about pulling forward hybrid or debt or is everything on the table, how do you think about that?"
},
{
"speaker": "Rejji Hayes",
"content": "Yes, I appreciate the question, Nick. I would say in short, I wouldn't say everything is on the table. So, you won't see us issuing equity in 2024. We have done in the past, though, as we have executed on forward opportunistically to at least take some of the price risk off the table. And I would say where the equity is today. I don't think that seems like the most likely trade. But I was speaking more towards parent debt financing needs. And certainly, our thinking is quite expensive, everything from senior notes to hybrids and those types of securities, all of which we've done pretty opportunistically in the past. As you may recall, we've got about $250 million coming due at the holdco next year. And so, we're mindful that we have, I'd say, modest new money needs on top of that. And so, we will see if there's good pricing in the market, particularly if the speculation around potential dovish policy -- dovish monetary policy from the Fed comes to fruition, but I have stopped wagering on that. So, we'll see what happens. But if we start to see a correction in the yield curve that's favorable and it creates opportunities for holdco debt financings. We'll look to do that. And again, I'd say the equity need still as is up to $350 million starting next year, and I don't see us pulling any of that forward."
},
{
"speaker": "Operator",
"content": "With no further questions in the queue at this time, I would like to hand the call back to Mr. Garrick Rochow for any closing remarks."
},
{
"speaker": "Garrick Rochow",
"content": "Thanks, Harry. I'd like to thank everyone for joining us today. I look forward to seeing you on the road soon. Take care, and stay safe."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. We thank everyone for your participation."
}
] |
cms | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, everyone, and welcome to the CMS Energy 2024 First Quarter Results. The earnings news release issued earlier today and the presentation used in this webcast are available on CMS Energy's website in the Investor Relations section. This call is being recorded. [Operator Instructions]"
},
{
"speaker": "Just a reminder, there will be a rebroadcast of this conference call today beginning at 12",
"content": "00 p.m. Eastern Time, running through May 2. This presentation is also being webcast and is available on CMS Energy's website in the Investor Relations section."
},
{
"speaker": "",
"content": "At this time, I would like to turn the call over to Mr. Jason Shore, Treasurer and Vice President of Investor Relations."
},
{
"speaker": "Jason Shore",
"content": "Thank you, Drew. Good morning, everyone, and thank you for joining us today. With me are Garrick Rochow, President and Chief Executive Officer; and Rejji Hayes, Executive Vice President and Chief Financial Officer. This presentation contains forward-looking statements, which are subject to risks and uncertainties. Please refer to our SEC filings for more information regarding the risks and other factors that could cause our actual results to differ materially."
},
{
"speaker": "",
"content": "This presentation also includes non-GAAP measures. Reconciliations of these measures to the most directly comparable GAAP measures are included in the appendix and posted on our website. And now I'll turn the call over to Garrick."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Jason, and thank you, everyone, for joining us today. CMS Energy, 21 years of consistent industry-leading results. And what sets us apart is our performance, and it starts with our investment thesis. It is how we prioritize and focus our work to deliver the service our customers deserve in the financial outcomes you expect."
},
{
"speaker": "",
"content": "As we look ahead, we see ample investment opportunity over the long term as we lead the clean energy transformation and deliver the critical work needed to improve the reliability and resiliency of our electric and gas systems."
},
{
"speaker": "",
"content": "This important work is supported by legislation and a constructive regulatory environment, which provides confidence in making required investments to strengthen our system and prepare for a clean energy future."
},
{
"speaker": "",
"content": "We plan ahead through our electric reliability road map, natural gas delivery plan and our upcoming renewable energy plan, which all provide visibility and transparency, and the work will deliver to keep our systems safe, sound and clean."
},
{
"speaker": "",
"content": "At CMS Energy, we work both sides of the equation. We make important investments in our systems, and we work to keep bills affordable. Our CE Way lean operating system helps us improve our performance, increase productivity and take costs out of the business. And we are hard at work to grow Michigan through economic development, ensuring Michigan thrives well into the future. These efforts are important and help us keep customers' bills affordable."
},
{
"speaker": "",
"content": "At CMS Energy, we make our investment thesis work year after year, and it continues to set us apart in the industry, delivering results for all our stakeholders. Today, I'm going to share 3 focus areas that have me excited about our future and give us confidence in our outlook."
},
{
"speaker": "",
"content": "First, our electric distribution system. As our world becomes more dependent on electricity for business growth, technology advancements, devices and vehicles, our system needs to be stronger, smarter and more resilient for our customers. But our vast electric distribution system is aging. It needs to be modernized and strengthened for increasingly severe weather. Over the past 5 years, we have seen some of the highest wind speeds on record in more frequent storm activity."
},
{
"speaker": "",
"content": "We have responded to this need through our electric reliability road map. Currently, a 5-year $7 billion plan to improve performance and harden our system for the future. The plan utilizes best practices from across the industry, including designing the system with stronger pull, undergrounding, sectionalizing in further automation. And given the size of our distribution system, 90,000 miles of line, nearly 1,200 substations and a historically lower investment per mile compared to peers, we see a long runway of needed investment."
},
{
"speaker": "",
"content": "We've incorporated roughly half of the incremental $3 billion you see on Slide 4, into our current capital plan, and you'll start to see this investment show up in our next electric rate case, which we'll file in the second quarter. These important investments will mean fewer in shorter outages for our customers, and we are already seeing meaningful improvements in the investments made over the last few years."
},
{
"speaker": "",
"content": "The second focus area I want to share is our continued leadership of the transformation to clean energy in the industry. In the past, I have shared our approved plans to eliminate coal in 2025, reduce carbon, grow energy efficiency and build out renewables in pursuit of our net zero target and cleaner air for our customers and our planet."
},
{
"speaker": "",
"content": "In late 2023, much of our clean energy targets were bolstered by Michigan's new clean energy law. This law is unique in the industry and is good for all stakeholders. It provides us with the opportunity to further reduce our carbon footprint while maintaining resource adequacy, affordable customer builds and delivering for our investors."
},
{
"speaker": "",
"content": "On the right side of the slide, you'll see the opportunities ahead, as we prepare to meet Michigan's new clean energy law. It supports an accelerated plan with the decarbonization of our system. With an enhanced financial compensation mechanism, which provides a roughly 9% return on clean purchase power agreements."
},
{
"speaker": "",
"content": "In addition, there's an increased incentive on energy efficiency as we target 60% renewables by 2035 and 100% clean energy by 2040. And it gives us important flexibility as we think through how to best meet our customers' needs with renewables across the broad MISO footprint. This mechanism, the flexibility in the law, helps us balance customer affordability as we work through this transition."
},
{
"speaker": "",
"content": "For our customers, all this means stronger, more resilient and cleaner energy. For our investors, an exciting and robust investment runway well into the future."
},
{
"speaker": "",
"content": "Now let's work the other side of this investment equation. The third focus area that I want to share today how we are helping Michigan grow and thrive, which is good for our company, and our customers."
},
{
"speaker": "",
"content": "Growth across our service territory is good for Michigan, helps keep bills affordable for our customers and provides headroom to the investments, I just referenced. And I couldn't be more excited about the growth we need in our state."
},
{
"speaker": "",
"content": "Michigan has a strong fiber network, access to fresh water, temperate climate, energy-ready site, and attractive energy rate. In February, we secured a contract with a large data center in the heart of our service territory. The majority of the 230 megawatts of new load is expected to be online by 2026. This is nice load growth."
},
{
"speaker": "",
"content": "And I'm even more excited about the manufacturing load growth we are seeing in Michigan, which is a differentiator for us. Our statewide leadership project such as Gotion, Hemlock Semiconductor, Ford and many others, continues to drive new and expanding load in our service territory. These projects bring significant jobs, supply chain, commercial growth, housing starts and broad Michigan investment."
},
{
"speaker": "",
"content": "The ancillary benefit of manufacturing growth are good for all customers, can bolster our confidence in our plan for 2024 and beyond. Our customers thrive when Michigan thrives. And I'm proud of the diversity and quality of new load our leadership is working to bring to the state."
},
{
"speaker": "",
"content": "Now let's get into the numbers. In the first quarter, we reported adjusted earnings per share of $0.97. Although we experienced a warmer-than-normal winter, the healthy set of countermeasures we deployed in 2023 and as well as our active use of the CE Way continued to benefit us in 2024. We remain confident in this year's guidance and long-term outlook and are reaffirming all our financial objectives."
},
{
"speaker": "",
"content": "Our full year guidance remains at $3.29 to $3.35 per share with continued confidence toward the high end. Longer term, we continue to guide to the high end of our adjusted EPS growth range of 6% to 8%, which implies and includes 7% up to 8%. With that, I'll hand the call over to Rejji."
},
{
"speaker": "Rejji Hayes",
"content": "Thank you, Garrick, and good morning, everyone. On Slide 7, you'll see our standard waterfall chart, which illustrates the key drivers impacting our financial performance for the quarter and our year-to-go expectation. For clarification purposes, all of the variance analysis herein are in comparison to 2023, both on a first quarter and 9 months to go basis."
},
{
"speaker": "",
"content": "In summary, through the first quarter of 2024, we delivered adjusted net income of $288 million or $0.97 per share, which compares favorably to the comparable period in 2023 largely due to higher weather-normalized sales and lower service restoration costs of utility, partially offset by mild weather."
},
{
"speaker": "",
"content": "To elaborate on the impact of weather, we experienced another warm winter in Michigan during the first quarter, which had the second lowest number of heating degree days in the past 25 years. The warm winter weather resulted in $0.06 per share of negative variance, which appears modest on the surface given the historically low number of heating degree days. However, it's important to note that last year's winter was also quite warm."
},
{
"speaker": "",
"content": "Rate relief net of investment-related expenses resulted in $0.05 per share of positive variance due to constructive outcomes achieved in our most recent electric rate case and last year's gas rate case settlement coupled with residual benefits from our 2023 electric rate case settlement approved last January."
},
{
"speaker": "",
"content": "From a cost performance perspective, our financials in the first quarter of 2024 were positively impacted by lower operating and maintenance or O&M expenses primarily attributable to lower service restoration costs than we experienced last year."
},
{
"speaker": "",
"content": "Also, as Garrick noted, we continue to see benefits from select cost reduction initiatives implemented in 2023, which have offset modest inflationary trends we've experienced in various cost categories such as wages, as planned, and we anticipate this trend to continue over the remainder of the year."
},
{
"speaker": "",
"content": "And our [ catch-all ] category represented by the final bucket in the actual section of the chart, you'll notice a healthy pickup of $0.19 per share, largely driven by weather normalized sales, which contributed almost half of said positive variance, particularly in our residential and commercial customer classes. It's worth noting that the leap year impacts comparability with 2023 for weather-normalized sales, but even absent the effects of the leap year, our residential weather-normalized sales up about 0.5%, and our commercial customer class was up almost 2.5% versus the prior year, which highlights the continued solid performance of our higher-margin customer classes."
},
{
"speaker": "",
"content": "Looking ahead, we plan for normal weather, as always, which equates to $0.22 per share of positive variance for the remaining 9 months of the year, given the mild temperatures experienced for virtually all of 2023."
},
{
"speaker": "",
"content": "From a regulatory perspective, we're assuming $0.18 per share of positive variance, which is largely driven by the constructive electric rate order received from the commission in early March. We are also assuming a supportive outcome in our pending gas rate case."
},
{
"speaker": "",
"content": "On the cost side, we anticipate lower overall O&M expense at the utility driven by the usual cost performance fueled by the CE Way, and last year's voluntary separation program, among other 2023 cost reduction initiatives that continue to bear fruit."
},
{
"speaker": "",
"content": "We also assumed lower service restoration costs given last year's record level of storm activity in our service territory. In aggregate, we expect these items to drive $0.09 per share of positive variance for the remaining 9 months of the year."
},
{
"speaker": "",
"content": "Lastly, in the penultimate bar on the right-hand side, you'll note a significant negative variance which largely consists of the absence of select onetime countermeasures from last year and the usual conservative assumptions around weather-normalized sales and nonutility performance among other items. In aggregate, these assumptions equate to $0.52 to $0.58 per share of negative variance."
},
{
"speaker": "",
"content": "Slide 8 offers the latest updates on our regulatory forward calendar. As you'll note in the top section, we plan to file a Renewable Energy Plan or REP by mid-November, which will highlight our strategy for complying with the various renewable energy targets associated with Michigan's new clean energy law. We are excited by the prospects of the new law, which will support our net zero carbon by 2040 goal and look forward to socializing our filing with key stakeholders in the coming months."
},
{
"speaker": "",
"content": "Once filed, the commission will have 300 days to issue an order, which will likely be in the third quarter of 2025. Therefore, as mentioned during our fourth quarter call, you should expect to the 5-year plan that will roll out in the first quarter of 2026 will incorporate a greater portion of the financial impacts of the REP."
},
{
"speaker": "",
"content": "Moving on to our general rate case filings. You can expect our next electric rate case to be filed in late May to early June time frame. This filing will incorporate some of the initial spend we have outlined in our 5-year electric reliability road map that Garrick touched on earlier. Given the 10-month stipulated period for rate cases in Michigan, we would expect to receive an order from the commission in the first quarter of 2025 and thus, the related financial impact."
},
{
"speaker": "",
"content": "Lastly, we anticipate an order in our pending gas rate case by mid-October, absent a settlement. While we don't always include a balance sheet update on our formal presentation, it is worth noting that Moody's and Fitch reaffirmed our credit ratings in March and April, respectively, as noted at the bottom of the table on Slide 9."
},
{
"speaker": "",
"content": "Longer term, we continue to target solid investment-grade credit ratings, and we'll continue to manage our key credit metrics accordingly as we balance the needs of the business. And with that, I'll hand it back to Garrick for his final remarks before the Q&A session."
},
{
"speaker": "Garrick Rochow",
"content": "Thank you, Rejji. Our simple investment thesis is how we run our business and provides us with confidence for a strong outlook this year and beyond. 21 years of consistent industry-leading financial performance, 21 proof point, regardless of conditions, no excuses, just results. With that, Drew, please open the lines for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question today comes from Shar Pourreza from Guggenheim Partners."
},
{
"speaker": "Shahriar Pourreza",
"content": "I guess, firstly, just given you have an upcoming electric case. How are you thinking about any kind of incremental construct improvements there? Would you kind of seek an expanded IRM framework? And do you need to address any kind of the rate design issues with C&I rates, especially as you're trying to accommodate new load like data center growth, especially just trying to kind of balance that customer rate impact."
},
{
"speaker": "Garrick Rochow",
"content": "Shahriar, you want me to get into rate design. You guys are all going to fall asleep on this call if I go into rate design. Let me start out with the fundamentals of this electric case. I think this is really important. You've heard me time and time again, whether it's investor meetings or in our calls and the importance of improving reliability. We've seen higher wind speeds, more frequent storm activity. And just this is our focus as a company, how we improve reliability and the longer-term resiliency of our electric system."
},
{
"speaker": "",
"content": "You can also hear that from the commissioners. They're very clear about that expectation. And so I would say there's really good alignment there. And this reliability road map does just that. It's aimed at those important capital improvements. There's some O&M work associated with that as well. These are best practices in the industry, which we're deploying across our system and going to a meaningful benefit for our customers."
},
{
"speaker": "",
"content": "In addition to that, we're focused on the affordability piece. This is how the fundamentals of this, great to invest the capital, but you also have to be focused on the affordability piece for our customers. And so it's driving down unit cost through the CE Way, it's other cost offsets, there's a whole range of things we're doing to make sure this next electric rate case delivers for our customers in terms of improved reliability and offsetting from a cost perspective. So that's the fundamentals of the case."
},
{
"speaker": "",
"content": "And so we're going to look at different mechanisms in that case. As I've shared before, I would anticipate that we, again, take advantage of our infrastructure recovery mechanism that was supported in the last case. We'll look at a storm recovery mechanism. We've utilized that in previous cases. We'll continue to look at that optionality and what that could look like in this case."
},
{
"speaker": "",
"content": "Again, longer term, we'll file this in the May, first part of June. I feel confident about what we're putting together based on the important merits of the case that are going to improve reliability, will balance the important components of affordability."
},
{
"speaker": "",
"content": "Now your question on rate design, there's a lot in rate design. I really will put you to sleep if I go there. We're going to make sure as the state expands, and we have this important load growth that both energy and capacity component, that cost of service mechanism is appropriately allocated to where those costs are. That's what we've done historically. That's what the commission supported. And so we'll look at that certainly within the context of this case, but it's really smaller in the grand scheme of the important work of this case."
},
{
"speaker": "Shahriar Pourreza",
"content": "Got it. Perfect. And then lastly, as we're thinking about the energy law construct [indiscernible], I guess, what are some of the first changes you can implement, especially as we're thinking about the upcoming IRP update. Would you lean more on sort of that FCM construct? And is any of this kind of embedded in your long-range growth guidance?"
},
{
"speaker": "Garrick Rochow",
"content": "It's still early days on some of those modeling. So we'll file our REP, Renewable Energy Plan, on November 15. And as I've shared historically here or previous here, there's a broad spectrum of ownership versus PPAs. PPAs obviously have the opportunity for the financial compensation mechanism or if you're going to build everything and own everything, obviously, you have the opportunity to earn your ROE."
},
{
"speaker": "",
"content": "So there's a broad spectrum. You do all either end, those are the bookends. I think it's somewhere in the mix, and there's a lot of variables we need to consider that we're modeling out right now, and that's why we're not prepared to share what that looks like. But let me hand it over to Rejji, I know he has some additional thoughts on this."
},
{
"speaker": "Rejji Hayes",
"content": "Thanks for the question. All I would add to Garrick's comments is that in our current 5-year plan, what we've incorporated is just a modest amount of PPAs with the financial compensation mechanism, and that's solely because of the fact that any PPA put in place after June of this year would be subject to the new FCM, which is around 9% versus the prior of about 5.5%. And so we have a portion of that, albeit a small portion incorporated in this 5-year plan."
},
{
"speaker": "",
"content": "We've also incorporated the enhanced economic incentives associated with energy efficiency. And so that's flowing through our plan as well. And remember, historically, we've, on the electric side, been reducing load about 2% year-over-year. And before the new energy law, we get a 20% incentive on top of that spend, that's now 22.5%, so that's also a source of financial upside embedded into this plan."
},
{
"speaker": "",
"content": "But to Garrick's earlier comments, the much more expansive opportunities, whether it's scaling contracts or the ownership opportunities or more specifically the rate base opportunities. Those are not incorporated into our 5-year plan and really won't be until 2026."
},
{
"speaker": "Shahriar Pourreza",
"content": "Okay. Perfect. Appreciate it, Garrick, for the record, your rate design answer was not boring at all."
},
{
"speaker": "Operator",
"content": "Our next question comes from Nick Campanella from Barclays."
},
{
"speaker": "Nicholas Campanella",
"content": "I guess just thinking about the other off-site opportunities, can you maybe give us an update on your conversations around DIG and the recontracting opportunity there? And how those discussions have been progressing? Is this something that we can maybe see an update on by year-end? Or is it more a '25, '26 item? Maybe just talk about timing there."
},
{
"speaker": "Rejji Hayes",
"content": "Nick, this is Rejji. I appreciate the question. Yes, as we talked about on our fourth quarter call, we still have about 30% to 35% open margin in the outer years of our plan, really starting in sort of 2026 or second half of 2016 going through 2028. We certainly are seeing attractive reverse inquiry for that open margin on the capacity side. We're sold through on the energy side through 2028 or through the duration of this 5-year plan, but there still are opportunities in the capacity side. And we'll be thoughtful."
},
{
"speaker": "",
"content": "We never are too aggressive in selling down that open margin. We like to have a little bit of optionality, particularly with a really attractive technical that we continue to see in Zone 7 with the tightening of supply and upward pressure on demand. And so we'll provide an update in our next 5-year plan, as we always do. And I expect that we'll be selling down a portion of the open margin ratably over the coming months and quarters, but should still have probably a little open margin as we provide a new 5-year plan in the first quarter next year. Is that helpful?"
},
{
"speaker": "Nicholas Campanella",
"content": "That is helpful. I appreciate that. And I guess thinking about the rate case cadence and outcomes. On the electric side, the last case to kind of pursue the fully litigated outcome, but on the gas side, you just received staff testimony. And I think, Rejji, I heard you say you get an order in fourth quarter absent a settlement. So just what's your reaction to staff starting point here? And what are your thoughts on being able to settle the gas case?"
},
{
"speaker": "Garrick Rochow",
"content": "I'd go back Nick to the fundamentals of that case, aiming for a safe natural gas system, you continue to reduce methane across that and deliver affordable natural gas to our customers. And so again, the imbalance -- that equation of making the investments in the natural gas system, also just like we're doing in the electric business, aiming for an improved affordability across the gas system through unit costs, through cost out using the CE Way and the likes."
},
{
"speaker": "",
"content": "So those fundamentals are true. Staff position, I would categorize as constructive, a constructive starting point. And so we'll look, once we have that position, we're going to look for the opportunity for settlement. We've been able to work with a number of the interveners in the past and have a good track record there. But I also hear this, I'm confident in the testimony and the merits of the case. So if we need to go to full distance, we will, and get a constructive outcome both for our customers and stakeholders."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jeremy Tonet from JPMorgan."
},
{
"speaker": "Jeremy Tonet",
"content": "Just want to dive in, I guess, to the sales outlook, came in a bit better than expected, I guess, for the first quarter and for the balance of the year, it looks like that's trending better than expected. And just wondering by customer class, if you could dive in a bit more on the drivers that you're seeing that within each class that is leading to this uptick?"
},
{
"speaker": "Rejji Hayes",
"content": "Ye's. Jeremy, this is Rejji. I appreciate the question. So yes, we were pleased with the first quarter performance of non-weather sales. We provide good color on that in our earnings digest, which you probably saw. But going through the customer classes, we saw residential up just under 1.5% versus Q1 of 2023. And so on the surface that looks quite good, but it's important to note that the leap day in the quarter because it's a leap year, drove about 2/3 of that. But still even absent leap day, I mentioned in my prepared remarks, still up about 0.5%."
},
{
"speaker": "",
"content": "I still think we continue to see continued upside of the return to work or return to facilities trend, where I think we had pretty conservative assumptions about returning to facilities, and we are seeing a stickiness to folks having our corporations retaining what I would describe as a hybrid workforce. And so that is still, I think, delivering some surprise to the upside, and it is a higher margin customer class, as you know."
},
{
"speaker": "",
"content": "On the commercial side, really quite pleased with what we've seen. And so the number was just under 3.5% increase versus Q1 of 2023. And the leap year only affected about 1/3 of that. So pro forma for the leap year, we were still just under 2.5%. So very pleased with that. And our speculation, we've seen some of the subsectors within commercial that have performed pretty well. Agriculture, mining, up about 6.5%. We also saw entertainment up about 3%. And so we've seen some of the subsectors perform pretty well."
},
{
"speaker": "",
"content": "But we also think because folks are actually going to the office, at least 3 days a week, that does create foot traffic in communities and folks are going to cafes and things of that nature. So that's also part of it as well, but that's a bit more speculate there, but that's our sense."
},
{
"speaker": "",
"content": "And then within Industrial, if you exclude one low-margin large customer, we're just over -- sorry, just slightly up, let's say, about 20, 25 basis points, and the leap year did have a big impact on that class. And so pro forma for the leap year, you're down about 1%. I will always caveat 2 things whenever we talk about weather-normalized sales. One, remember, those numbers include the fact that we're reducing our load by 2% each year in electric due to energy efficiency. So all these numbers should be on a gross basis, up 2%. And so you should provide that color to these industrial numbers."
},
{
"speaker": "",
"content": "The other thing I always caveat is that weather normalization math as good as our team is, as hard as they work to get it right, is a very imperfect science. And so it is very difficult to get these numbers exactly right."
},
{
"speaker": "",
"content": "But what I would say in terms of industrial that we feel very good, as Garrick noted in his prepared remarks about the economic outlook and just have a robust pipeline and a very diversified pipeline of industrial opportunities, which really aren't reflected in our numbers at this point. It won't be until the outer years of our plan, and we'll be disappointed if that opportunity doesn't continue to bear fruit for the next couple of years."
},
{
"speaker": "",
"content": "Now that's the color I can offer across each customer class, but certainly happy to take any follow-ups as needed."
},
{
"speaker": "Jeremy Tonet",
"content": "That's very helpful. And maybe just pivoting a bit here, it seems on the side that they lay out there's a bit of cushion to hitting the guide in '24. And so just wondering, I guess, how you feel confidence level guide at this point, does it put you in a position to start thinking about '25? Just wanted to get a sense for how that stands."
},
{
"speaker": "Rejji Hayes",
"content": "Yes. I would say, Jeremy, early days. Obviously, we're delighted that 2024 is not 2023 in that we don't have a big storm as well as mild weather to start off the year, which we obviously saw last year. But to be clear, we still saw negative variance in terms of weather, top line-related weather. And so there's still some work to do. And so we are countermeasuring and again, very confident in the outlook. But it's a little early before we start thinking about derisking 2025 and beyond."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Arcaro from Morgan Stanley."
},
{
"speaker": "David Arcaro",
"content": "I was wondering what you're seeing in terms of maybe data center demand in the pipeline. Any uptick in further requests to connect beyond the big kind of megawatt addition that you called out? And wondering if that customer class, I guess, would potentially be involved in the voluntary renewables plan? Any upside potential there?"
},
{
"speaker": "Garrick Rochow",
"content": "Thanks for your question, David. A couple of things on this. I typically don't like to talk about the pipeline just because it's pretty speculative on that. And many of these data center companies are testing the waters in a variety of different utilities. And so we typically talk in terms of contracts. And when we talk about economic development, whether it's manufacturing or data centers, it's secured contracts, which we, again, feel really good about. Let me reflect a little bit on this project, and then I'll talk -- I will highlight the pipeline. I will get to your answer."
},
{
"speaker": "",
"content": "This particular project, this data center expansion that we mentioned in the prepared remarks, is 230 megawatts, online by 2025, a majority of the load in place by 2026. And so that does speak to our ability and capabilities to be able to deliver for these customers."
},
{
"speaker": "",
"content": "And then you see Michigan, and I said this in some of my remarks, temperate climate, which is great for the heating and cooling load of a data center, a lot of freshwater and then energy-ready sites, attractive energy rates, good fiber network, all that comes together to make Michigan really attractive."
},
{
"speaker": "",
"content": "I will say within the state of Michigan, there is a sales and use tax that exists where there's roughly a dozen states that have the sales and use tax in place, about 6%. There is an exemption process as being a build that are being considered in the House and Senate. It's passed the House in a bipartisan way. It's moved over to the Senate for consideration. We think that's going to move forward, that exemption, probably in the June, July time frame at the end of the session before they go on summer break. And that will open up Michigan a bit more for that pipeline."
},
{
"speaker": "",
"content": "There are companies that are exploring Michigan right now, large data center providers, names that you would recognize. But again, it's a little bit -- they're testing the water in a lot of different locations. And so we'll see how Michigan progresses. We're certainly an attractive place to do business, and we'll look to track that low growth appropriately."
},
{
"speaker": "",
"content": "And but as I stated in my previous remarks, we want to make sure there's a good balance that they're picking up the costs associated with that load as well, both from an energy and capacity perspective. So that's all the things that work in the balance, David. Hopefully, that provides some light to your question. Let me know if I didn't strike the right balance there."
},
{
"speaker": "David Arcaro",
"content": "It does. That's helpful. Yes. And are you thinking there could be upside to your long-term load growth expectations? Or is it still early?"
},
{
"speaker": "Garrick Rochow",
"content": "We've got a -- we have -- between the manufacturing load this contract and the data center load that's contracted. As Rejji said, it's a nice piece of load growth that we factored in the later years of this 5-year plan, but future 5-year plans. And we're excited about what that means. And there's a strong pipeline, both from a manufacturing perspective and to a degree, the data center perspective as well. I'd be disappointed if some of those projects in the pipeline didn't materialize."
},
{
"speaker": "David Arcaro",
"content": "Okay. Great. That's helpful. And a separate topic. I was wondering you're just latest expectations for the performance-based rates process in terms of timing and where that outcome might be headed."
},
{
"speaker": "Garrick Rochow",
"content": "That's progressed in a constructive way. We had close to 10 or a dozen metrics that were originally proposed. It's narrowed to 4 metrics that are benchmarkable and there's good standards. And so again, a constructive process plays out. There's more work to do from our perspective when we filed comments in the February, March time frame."
},
{
"speaker": "",
"content": "We're expecting a report from the Michigan Public Service Commission staff in May, and so we'll see the next round of thinking. I would suggest that a couple of electric rate cases away, not this case, perhaps the next case before we see implementation. But again, this is an evolving process with the Public Service Commission."
},
{
"speaker": "Operator",
"content": "Our next question today comes from Michael Sullivan from Wolfe."
},
{
"speaker": "Michael Sullivan",
"content": "Just sticking with the data center conversation, it sounds like you're kind of optimistic on this legislation and if that does pass and start to bring more interest to the state, what do you think about the potential for DIG being used in its entirety as like a behind-the-meter solution for like a larger type data center build-out? I know there's been a lot of focus on that on the nuclear side of things elsewhere, but people talking about gas as well. So just curious of your thoughts there."
},
{
"speaker": "Garrick Rochow",
"content": "Similar to Rejji's comments, from an energy perspective, energy tools and a capacity of the bilateral contracts, much of DIG has been spoken for at attractive -- really attractive position that either meets our expectations or is above our expectations. And so there's really unless you're beyond 2028, and maybe in the 2030s decade, DIG's really not available because it's already been secured and with, again, attractive energy tools and bilateral contracts for capacity."
},
{
"speaker": "Michael Sullivan",
"content": "Okay. Fair enough. Makes sense. And then just on your upcoming [ audit rate ] case filing here just to set expectations. I know 1 of your peers in the state recently filed and got a pretty quick response from the AG. Are you anticipating something similar with yours? Should we just be prepped for that?"
},
{
"speaker": "Garrick Rochow",
"content": "It is -- we got primaries in August, and that means early [indiscernible] balance start in June. And so its political season already in Michigan. And so I would anticipate that. Look, the Attorney General participates in all our cases, that's been a historical practice. Sometimes those are more public than other times. We stand, as I shared earlier, by the merits of the case, both in our gas case that's underway right now and this electric rate case."
},
{
"speaker": "",
"content": "The team just went through a walk through this week, and I couldn't be more proud of the work the team's put together on it. As I shared earlier in my questions or responses to questions, we're focused on reliability. That's going to improve for our customers. That is absolutely the right thing to do, well aligned with the Public Service Commission."
},
{
"speaker": "",
"content": "We're working hard to create affordability, and we're good at that through the CE Way, the reducing power supply cost, their unit costs from execution of capital. And when you get that mix right, that equation, right, it makes it I mean you get good outcomes. And so I'm excited about this case. It's certainly going to be a step-up in capital. There's going to be some O&M work too, that's focused on reliability, but there's also some offsets that are really exciting that make us -- get me excited, as you can tell by the tone of my voice about what we're filing and what we put it together because it's going to be good for customers, and it's going to be good for all stakeholders."
},
{
"speaker": "Operator",
"content": "Our final question comes from Andrew Weisel from Scotiabank."
},
{
"speaker": "Andrew Weisel",
"content": "Follow up on the rate cases here. Just a couple of follow-ups on the rate cases. So first, I think you just alluded to this to the electric side. You're going to have more capital and more O&M. Just from a headline perspective, should we expect a larger revenue increase request than what we've seen in past [ dialings ] in terms of percent increase to customer bills."
},
{
"speaker": "Garrick Rochow",
"content": "Yes. The short answer is yes. But again, important work from a capital investment perspective and reliability, and we've done a lot to offset some of the O&M costs components of this to strike that right balance. And that's what I mean by the important fundamentals or merits of the case."
},
{
"speaker": "Andrew Weisel",
"content": "Okay. Very good. And then procedurally on the gas side. I know this case is unique in that there's no ALJ. Does that change the time line at all or the potential for settlement? You talked a bit about settlement, but the lack of ALJs that factor in at all?"
},
{
"speaker": "Garrick Rochow",
"content": "No. The team seems excited about the opportunity to get to the table. Now that we have staff position now that we know where intervenors are at, to talk settlement. And as I shared, we've been able to navigate that with success in the past with all interveners, all stakeholders. And so we'll look to do that, but also hear my confidence in the merits of the case that if we need to go to full distance, we will. And I know that will get a good outcome for our customers and for stakeholders."
},
{
"speaker": "Operator",
"content": "That concludes the Q&A portion of today's call. I'll now hand back over to Garrick."
},
{
"speaker": "Garrick Rochow",
"content": "Thanks, Drew. I'd like to thank you for joining us today. I look forward to seeing you on the road soon. Take care and stay safe."
},
{
"speaker": "Operator",
"content": "That concludes today's call. Thank you for your participation. You may now disconnect your lines."
}
] |
cnc | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Centene Corporation Fourth Quarter and Full Year 2024 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Jennifer Gilligan, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Jennifer Gilligan",
"content": "Thank you, Rocco, and good morning, everyone. Thank you for joining us on our fourth quarter 2024 earnings results conference call. Sarah London, Chief Executive Officer; and Drew Asher, Executive Vice President and Chief Financial Officer of Centene will host this morning's call, which also can be accessed through our website at centene.com. Any remarks that Centene may make about future expectations, plans and prospects constitute forward-looking statements for the purpose of the safe harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by those forward-looking statements as a result of various important factors, including those discussed in our fourth quarter 2024 press release, which is available on the company's website under the Investors section. Centene anticipates that subsequent events and developments may cause its estimates to change. While the company may elect to update the forward-looking statements at some point in the future, we specifically disclaim any obligation to do so. The call will also refer to certain non-GAAP measures. A reconciliation of these measures with the mostly -- most directly comparable GAAP measures can be found in our fourth quarter 2024 press release. With that, I would like to turn the call over to our CEO, Sarah London. Sarah?"
},
{
"speaker": "Sarah London",
"content": "Thanks, Jen, and thanks everyone for joining us this morning. As an enterprise, Centene is stepping into 2025 with a clear strategy, compelling embedded earnings power, and positive momentum within each of our lines of business. We have delivered significant operational improvements and see exciting opportunity ahead as we continue to modernize our platform, automate our administrative processes through the deployment of AI, and leverage our unparalleled data to create insights that make our business better, improve the quality of healthcare for our members, and transform how the healthcare system serves millions of Americans. Today, we reported fourth quarter adjusted diluted EPS of $0.80 and full year 2024 adjusted diluted EPS of $7.17, strong results that demonstrate the durability of our earnings power and position the company to execute against our strategic goals in 2025. Driven by better-than-expected results during the Medicare annual enrollment period and a program expansion in Medicaid, we are lifting our full year 2025 revenue guidance by $4 billion. Our outlook for full year 2025 adjusted diluted EPS remains unchanged as greater than $7.25, and we are pleased with the trajectory we are on at this early stage in the year. To that end, let's talk about the opportunities in each of our business lines and how we are positioned for 2025. First, Medicaid. Today, we serve 13 million Americans across our Medicaid portfolio, offering critical access to vital medical services and support for some of this country's most vulnerable and complex populations. Post-COVID era eligibility redeterminations generated significant membership transition within the safety net program, but that chapter is now coming to a close. In 2025, we expect improved membership stability and a gradual return toward equilibrium with respect to rates and the risk profile of our members. We continue to have constructive dialog with our state partners, providing us with confidence in our ability to command rates that will support a return to target Medicaid margins. This is visible through a strong result for 1/1/25 effective rates, where we were able to achieve a mid-4% composite rate adjustment. We continue to expect a full year 2025 composite rate adjustment of 3% to 4%. While we have been focused on supporting our members and state partners through the redeterminations process, Centene's local Medicaid teams never stopped working to develop innovative care programs and solutions to promote access for our unique member base. For Centene, transforming the health of the communities we serve means bringing care to our members, ensuring it is local, integrated, and sustainable and working to influence positive health outcomes for our members as early as possible in the care journey, in some cases, before they are even born. To this end, in Nevada, we are actively working to address the challenges of rural healthcare access for expectant moms. Our SilverSummit team is distributing tablets to support increased prenatal and postpartum telehealth visits for mothers in rural counties. We have also sponsored telehealth training, with a particular focus on postpartum behavioral health support. Another great example of innovative programming comes from our Meridian team in Illinois, where we are taking a food is medicine approach to supporting members with uncontrolled high blood pressure. Members have access to a 12-week comprehensive program that includes nutrition counseling, along with four weeks of medically tailored meals, followed by four weeks of healthy food boxes, followed by four weeks of fresh produce vouchers. The goal is to build and sustain the changes in eating habits that will support long-term hypertension control. As we move through 2025, we are looking forward to turning the page on the redeterminations era, returning to overall Medicaid program stability and working closely with our state partners on innovations that deliver not only healthcare, but also better health within our communities. Turning to Medicare. We are pleased to be generating material progress within our Medicare business. The most recently released Stars results, published during fourth quarter 2024 and applicable to benefit plan year 2026, are an excellent window into our notable advancement. Within these results, 55% of our members are associated with 3.5 star plans or better, up from 23% last year. We continued to operate and execute with increased precision throughout 2024, driving year-over-year improvement in many of our core administrative measures. We also continued to make progress closing care gaps for our members with year-over-year performance improvement in our HEDIS rates, as well as medication adherence. And in a credit to our team's leadership and effort around continuous improvement, 1/1/25 go-live for Medicare was the smoothest I've ever seen at Centene. We expect these and other advancements in our processes and key metrics to support Stars results as we take on 2025. As you've heard from us before, we pruned our Medicare Advantage footprint coming into 2025 to better align with our Medicaid presence and capabilities, enhancing our ability to leverage Centene's size, scale, and expertise. With this refined footprint and refreshed products, we produced very good results relative to our expectations during the 2025 annual enrollment period. We now expect Medicare enrollment in the low-to-mid 900,000. Product design, successful management of our distribution channels, and local market knowledge contributed to the better-than-expected results. It is still early, but based on things we can know today, such as demographics and retention levels, we are pleased with the membership mix we are carrying into 2025, including a duals mix around 40%. Amid program changes related to the Inflation Reduction Act, Medicare Part D presented Centene with a nice growth opportunity in 2024 and the team executed well against that strategic plan. Part D or PDP is positioned to be a larger business for us once again in 2025, both by revenue and membership. During open enrollment, we went to market with a deliberate focus on value for our members, including premium affordability. This plan, complemented by the CMS demonstration program, yielded strong AEP results that are expected to generate 2025 revenue of approximately $16 billion, better than our previous expectations. Here too, we are early relative to observed experience, but as we look at factors such as member demographics and product selection, we remain confident in the financial objectives we set forth at December's Investor Day, including a 1% target margin for the PDP business in 2025. Finally, a brief comment on the Medicare Advantage advance rate notice released last month for the 2026 revenue year. While the information is not final, we are pleased to see the potential for a positive directional shift in funding for this important program, including the incorporation of a higher level of base rate medical cost trend. Final rates are expected in April, and we will continue to assess the various program changes anticipated for 2026 and the funding necessary to maintain compelling plans and create value for seniors as we build out our preliminary 2026 strategy. Within our Medicare segment's 2024 performance as a strong jump-off point, we are excited to build upon the operational progress we made last year, while taking important steps on our path towards breakeven in Medicare Advantage in 2027. Finally, marketplace. Across our footprint, our marketplace team has demonstrated consistently strong results through disciplined pricing, strong distribution relationships, as well as unmatched local knowledge of the marketplace population. Ambetter delivered an outstanding performance in 2024 and carried that momentum into their 12th open enrollment period, once again executing well on fundamentals and positioning our portfolio of products for another year of strength in 2025. According to CMS, enrollment across the ACA market grew roughly 13%. But given program integrity changes such as FTR or failure to report and the agent of record lock, our focus has been on effectuated membership. For Ambetter, January effectuated enrollment turned out to be a little stronger than what we had incorporated into our outlook for the business at our Investor Day in December, driven by strong member retention. Overall effection rates to date are directly in line with historical norms for Ambetter, which positions us for a peak marketplace membership during the first quarter, slightly above 5 million members. Looking down one level deeper, the demographic of our effectuated membership is similar to the member mix in 2024. Our book is expected to be roughly 51% female with an average age of 39.4, continuing a year-over-year trend of slightly younger membership. At the same time, our metal tier shifted slightly towards silver. While we have been near 70% silver over the last few years, in 2025, we expect to have nearly 75% of our membership in silver plans, consistent with earlier years of the program. As a reminder, our outlook continues to provide for an anticipated return to the pre-COVID era membership seasonality, with net attrition down to the mid-4 millions by year-end. Overall, we are pleased with the early indicators around our marketplace business and believe that we positioned ourselves well in 2024 by being the first carrier to introduce an agent of record lock. Our view through January suggests a more muted impact to membership from the program integrity changes than originally anticipated, but we believe some may require a longer tail to play out and that it will be a few months until effectuated enrollment results are fully understood. As you would expect, we will continue to closely monitor effectuation rates, voluntary member terminations and other trends within our book as we move through the first quarter. As we think about future trends in the individual market, I did want to call out the strong results we saw during open enrollment in our Georgia markets. We were pleased to be able to support Commissioner King and the State of Georgia as they made their transition to being a state based exchange, and we are excited to see how Georgia Access provides a model for advancing the growth of the individual market, both on and off-exchange, which includes access to ICHRA. As we shared in December, we continue to view ICHRA as the future of health insurance for working Americans and is an important part of Centene's future earnings power. In January, we announced the addition of Alan Silver to our leadership team. Alan is now President of Ambetter Health Solutions, which focuses on ICHRA or Individual Coverage Health Reimbursement Arrangements. Alan previously led retiree medical and ICHRA initiatives at Willis Towers Watson, and we are thrilled that he has joined our team. As we turn the page to a new year, it is important to acknowledge the incredible amount of hard work and tenacity from the [Cen Team] (ph) that enabled Centene to deliver on our financial commitments in 2024. Countless obstacles and macro-level challenges faced by our team and our industry at large required focus and execution by colleagues from across our organization. As a result of staying tightly aligned to our strategic goals and our mission, we are now well-positioned to capitalize on the important opportunities that we see ahead of us in 2025 and beyond. In 2025, we expect to collaborate with our state partners to achieve better alignment for Medicaid rates and member acuity. Our Medicare Advantage business, following successful execution during AEP, will focus on key operational initiatives to drive us forward on our journey to breakeven in 2027. And as the category leader, our marketplace team will once again offer access to high quality and affordable healthcare this year to approximately 5 million Americans. There is significant earnings power embedded in this business. With between $3 and $4 of adjusted EPS opportunity to unlock over time, we are eager to achieve our next set of enterprise milestones, deliver on our commitments to our members, and generate shareholder value in 2025 and beyond. With that, I'll turn it over to Drew."
},
{
"speaker": "Andrew Asher",
"content": "Thank you, Sarah. Today, we reported fourth quarter 2024 results, including $36.3 billion in premium and service revenue and adjusted diluted earnings per share of $0.80 in the quarter. For the full year, we reported $7.17 of adjusted EPS, well ahead of our previous guidance. In addition to ending the year strong, our results include a $0.29 net benefit for a marketplace cost sharing reduction or CSR settlement related to prior years. Our Q4 consolidated HBR was 89.6%, while our full year consolidated HBR was 88.3%, consistent with our previous guidance range. Our Q4 Medicaid HBR was 93.4%, up 30 basis points from Q3. We were expecting a couple of late year 2024 retro adjustments that did not come in by year-end. Medicaid trend story is similar to our last discussion. Stable trends overall now that we are essentially through redeterminations other than behavioral health and some pockets of home health costs, consistent with past commentary. Our full year 2024 Medicaid HBR at 92.5%, temporarily high, driven by redeterminations, presents us meaningful earnings power over the next couple of years as we turn the page on 2024 and better match rates and acuity going forward. Case in point, we are yielding around the mid-4s in net rate increases for the 1/1/25 cohort, which now represents about 40% of our annual Medicaid premium. The Medicaid membership settled out right in that 12.9 million to 13 million zone we had targeted and our 2025 guidance is predicated on staying in this membership zone throughout 2025. Medicare segment performance was strong in Q4, including a very good overall 2024 performance in PDP, as a few of you were concerned with the Inflation Reduction Act at the beginning of 2024. The Q4 PDR related costs in Medicare Advantage were consistent with what we last told you. Commercial segment results were strong in Q4 due to the CSR settlement, otherwise, they were right on track. Overall, exiting 2024 in a position of strength should bode well as we enter 2025, and continued Medicaid rate action, as well as execution on initiatives designed to improve quality and the affordability of healthcare, should enable us to achieve our 2025 Medicaid goals. Moving to other P&L and balance sheet items, our adjusted SG&A expense ratio was 8.9% in the fourth quarter, compared to 9.7% last year, a continued blend of business mix and discipline. Cash flow provided by operations was only $154 million for the full year, driven by the timing of pharmacy rebate collections, the reduction in risk adjustment payables, and the buildup of state premium payments receivable. As these items normalize in future periods, it sets us up for stronger operating cash flow in 2025. Our unregulated and unrestricted cash on hand at quarter-end was $248 million. During the fourth quarter, we repurchased 14.4 million shares of our common stock for $930 million. For the full year 2024, we repurchased 42 million shares for $3 billion. We have taken out over 100 million shares in the past few years. At the same time, our debt-to-adjusted EBITDA was only 2.9 times at year-end. Our medical claims liability totaled $18.3 billion at year-end and represents 53 days in claims payable, compared to 51 in Q3 of 2024 and 54 in Q4 of 2023. One DCP note looking ahead, given the meaningful growth in PDP in 2025, largely driven by the Inflation Reduction Act and the fact that pharmacy claims complete very quickly compared to medical claims, this should lower our consolidated DCP by a few days in 2025. While 2024 was certainly a challenging year, we still grew adjusted EPS over 7%, powered through redeterminations, made some great progress in Medicare Stars, and seized meaningful growth opportunities in marketplace and PDP. Let's turn the page and look ahead. As you heard from Sarah, our marketplace open enrollment period reflects very good execution by our team and keeps us on track for our 2025 forecast elements covered at Investor Day. We expect to peak right above 5 million marketplace members during Q1 and then a trip the remainder of the year back to mid-4s, consistent with pre-COVID enrollment patterns, where Q1 was typically the annual peak of membership. And we need to see the pattern of membership throughout Q1 2025 before we touch commercial revenue guidance of $34 billion. In our Medicare business, 2025 volume has started out stronger than expected, driven by the annual enrollment period results, notably driven by stronger retention. And our PDP business was over 7.5 million members as we entered 2025. Accordingly, we expect the Medicare segment to be about $2.5 billion higher in premium revenue in 2025 than what we discussed at Investor Day in December. In addition to that $2.5 billion, there is another expected $1.5 billion in Medicaid revenue from a program change, adding behavioral health coverage in one of our state contracts. So, we are increasing our consolidated 2025 premium and service revenue guidance range by $4 billion to a range of $158 billion to $160 billion of premium and service revenue. This is good news as you think about the long-term earnings power of Centene. At this very early point in the year, we are reiterating our 2025 adjusted diluted EPS guidance floor of greater than $7 in -- $7.25. Quick comment on 2026 Medicare rates. The preliminary percentage rate change for us is in the low-to-mid 3s, including the positive impact of Stars from the work we did in 2023 and 2024. It's great to have 2024 behind us and have earnings power consistent with our Investor Day discussion in front of us. As importantly, we are really excited about the number of initiatives in flight and in our sights designed to make healthcare simpler, more accessible, and more affordable, just like we've been able to help shape in marketplace, which has been a great solution for over 23 million Americans. We are proud and honored to serve members, states, and the federal government in Medicaid, Medicare, and marketplace programs into 2025 and beyond. Thank you for your interest in Centene. Rocco, let's open up the line for questions."
},
{
"speaker": "Operator",
"content": "Absolutely. [Operator Instructions] Today's first question comes from Josh Raskin with Nephron Research. Please go ahead."
},
{
"speaker": "Josh Raskin",
"content": "Hi, thanks. Good morning. I heard the 13% on the exchanges, but maybe you could speak to your expectations around total exchange market growth when all is said and done in 2025 and maybe a little bit more color on what you're seeing around that subsidy verification process? And then maybe even just walk us through the mechanics of how that works at the member level and when you think you'll know your fully effectuated membership totals."
},
{
"speaker": "Sarah London",
"content": "Yes, absolutely. Thanks, Josh, for the question. So CMS put out 13 million -- sorry, 13% as the sort of January-to-January enrollment growth. As we've talked about before, our view was that effectuated membership was going to be sort of the important number to track, partly because of the payment -- the program integrity changes that were being put in place. And we referenced what we were seeing at December Investor Day in terms of slower throughput relative to over-enrollment because of the agent of record lock. That we saw improve as we moved through OE, but we still think there's probably a little bit of backlog that is being worked through there. And then again, the FTR -- failure to report process, I think we had anticipated a little bit more impact in the OE period. That appears to be more muted, but that's where we also think there is potentially a longer tail for that to play out. And so, to your point, sort of the step through that -- stepping through that as an illustrative process, what happens there is a notification to the member of the need to file taxes and sort of a notification sent to the members relative to the impact that would have on enhanced APTCs. Consumers have the opportunities to attest to having filed taxes and then there's a process of multiple checkpoints as we move through February and March and ultimately into the April window. And so, that's part of why we think there may be additional impact that we see in Q2. And so, we're continuing to hold our view relative to impact on effectuated enrollment, but we're going to need to see how that plays out. So, a little bit stronger in terms of our effectuation in January, which means we're starting from a good place, which is great, but we want to see a couple more months play out until we know where that's going to settle."
},
{
"speaker": "Josh Raskin",
"content": "And I think you said the effectuation levels are similar to what you've seen in the past. So, what is that delta? If there's 13% total growth, what do you think that translates into effectuated or should we say, well, if effectuation is the same percentage, then 13% market growth is 13% effectuated growth?"
},
{
"speaker": "Sarah London",
"content": "There's usually a delta between enrollment and effectuation. And again, our -- what we're seeing from an effectuation standpoint is, as you said, directly in line with historical norms. So our -- the growth that we saw was a little bit stronger than the 13% and the effectuation, then that retention from our book is putting our membership at slightly above 5 million. But again, I think we need to see how the program integrity impacts play out in Q2 to know what the net market growth post effectuations will look like."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Justin Lake at Wolfe Research. Please go ahead."
},
{
"speaker": "Justin Lake",
"content": "Thanks. Good morning. Just a couple of quick numbers questions. First, looks like the PYD in the quarter was north of 400 million, up about 300 million year-over-year. Can you tell us what drove that? And Drew, I know it doesn't all hit the bottom line. So, maybe you could tell us the net benefit there. And then just quickly on the Medicaid retros that didn't hit in the fourth quarter, anything you could share on the size there? And is it just a timing issue where they'll hit in Q1 or did they just not happen at all? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes, why don't I hit the retros and then if you want to talk about PYD? So, as you heard from Drew, we had rate action expected late in the quarter that didn't come through. We're not counting on that in 2025. To the -- so to the extent that any of that does materialize, it would be a benefit to 2025. We did see positive movement in the 1/1 rates. And in some cases, those are sort of linked. And so, that's where you saw the mid-4 composite rate for 1/1. So, very consistent with the theme that we've seen throughout this process, which is, I think we've made great progress in terms of being able to influence states with data and get to the right level of rates. We just aren't always perfect in predicting the timing."
},
{
"speaker": "Andrew Asher",
"content": "Justin, you're right. With the prior-year development, if you look on the last page of the press release, we had about a little over $2.4 billion for the full year, including strength in Q4. That includes the CSR. That's a medical expense item of over a couple of hundred millions. So that leaned into probably that differential you're referring to in Q4."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Stephen Baxter, Wells Fargo. Please go ahead."
},
{
"speaker": "Stephen Baxter",
"content": "Hi, thanks. Just wanted to ask about the Medicaid rate assumptions. I mean, based on the rates that you're getting for 1/1, it seems like the rest of the year placeholder is something probably in the zone of 2%, 2.5%. And logically, it seems like every rate update you get going forward should be better informed, both from a cost and acuity perspective. Is there anything structurally different about the dislocation in the rest of the book that suggests that a lower rate update would really be kind of the sensible base case at this point, or how should we think about the conservatism potentially of the assumptions you're making in Medicaid rates for the second half of the year? Thank you."
},
{
"speaker": "Sarah London",
"content": "Yes. I mean, again, we continue to expect the full year 2025 composite rate between 3% and 4%, obviously, a little bit stronger in that 1/1 cohort. I think you're right that we are coming into all of these conversations with more robust data just as time has rolled forward and being able to really see the run-out and move forward sort of the prior period from an actuarial standpoint. So I think that is part of why we saw some of the strength in the 1/1/25 rate. Again, really constructive conversations with the state partners and really databased in how we're looking at everything. So I don't think there's anything structurally different. I will point out that as we've gone through the back half of 2024, the degree to which states are open to things like retros, midyear adjustments, and just understanding that we need to get to a place where the programs are funded sufficiently in order to make sure that we are supporting members the way that they want to, I think, is probably different than we've seen in the past. And so, again, I think that makes us feel good about how we're positioned moving into 2025. But as you heard, it is a question of getting the timing to line up and that's why we think that we'll make progress in 2025 toward that equilibrium in terms of long-term margin. But it may play out through the course of the year."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from AJ Rice at UBS. Please go ahead."
},
{
"speaker": "A.J. Rice",
"content": "Hi, everybody. Maybe just ask about two things. One, on the Medicaid side, when you look at the underlying utilization trend trying to normalize, which I know is probably hard for redetermination impact, are you seeing it return to sort of your normal low-single digit cost trend or is it still somewhat elevated on just an apples-to-apples year-over-year basis? And then on the Medicare, medical loss ratio ended up being better than expected. And I know there's reference to an adjustment to the premium deficiency reserve. I'm just trying to understand, what are you seeing there on the cost trend versus the adjustment that you made relative to the premium deficiency reserve?"
},
{
"speaker": "Sarah London",
"content": "Yes. On Medicaid, I think as you heard from Drew, no new trends to report and we continue to look at that cohort of continuous members to evaluate how sort of apples-to-apples trend is evolving. Nothing alarming there. So it's really same story that we've been sharing over the last couple of quarters. Also felt good about the run rate medical expense that evolved in Q4 and exiting the quarter better than we started. So, nothing has really shifted there. And then from a Medicare standpoint, do you want to talk about Q4 and full year?"
},
{
"speaker": "Andrew Asher",
"content": "Yes, Medicare finished strong. The performance -- the outperformance in the quarter was largely driven by PDP. So we finished PDP very strong, which is good to see in sort of the first major year of the IRA changes in 2024, sort of getting the bids and the execution and the cost structure right. So that gives us some confidence as we enter 2025 with further changes in the IRA, as reflected in the guidance we laid out at Investor Day."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Adam Ron with Bank of America. Please go ahead."
},
{
"speaker": "Adam Ron",
"content": "Hey, thanks for the question. You guys didn't really touch on seasonality for 2025, at least not on this call. So I'm curious, in terms of Medicaid MLR, if you still expect sequential Medicaid MLR declines in every quarter throughout the year? And if there's any indication you can give us of like where you think Q1 will end and what the slope of that curve looks like, it'd be very helpful. Thanks."
},
{
"speaker": "Andrew Asher",
"content": "Yes, that's a good question. As we think about -- so think about our three segments. Commercial, consistent with the past, you expect the HBR to start low and tick up throughout the year as members satisfy deductibles and so on. But in Medicare, pretty big difference. Instead of sloping down through the year, it should start out lower in the Medicare segment and slope up through the year. And that's really driven by what's now about half of our Medicare segment revenue coming from PDP and the IRA changes. So that's something to watch out for as we go through the year, once again, a sloping upward Medicare HBR. And then Medicaid, as we said at Investor Day, back half should be better than the front half in terms of HBR. The front half HBR of 2025, certainly expect that to be better than the back half of 2024 HBR. So you put all those things together and what we said at Investor Day was about 60-40 in terms of earnings per share first half versus second half. Probably should be better than 60% or greater than 60% in the first half of the year relative to the back half."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Sarah James at Cantor Fitzgerald. Please go ahead."
},
{
"speaker": "Sarah James",
"content": "Thank you. I'm hoping you can help us bridge the old to the new guidance a little bit. So you've got $4 billion more in revenue, EPS stayed the same. Is there any other moving pieces or is it just conservatism? And then, specifically to how you're thinking about now for exchanges and Part D, would those margins be flat, up, or down year-over-year? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. So I would say, we're -- we haven't yet closed January. So it's a little bit early and I think we've pointed to some solid early results, but wanting to see how those play out in terms of membership and experience. And then in terms of PDP margin, we said we're still targeting that 1% for the PDP book. And relative to marketplace, we've said and continue -- hold that we would be well into the 5% to 7.5% range for marketplace, and that includes what we've seen so far."
},
{
"speaker": "Andrew Asher",
"content": "You're right to point out the $4 billion. That's earnings power for the future. It's just real early to sort of pinpoint exactly how much of that will show up in 2025. But we're really excited as we create additional revenue sources that bodes well for long-term earnings power for the company."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Scott Fidel with Stephens. Please go ahead."
},
{
"speaker": "Scott Fidel",
"content": "Hi, thanks. Good morning. I was hoping just given some of the moving pieces that we saw in 2024 on operating cash flow, whether you'd be comfortable maybe just giving us a bit more of a sort of fine-tuning on your expectations for operating cash flow in 2025? And then just related to that, maybe sort of your updated thinking around what's embedded at this point for buybacks in terms of full year buybacks and then any sort of pacing around that? Just curious on whether you know sort of 2024 operating cash flows influenced the trajectory of that. But at the same time, you ended the year at a pretty solid spot in terms of unregulated cash at the parent. Thanks."
},
{
"speaker": "Andrew Asher",
"content": "Good questions. And I'm sure you understand this and those that understand the HMO industry understand that there's a difference between the cash flow operations on the cash flow statement, which is really the activity of receivables and payables down embedded in the statutory entities. But when that rolls up, if you look at the last actually three to five years, we've averaged 1.3 times to 1.4 times adjusted net income. So that's -- if you sift through any given year of satisfying risk adjustment payables or building up pharmacy rebate receivables and look at an extended time period, that's a pretty good indicator of a multi-year view. Underneath that, what really matters, as you point out appropriately, is the cash you're able to dividend up to the parent from the subs. And we've got no change in view compared to what we rolled out at Investor Day, where we expect about $2 billion of share repurchase that's embedded in our guidance for 2025. So the fact that we had, let's say, weak cash flow from operations on the cash flow statement in 2024 because of those shifts in receivables and payables, that had no bearing on our ability to go buy back $3 billion of shares -- or $3 billion worth of shares in 2024. But it's something to track and we'll keep you updated as we move through 2025 on sort of having some of those payables and receivables turn in the underlying cash flow from operations."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Andrew Mok at Barclays. Please go ahead."
},
{
"speaker": "Andrew Mok",
"content": "Hi, good morning. Quick clarification, then a question. I think you mentioned that ACA effectuated enrollment turned out to be a little stronger than you expected, but I didn't hear how much better it came in. So, can you clarify that point first? And then secondly, I wanted to revisit your assumption that ACA membership could be down 20% to 30% if enhanced APTCs expire. Are buydowns contemplated within that assumption? And can you walk us through the impact that buydowns would have and how your products are positioned relative to the market if there is a shopping event next year? Thanks."
},
{
"speaker": "Sarah London",
"content": "Sure. So, let me sort of take a step back, because there -- this was a sort of a unique open enrollment period because of the program integrity checkpoints that were added to the process. And so, when we think about what was expected versus what we saw, you also have to think about the degree to which our assumptions in terms of the impact of those programs came into play during the various time periods. So, when we talked in December about our expectations, it was overall market enrollment growth then muted by the agent of record lock and failure to report, periodic data matching, things like that. What we're seeing in January is a more muted impact of those program integrity checkpoints. And so, the effectuation rates, which are in line with historic norms for us, are slightly higher than what we had been expecting. That's leading to the 5 million -- slightly above 5 million peak that we're expecting. But as we look through the rest of Q1 and into Q2, and particular -- particularly on the FTR process, which is going to hinge on that tax filing date and then post-tax filing reconciliation, we still think that there is potential membership impact that will play out in Q1 and Q2. So we're tracking ahead of what we expected. That may end up being a benefit full year, that may end up just being a delay in terms of the impact of those programs. And that's why we want to wait and see kind of how the next couple of months play out. And obviously, we'll make sure to keep you all posted on what we see as those shifts -- as those programs kind of shake out and settle as we get to midyear. And then relative to overall impact of enhanced APTCs, we talked about in December the idea that without sort of major mitigation efforts, if enhanced APTCs were to go away or not be renewed in their entirety, that could be somewhere between a 20% and 30% membership hit to our book. The reality is that the iterations, anything less than of a full drop-off of the enhanced APTCs are numerous. And so, whether there's a cap at 400% FPL or 350% or -- we think about different mechanisms to create more kind of investment of membership and participation in the program. There are lots of different alternatives that have been discussed and explored, and we run scenarios across all of those and think about what the buydown implication might be, what product design will matter, what the different price sensitivities are of our members along the FPL continuum. So, you can be sure that our team has been spending many hours running those over, frankly, the last year and looking forward to getting more clarity as we move over the next couple of months about how to prepare for the next OE cycle, including potentially filing two sets of bids. So, lots more to play out there. And again, that's one we'll continue to keep you posted as we start to understand kind of what the trajectory will be there."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Lance Wilkes with Bernstein. Please go ahead."
},
{
"speaker": "Lance Wilkes",
"content": "Great. Thanks. Can you talk a little bit about pipeline and appeals process in the Medicaid space, and in addition to that, talking a little bit about what your strategic priorities are for investments, capability enhancements, and M&A as it relates to either Medicaid or other areas like M&A, vertical integration, et cetera? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes, absolutely. So, as you all well know, it's been a very busy last couple of years in terms of the RFP pipeline and really working through a backlog that came through post COVID. 2025 will be return to a more normal pre-COVID cadence. So, we have a handful of states and programs that are going through normal course reprocurements and then our team is, obviously, always evaluating net new opportunities and sort of positioning for growth. Relative to our protests, we have -- the Texas issue will continue to make its way through the legislature and the courts through the remainder of 2025. I think, as you know, the potential impact to 2025 of that was minor to begin with, but we think that will kind of play out here and we'll get more clarity through the rest of the year. And then we are still in process on the Georgia protests, and I think given the complexity of that process, we expect it will be a number of months before we hear any feedback. So, more to come on that front. And then relative to investments, I think we're -- as we've said over the last year to year and a half, as we've gotten more oxygen relative to operating bandwidth as we move through sort of the core of the value creation plan, we started to turn our attention to surveillance relative to inorganic growth and M&A, and that continues to be something that we're watching. Also, evaluating where there are interesting opportunities for investment in capabilities for our business lines. I would say, ICHRA is a place that we are very interested in and thinking about what the market may need relative to overall infrastructure to mature and how we could support that through various partnerships and investments. So I think those are sort of the major areas of focus. And of course, always looking at the relative use of capital and thinking about sort of the value it can create, including the value of Centene at these prices."
},
{
"speaker": "Operator",
"content": "Thank you. And the next question today comes from Michael Ha with Baird. Please go ahead."
},
{
"speaker": "Michael Ha",
"content": "Hi, thank you. Just another one on your exchange growth for this year. It's great to hear that effectuation rate was consistent with your historical norms. I know you mentioned it'll still take a few months until the full changes are well understood. But based on all the visibility you have sitting here today in February, I'm curious how much of a potential difference you think there could be now versus the next few months as you hit those checkpoints? What is the likelihood basically of a materially negative surprise in April that could compromise your exchange margin targets for the year?"
},
{
"speaker": "Sarah London",
"content": "So I think the question of timing of impact is a good one, and that's part of why we said we want to see how the rest of Q1 and part of Q2 play out, again, particularly relative to the FTR process and the fact that is anchored in the April filing dates. So I -- the message that we're trying to kind of make sure you all hear is that we built in assumptions around the impact of those programs and we are carrying those assumptions into the next couple of months to let that play out so that, ideally, there are no major negative surprises relative to what that impact might be. So I think we're being prudent in terms of how that tail may extend into Q1 and Q2, but baked into that are all the original assumptions of what the impact would be. And what we've seen thus far is more muted than that."
},
{
"speaker": "Andrew Asher",
"content": "One thing to add to that, the FTR implications, so let's say someone doesn't file a tax return and they lose their enhanced APTC in May, that's a prospective adjustment as opposed to what we got after in February of 2024, which was the broker -- the record lock for broker of record. So, yes, it's something to think through as we get through the next quarter or so with the FTR, but certainly pleased on how we started the year strong, and it's good to enter February and then March in a position of strength."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from George Hill, Deutsche Bank. Please go ahead."
},
{
"speaker": "George Hill",
"content": "Yes, good morning, guys, and thanks for taking the question. And Sarah, this is just kind of a point of clarification. On the effectuation rate, I thought that you had said there could be some upside in Q1 if the FTR hits later in the year and get back towards the normal guidance range. Is that correct? Or I guess, what I'm trying to worry about is, will this create any downside to the exchange membership outlook or guidance?"
},
{
"speaker": "Andrew Asher",
"content": "Yes, what we said in my script when I said, it's just too early to touch the $34 billion of commercial revenue. That's basically saying -- indicating that we're enthusiastic about our start, but we really want to look at the sloping of the next few months of membership before we consider any potential raise in that revenue. So we're sticking with the $34 billion for now. It's early and we'll see how really the next three or four months of membership play out. But once again, starting from a position of strength is a good position to be in."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from David Windley at Jefferies. Please go ahead. Hello, Mr. Windley. Is your line muted, perhaps?"
},
{
"speaker": "David Windley",
"content": "It happens to be. Yes, it is. Thank you. Thanks for taking my questions. I wondered on the exchange market, if you have, Drew, done a zero utilizers analysis in your plans, maybe particularly in some of the red states or FF -- federally facilitated marketplace states, to see where potential pockets of, I'll call, abuse of enrollment -- over-enrollment program integrity issues might be."
},
{
"speaker": "Andrew Asher",
"content": "We did pricing for 2025. We thought about -- first of all, we got a lot of the broker, let's say, disruption out of the way, beginning in February of 2024. And then, as you know, CMS ultimately adopted our idea, which is great and puts everyone on the same playing field coming into the open enrollment period for 2025. So, actually, incurred some of that membership attrition pressure into 2024. So that's behind us. As we thought about pricing for 2025, we did think about the mix of business around failure to report and put a -- quite frankly, put a pricing load in for that program integrity measures. So, we'll see how that plays out. But once again, feel good about what we're seeing so far, even though it's very early. And as Sarah said, we haven't closed January yet. It's only day two of the month of February. So I like the way we're starting, but there's more of the year to play out."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from John Stansel with J.P. Morgan. Please go ahead."
},
{
"speaker": "John Stansel",
"content": "Great. Thank you for taking my question. Just one quick one on PDP. Just can you give a bit more color on what played out during AEP kind of driving the above-expectations enrollment growth? And then just thinking longer term, how you see kind of the demo component within standalone PDP kind of contributing over the next couple of years? Thank you."
},
{
"speaker": "Andrew Asher",
"content": "Yes. No, good question. We ended the year at 6.9 million members, and as we said earlier, we're over 7.5. So I think it's once again the positioning of our product. I mean, this is a business we focus on, not everybody does. I mean, it's good to have both the Medicare Advantage and MAPD business, as well as a PDP business. There's some complementary and overlap nature to those. So I think the attractiveness of our products, which is driven by our underlying cost structure, which I think is excellent and that's reflected in the value that we can pass on to members and consumers. With respect to the demo, you had to elect into a multi-year demo. But obviously, CMS can modify the premium support each year. But once again, when you have a product that's driven by what we believe is an outstanding cost structure, then we should be able to sort of sustain that business regardless of what level of premium support makes its way into the demo over the next couple of years."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question today comes from Ryan Langston with TD Cowen. Please go ahead."
},
{
"speaker": "Christian Borgmeyer",
"content": "Hi, good morning. This is Christian Borgmeyer on for Ryan Langston. Could you quantify where PDP margins ultimately landed in 2024? It would be helpful as we think about the year-to-year progression into PDP margin guidance for 2025 and bridging for the IRA dynamics. Thanks."
},
{
"speaker": "Andrew Asher",
"content": "Well, certainly higher than the 1% or so that we had indicated coming into Q4, and that's the strength in the full year performance captured in the reported period of Q4. So, like how that bodes well for 2025, but you have to think about also, each year from a bid standpoint stands on its own and there's almost a reset in terms of the assumptions that you use and then pricing for the changes in the IRA. So, certainly, I like the way we ended. You can't just map that exactly into 2025, but that should bode well as we think about execution and performance in 2025 and what's now a $16 billion business for us."
},
{
"speaker": "Operator",
"content": "Thank you. And this concludes our question-and-answer session. I'd like to turn the conference back over to Sarah London for closing remarks."
},
{
"speaker": "Sarah London",
"content": "Thanks, Rocco, and thanks, everyone, for time and interest this morning. While it is early, we feel good about the progress that we've made in Medicaid matching rates and acuity and how we're positioned coming into 2025. We feel good about our marketplace execution once again in open enrollment and feel good about our Medicare segment overall. And so, really looking forward to executing in 2025 and continuing to keep this group updated on our progress as we move through the first quarter."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day."
}
] |
cnc | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Centene Corporation Third Quarter Results Conference Call. All participants will be in listen only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Jennifer Gilligan, Head of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Jennifer Gilligan",
"content": "Thank you, Rocco, and good morning, everyone. Thank you for joining us on our third quarter 2024 earnings results conference call. Sarah London, Chief Executive Officer; and Drew Asher, Executive Vice President and Chief Financial Officer of Centene, will host this morning's call, which also can be accessed through our website at centene.com. Ken Fasola, Centene's President, will also be available as a participant during Q&A. Any remarks that Centene may make about future expectations, plans, and prospects constitute forward-looking statements for the purpose of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by those forward-looking statements as a result of various important factors, including those discussed in our third quarter 2024 press release, which is available on the company's website under the Investors section. Centene anticipates that subsequent events and developments may cause its estimates to change. While the company may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so. The call will also refer to certain non-GAAP measures. A reconciliation of these measures with the most directly comparable GAAP measures can be found in our third quarter 2024 press release. Please mark your calendars for our upcoming Investor Day being held on December the 12th in New York City. With that, I would like to turn the call over to our CEO, Sarah London. Sarah?"
},
{
"speaker": "Sarah London",
"content": "Thank you, Jen, and thanks, everyone, for joining us as we review our third quarter 2024 financial results. Given the recent market volatility impacting managed care, let's start with the bottom line up front. The overall outlook for our business remains consistent with our updates in the quarter. We remain confident in our full year 2024 adjusted diluted EPS guidance of greater than $6.80 and our view of headwinds and tailwinds as we look to 2025 are largely unchanged from what we have previously shared. We still believe that we will grow adjusted EPS next year, and we still believe that we have a unique and powerful platform from which to drive long-term EPS growth of 12% to 15% in a normalized environment. Specific to the quarter, we are reporting third quarter adjusted diluted EPS of $1.62, a stronger result than our most recent expectation for the period with the upside driven in part by anticipated tax items shifting forward into the third quarter. Within our core business lines, Medicare and Marketplace performance was consistent with expectations in the quarter, and Medicaid performance ended up a little better than our mid-quarter commentary, aided by movement in rates we saw as a result of refreshed data and effective advocacy. In general, we are encouraged by progress we saw throughout the quarter relative to our ongoing dialogue with state partners to align Medicaid rates with the acuity of our post-redeterminations book of business. We have spent the better part of 2024 offering a significant level of transparency into our business during a year of unprecedented change. We are pleased that this transparency positions us today with a stable outlook for 2024. With that, let's get into the details, starting with Medicaid. As you know, our largest business has undergone significant transformation over the last 18 months as a result of the nationwide return of eligibility determinations. Since the start of this process, millions of Americans have been transitioned out of managed Medicaid across the country, materially shifting the Medicaid risk pool in a way that requires action by our state partners to right-size program rates to reflect the post-redeterminations member base. During the third quarter, our state partners continued to work through the tail of their respective redeterminations processes. And as we sit here today, the vast majority of the 30 states in which we operate are now through their respective backlogs. We closed the period with roughly 13 million members and are seeing evidence of membership leveling as we move into the fourth quarter. Since this process began, you have heard a consistent message from us in terms of our boots on the ground support for our members and, equally, our proactive data-driven dialogue with our state partners to ensure rate discussions throughout this period are fully informed and benefit from the most current data. As we sit here today, all of our states have acknowledged the need to match rates with acuity and all of our states have now taken action with respect to acuity adjustments in some form. While there is still work to do with respect to the sufficiency of rate adjustments, our conversations continue to be productive when we are encouraged by the engagement and the incremental movement we saw as the quarter unfolded. We now expect our back half composite adjustment rate to be in the 4.5% to 5% range. As state-by-state experience matures, we are still seeing just over 30% of members who were initially dropped from Medicaid eligibility ultimately return to us. Less than half these rejoiners are reinstated with retroactive coverage. The majority experience a coverage gap, which means we experience a corresponding premium gap. As we have discussed previously, this creates temporary pressure on the Medicaid MLR. However, a close look at the rejoiner trend suggests it is starting to slow. This incremental lessening of pressure as we move through Q4 and evidence of a return to a more normal churn rate across the Medicaid book offers a natural tailwind as we move into 2025. We continue to track the data closely and provide regular and detailed updates to our state counterparts. We believe the solid foundation of data-driven advocacy we have built over the last six quarters has served us well and will continue to do so as we advocate for appropriate 2025 rates and mid-cycle acuity adjustments. Overall, the movement we have seen in rates over the course of 2024 reinforces our view that what we are experiencing is a temporary dynamic and that state Medicaid programs will ultimately return to actuarially sound rates that match acuity. While redeterminations have captured much of the attention over the last few quarters, it should not go unnoticed that Centene has been equally busy delivering strong RFP results and positioning our Medicaid business for long-term growth. In August, the team at Pennsylvania Health and Wellness repercured our long-term support services business in that state, reinforcing the strength of this organization and serving low-income members with complex support needs. In September, we successfully reprocured our statewide presence in Iowa in a highly competitive process, and then earlier this month, Centine's Meridian Health Plan in Michigan won yet another 2024 RFP, this time providing integrated Medicare and Medicaid services for dually eligible members as Michigan transitions their statewide program to a [Heidi SNP] (ph). In short, we are making progress against rate and acuity alignment, and our best-in-class business development team continues to effectively articulate our value proposition. Throughout it all, our teams have worked tirelessly to advance our Medicaid quality results, deliver operational and compliance improvements, and innovate through local partnerships as we serve the most underserved communities across the country. And so, while the redeterminations process has been challenging, it has nonetheless mobilized us toward an operating discipline that is creating a stronger, healthier platform from which to grow. Turning to the rest of the business, our Medicare segment continued to perform in line with expectations during the quarter. As we look ahead, Medicare Advantage remains a strategically important pillar of our platform and represents significant opportunity for margin expansion as we continue to improve Stars, reduce SG&A, and advance our clinical programs. To this end, our 2025 star ratings, released earlier this month, which with financial implication for 2026, represent a meaningful step forward on the journey to margin recovery. These results demonstrate our ability to effectively identify areas of potential improvement and methodically execute on delivering those enhancements. During this cycle, we elevated our performance with 46% of members and plans at or above 3.5 stars versus 23% from the prior year, despite higher-than-industry-anticipated cut-point changes. Our Stars results represent strong overall improvement in our core operations and continued focus on quality for our members. Consistent with what we previewed on the Q2 call, we used 2025 bids as an opportunity to further focus our franchise on lower-income seniors and tighten the alignment between our Medicare Advantage business and our Medicaid footprint. We exited six states, while strengthening our offerings in key counties and regions within our existing footprint. As a planned byproduct of this work, we were able to streamline our contract portfolio, creating more balanced membership across our contracts and enabling greater focus and impact in our program investments going forward. These adjustments position us for a preliminary view of 2025 Medicare Advantage revenue in the range of $14 billion to $16 billion. As we have shared previously, this implies down membership year-over-year, but represents progress on our path to breakeven in this business. Within our Medicare portfolio, our Part D business will generate a more sizable revenue contribution in 2025, owing in part to significant changes adopted as a result of the Inflation Reduction Act. Though it is early, we are pleased with our preliminary view of product positioning, and we expect Part D revenue to grow significantly next year with potential for membership growth as well. In light of recent policy changes that make Centene's industry-leading Medicaid footprint a competitive advantage as we look to serve more dual-eligible Medicare members, we remain focused on the compelling opportunity our Medicare platform provides for both margin expansion and growth long term as we turn around and stabilize this business. Finally, our marketplace business continues to perform well in 2024. Our results in the quarter were in line with our most recent expectations as we capitalize on more than a decade of experience to effectively serve now 4.5 million members. Looking to 2025, we believe our Marketplace products are well positioned relative to our strategy. Open enrollment will not begin for another week, but our early expectation is that, we will be able to achieve pre-tax margins well within our targeted range of 5% to 7.5%. Centene demonstrated our thought leadership in Marketplace earlier this year by implementing an agent of record lock policy, which was subsequently implemented market-wide by CMS in July. In addition, CMS has introduced program integrity processes in line with both Centene advocacy and pre-pandemic era policy that will further improve controls on exchange enrollment during this open enrollment cycle. These types of policies improve the member experience as well as the quality of our book, but we do expect they will create a moderating effect on overall market growth in 2025. As a result, our membership growth expectation for this year's Marketplace open enrollment remains modest. Continued migration of commercial small group enrollment into the exchanges, expanding access and affordability initiatives, as well as the program integrity enhancements, net out to a view of mid-single-digit macro market growth in 2025. Ultimately, we are pleased with the performance of our marketplace business and believe this market, that now serves a strong bipartisan base of more than 20 million Americans, can be a powerful platform to expand affordable health care coverage and access for individuals across the country. As we close out year three of our value creation plan, we're pleased with the progress we have made, but even more pleased with the second order opportunities we see ahead as we continue to drive operational improvements and mine efficiencies in our business model. This quarter, we advanced work on a project some of you have heard me speak about, namely the use of AI to automate and optimize our management of provider contracts. By deploying AI within our provider operations, we can reduce the amount of manual labor associated with the installation of new contracts, as well as the significant maintenance required for the tens of thousands of existing provider agreements within our portfolio. Additionally, AI will allow us to produce considerably stronger analytics on provider performance, an important lever for advancing initiatives such as value-based care across our business. The team's diversified portfolio continues to allow us to navigate unprecedented landscape challenges and build for the future. Our quality team kept the gains from last year's Medicare Advantage Star scores and built on them, strengthening our Medicare platform. Our health plan and business development teams defended existing contracts and won new ones, expanding the reach of our leading Medicaid franchise. Marketplace continues to deliver value for our members and earnings power for our enterprise, generating important returns and creating a compelling platform to support growth in the individual market. And we continue to find opportunities to get better at the basics and innovate in how we show up to support our members, providers, and regulators. With the election now 10 days away, I'll highlight again that our product and government relations teams have been preparing for months for the many post-election scenarios that may emerge. No matter the results on November 5th, Centene is well positioned as an industry thought leader for maintaining coverage and affordability for Americans across each of our product lines. The momentum across this enterprise is palpable, and it is a direct result of the efforts of our more than 60,000 [Centenemers] (ph), committing their time and energy and talent to improving the health of the communities we serve. To this end, I want to recognize those who showed up to support our members and fellow employees who were impacted by Hurricane Helene and Milton. The Centene took immediate and urgent action, including Centene foundation efforts to deploy much-needed financial support to key nonprofit partners in impacted states, headquarters teams coordinating the shipments of over-the-counter medicine, and other hard-to-find supplies to our communities in North Carolina and Florida, and colleagues opening their homes to fellow employees impacted by the storm. You went above and beyond for our members and each other and showed what it means to be part of the Centene. Thank you. With that, I'll turn it over to Drew."
},
{
"speaker": "Andrew Asher",
"content": "Thank you, Sarah. Today we reported third quarter 2024 results, including $36.9 billion in premium and service revenue and adjusted diluted earnings per share of $1.62. Q3 performance was ahead of our previous expectations and keeps us on track to deliver adjusted diluted earnings per share in excess of $6.80 in 2024. As you saw in our press release this morning, the adjusted diluted EPS for the third quarter includes $0.10 associated with a marketplace premium tax benefit that we previously expected in the fourth quarter of 2024, so merely a timing shift. The quarter also includes about $0.4 of accelerated income tax benefit. Even without those two favorable timing items, we were still a little ahead for the quarter. Our consolidated HBR was 89.2% for Q3, which brings us to 87.9% year-to-date. Consistent with our previous public commentary, our Medicaid membership was just over 13 million, and our Q3 Medicaid HBR at 93.1% was a little above Q2. While there are still very small pockets of redetermination activity occurring, we largely expect stability in our Medicaid membership around that 12.9 million to 13 million mark as we close out 2024. With every month that goes by, we continue to make progress with our state partners and their actuaries in our efforts to match rates with acuity. As Sarah mentioned, now 100% of our states have acknowledged and acted. So it's just a matter of sufficiency of rates, state-by-state, program-by-program. We remain confident that this is not a matter of if, but when we get back to equilibrium between rates and acuity. We are pleased and encouraged by the progress since our last call, but there's more wood to chop with our state partners, supported by the irrefutable data we provide. The commercial HBR of 80% was right on track for Q3, and we showed a little bit more growth with 4.5 million Marketplace members at quarter end, 22% growth from a year ago. We continue to be pleased with the execution in our Marketplace business. And while the open enrollment period hasn't yet started, we believe we can grow during open enrollment and achieve our margin goals in 2025. Medicare results in the quarter were consistent with our expectations, including a segment HBR of 88.0%. Good execution in 2024 in both our Medicare Advantage and PDP businesses, enables us to enter 2025 right on track. As you saw with the landscape file, we continue to take Medicare Advantage actions designed for the long run, consistent with our strategy focused on low income and dual eligible. We exited six of our smaller states that didn't quite match our Medicaid footprint, and we administratively reduced our number of H contracts by about 30%. While we have much of the annual and open enrollment periods yet to play out, as Sarah covered, we are still targeting $14 billion to $16 billion of Medicare Advantage revenue in 2025. And we are still targeting the same 2025 result that would be consistent with an approximate $125 million of premium deficiency related expense that would be recorded in Q4 of 2024. So overall, no major changes to our Medicare Advantage game plan. Similarly, our Stars game plan is on track at 46% and 3.5 stars for the 2026 payment year as we covered in our October 11th 8-K. As we've talked about for the last couple of quarters, we expect meaningful revenue growth in our PDP business in 2025, largely driven by the Inflation Reduction Act mechanics. Furthermore, our bids positioned us well, anchored by our outstanding pharmacy cost structure, that when coupled with the CMS demo, facilitates very low cost and attractive products for seniors. For 2025, we are pleased to again be below the auto-assigned benchmark in 33 out of 34 regions. And our zero premium product, inclusive of the federal demo subsidy, is available to seniors in 43 out of 50 states. So we think our reported premium yield will more than double in 2025 compared to 2024 due to the IRA, and we should be able to grow membership as well, subject to the annual enrollment period that just started. We are targeting a 2025 PDP margin of 1% or so that we will look to edge up over time, and that is on a much higher revenue base for 2025. Our adjusted SG&A expense ratio was 8.3% in the quarter, a good result contributing to a slightly better view for 2024. Cash flow used in operations was $1 billion for Q3, driven by a few normal course balance sheet items. One, the settlement of marketplace risk adjustment payables for the 2023 benefit year, with the corresponding collection of over $800 million of 2023 receivables expected in Q4. Two, Medicaid rate increases not yet collected. And three, an increase in Part D receivables. Unregulated cash on hand at quarter end was $266 million. During the third quarter plus October, we deployed approximately $1.6 billion on Centene shares for a year-to-date total of 2.4 billion. Our debt to adjusted EBITDA was 2.9 times at quarter end. Our medical claims liability at quarter end represented 51 days in claims payable, down three days sequentially, and down two days compared to Q3 of 2023. If it weren't for a higher level of state-directed payments in Q3, we would have been at 53 days. We have updated our 2024 guidance elements to help with your modeling as we look towards wrapping up 2024. Our full year premium and service revenue is $2 billion higher than previous guidance, which gives us more earnings power for the future. Our consolidated 2024 HBR guidance of 88.3% to 88.5% reflects the Medicaid insights and updates we have provided you at the last couple of investor conferences. We continue to expect Q3, 2024 to be the high watermark for our Medicaid HBR. 2024 SG&A guidance midpoint of 8.6% is slightly down due to cost management and revenue growth. And to round out a couple of other metrics, we expect investment income of over $1.7 billion, excluding gains and losses on divestitures, and depreciation expense in the zone of $550 million. Importantly, we are still on track for greater than $6.80 of adjusted diluted EPS in 2024. Q3 represents another quarter of good progress, from another divestiture to cost management to revenue growth to Stars, and wins in Iowa Medicaid, Pennsylvania LTSS, and Michigan Heidi to boot. Execution in our diversified portfolio enables us to reaffirm our 2024 adjusted diluted EPS guidance of greater than $6.80, despite the temporary Medicaid rate acuity mismatch that we've been briefing you on since May. As we make forward progress quarter after quarter, we still expect to grow adjusted diluted EPS in 2025 and beyond. Thank you for your interest in Centene. Rocco, let's open it up for questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Today's first question comes from Stephen Baxter at Wells Fargo. Please go ahead."
},
{
"speaker": "Stephen Baxter",
"content": "Hi. Thanks. I was hoping for the Medicaid MLR, you could potentially provide a little bit of commentary about where you're expecting the fourth quarter to land and any bridging items maybe we should consider, including maybe whether there is any retroactivity in the third quarter, either positive or negative. And then, I guess, just a follow-up would be, I'd love to hear you talk about the total level of cost growth that you're seeing in the Medicaid business and where that sits in the second half, trying to understand how much margin impact we should think about the composite rate update you discussed producing. Thank you."
},
{
"speaker": "Sarah London",
"content": "Sure. Thanks, Stephen. So let me tell you a little bit about what we saw in the quarter and what that means for us as we sort of look into Q4 and 2025. And really, it is result of the groundwork that we laid out over the last 18 months and what we've shared with you in terms of the proactive dialogue with the states. And I think also a result of being the largest Medicaid provider and being maniacal about data. And so, as we saw the inflection around the dislocation between rate and acuity start to pick up in Q2, we were very early to call that out. We were very early to bring that to our state partners to show the data and then to continue to refresh that data on an ongoing basis. And that then became an important input if you think about the 14 states that have rate updates between 7/1 and 10/1. You also heard from both my and Drew's commentary that one state that we've been waiting for to get an adjustment back to 2023, one of our smaller states. But that did come through, and therefore, have universality in terms of states acknowledging that there's a need to get rates and acuity together and also demonstrating their willingness to do so. So all of that nets out to the commentary around the composite rate adjustment being in the high 4s to 5% as we think about the year. Also informs the fact that we're encouraged by the momentum that we saw in the quarter and how we think about that influencing the conversations around not just 2025 rates, but continuing to push for mid-cycle acuity adjustments. As you heard from Drew, there's still work to do. But again, the fact that bringing that data forward, leveraging the strong relationships that we have at the state level and being able to push those productive conversations to drive results I think, is sort of what we stand on. I don't know if there's anything you want to add in terms of cost trend or anything."
},
{
"speaker": "Andrew Asher",
"content": "Yes, Stephen, as you think about the progression from Q3 to Q4, just think about Q3 in Medicaid HBR being the high watermark, as I said in my remarks. And then we've got one pretty big state with a 9/1 renewal in three states with 10/1 renewals and rate updates that obviously will impact Q4 more so than Q3. And then you didn't ask about other lines of business. But if you step back and think about the HBR in the aggregate, setting aside Medicaid, Q4 seasonally is higher in the Medicare and commercial segments. Commercial, typically, because of deductibility and seasonality sort of ticks up during the year. And then in Medicare, usually Q1 and Q4 are a little bit higher than Q2 and Q3. So that rounds out as you think about your modeling from Q3 to Q4 in the context of the aggregate guidance that we provided."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today from Josh Raskin at Nephron Research. Please go ahead."
},
{
"speaker": "Josh Raskin",
"content": "Hi. Thanks. Good morning. Just a follow-up on that. Could you speak to core Medicaid utilization trends sort of outside of the acuity shifts, what you're seeing in terms of sort of same-store utilization trends? Maybe specifically comment on behavioral health and maybe the areas you talked about in early September. And then separately, you said sort of the reverification process is sort of complete in your state. I mean, you're kind of back to the normal procedures around reverifications, how does that change the conversation with the states? Does that have any impact on sort of how you're advocating for rates? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, Josh. There's nothing really new to add relative to the trend conversation from the updates we gave in Q2 and then throughout Q3. So obviously, the major driver of HBR in Medicaid is the mismatch of rate and acuity. And as we called out before, we have the ability to isolate sort of underlying continuous member cohorts to validate the fact that there is no sort of massive trend sitting in that continuous member book. There are pockets of trend that are exactly the same as we've been calling out previously. So behavioral health, home health, and then, obviously, at a state level, there are those program-specific issues where a state may have changed to the program and needs to give us rate to account for that, which is really normal course blocking and tackling. But in an environment where you have redetermination sort of pressing down on the whole book, those issues become a little bit more visible. But think about things like adding GLP-1s to the preferred drug list, changing rules around behavioral health access and changes to prior off ability on our side and sort of cost management techniques. So those are again very consistent with what we've been saying throughout the quarter. We didn't see any new changes as we came out of the quarter. And then relative to your other comment, we are again seeing states kind of get through the tail of the administrative process. But relative to the rate conversations, those really are sort of aggregate data-based. And so, understanding the impact of what those administrative changes do in terms of the remaining population and then what the resulting acuity is, all of that is -- there's a willingness and appetite by the state to look at that. And it's pretty consistent with the actuarial process, because there is a normal look back. And so, the fact that we're through, again, largely through that tail is not prohibitive relative to the advocacy work that we need to do to make sure that rates are matching what the acuity is netting out to."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from A.J. Rice at UBS. Please go ahead."
},
{
"speaker": "A.J. Rice",
"content": "Hi, everybody. Just trying to drill down to put perspective on what you guys are saying versus what some of the peers have said. So, if your composite rate increases are in the 4.5% to 5% range, and this is the worst for medical loss ratio and you can get better from here, it sounds like, with rate updates similar to that. Can you sort of parse out -- obviously, that's a blend of the states that didn't update as well as the states that have updated presumably at higher rates. What types of rate updates do you think you need? I mean, we've had others say they need high single-digit updates, one even said maybe low double digit updates. What -- how much do you need to meet your goal of showing consistent MLR improvement going forward?"
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, A.J. I mean, the answer is, obviously, different state-by-state. And as we've said, there's still work to do relative to sufficiency. I think the fact -- and we've called this out before that we are in sort of an unprecedented time. And so, where we have seen the rate adjustments that are outsized relative to what would be normal course, all lends itself to the sort of encouraging view that we have that states understand that they need to make up the difference between where the rates may stand for a specific state or specific program and then what we're seeing in terms of the actual experience. I don't know, Drew, if there's anything you want to add?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. No, we'll just keep forging ahead. I mean, we've gotten rates in the high single-digit range in the very, very small states. So don't get too excited, we got a 10%. But that just gives you the indication of states are looking at the data that we're providing and looking at recent data as well and trying to balance that into their actuarial process. We're making progress here. We still have wood to chop. We'll be working on that throughout 2025 when we have the 1/1 cohort that we're starting to get visibility on recently, and then moving to 4/1, where we have one big state, and then almost half of our rated 7/1 to 10/1."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Justin Lake with Wolfe Research. Please go ahead."
},
{
"speaker": "Justin Lake",
"content": "Thanks. Good morning. I'll just follow up on some of the questions. First of all, on rates, just a clarification. Can you tell us specifically what period we should be thinking about, that 4% to 5% composite covering? Is that the year? Is that second half? And maybe you could share with us just because some of your peers had so we can get a kind of baseline, what's the cost spread that compares to that 4% to 5% that you're seeing now? And lastly, you've seen a significant pickup in Medicaid pass-through payments. Just want to make sure, is that 4% to 5% you're talking about, including pass-through payments? Or does it net those pass-throughs out? Thanks."
},
{
"speaker": "Andrew Asher",
"content": "Yes. Thanks, Justin, for the questions. So the 4.5% or the high 4s to 5% is the back half rate, so more recent time period. And then we look at that as net rates. And so, pass-throughs would be excluded from that as would programmatic changes to the extent that benefits were adjusted. So we're looking at that as sort of a net fundamental rate even though the gross rates are often a little bit higher depending on the unique state program. And I would think a bit less as cost trend and more about trying to peg that exit med-expense PMPM as we exit the redetermination time period and then matching the rates against that exit rate. As Sarah indicated, when we look down into our book of business and look at continuous members, and these are pretty big cohorts that have been with us, I mean, millions and millions of members, so statistically sound, that have been with us for two years. There's not a whole lot of trend. There's some typical trend in the high acuity populations, reasonable levels of trend and pretty flat in TANF. So I would think of it more as like pegging that exit run rate PMPM, matching rates against it that we'll be working on over the next couple of cycles."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Sarah James at Cantor Fitzgerald. Please go ahead."
},
{
"speaker": "Sarah James",
"content": "Thank you. Is there a way to size up the pent-up demand portion of trend that would slow as rejoiners slow versus the acuity mix that would continue? And on the GLP-1 flag, can you size how much pressured trend that is for states that cover it and whether there is a corresponding adjustment in rates or there's a lag there for catching up?"
},
{
"speaker": "Sarah London",
"content": "Yes. So relative to rejoiners, I think as we called out that dynamic and that cohort in particular where, again, immature months, we're seeing 30% of members who are coming back and as this process has unfolded, an increasing gap in terms of how long it takes for them to come back, which then puts them out of that retroactive reinstatement window is part of what's been contributing to the HBR pressure and delta that you've seen in the last two quarters. And my commentary about the fact that, that dynamic is slowing, I think, is important. Because those -- the rejoiners tend to come back and find their way back because they are in need of health care. And so, again, they create sort of this artificial pressure where they're using the system and we haven't received premiums for the time period that they weren't enrolled even though they were eligible. So the more of that we work through and have now worked through over the last couple of quarters means that, that should create a natural tailwind as we turn into 2025. And then GLP-1s, Drew, maybe you want to talk about the states that have put those on formulary and the data that we can present to them as they think about making sure we get paid for it."
},
{
"speaker": "Andrew Asher",
"content": "Actually, we've had a couple of states that have had GLP-1s available for the weight loss indication for a while. So we've got good data. Then we take to other states that are maybe contemplating, should they put it on their formulary, should they not and share that data with them. It also helps shape the rate discussion of -- the ramping of that that we saw in those states that have been on it for over a year. So there's a handful of states. The states can make those decisions, and we administer and then we share data. There's one state that recently added GLP-1s, I believe, as of August. And we're sharing data monthly with them to make sure that the rate that they loaded in, the PMPM rate, their estimate upon the commencement is consistent with the uptake that is being seen in that specific state."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Andrew Mok with Barclays. Please go ahead."
},
{
"speaker": "Andrew Mok",
"content": "Hi, good morning. Last quarter, you categorized Medicaid HBR improvement as a tailwind for 2025. With a modest setback in Medicaid MLR in the quarter, is it still fair to characterize Medicaid MLR as a tailwind for next year? And what visibility do you have into 1/1 rate updates at this point? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. I would say, yes. Medicaid HBR improvement is definitely a tailwind for 2025. As you heard Drew say, we've started to get some of those 1/1 rates, and we'll have a lot more visibility and obviously be able to update you on 2025 overall at our Investor Day in December. But I still believe we'll be able to grow adjusted EPS, and those headwinds and tailwinds in the aggregate that we've shared previously remain the same"
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Lance Wilkes with Bernstein. Please go ahead."
},
{
"speaker": "Lance Wilkes",
"content": "Great. I was hoping you could give a little more detail to help our understanding on some of the rates in rejoiner aspects. In particular, with rate increases, as you're doing those, are states doing that by program or at a composite level across programs? And then when you're thinking about rejoiners and maybe any comments on levers would also be interesting, but rejoiners. Do you have cohorts that are there long enough that you can see a normalization in utilization patterns? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. On the -- so first of all, relative to rates, states do -- we get sort of a composite rate, but it's a reflection of a buildup of the underlying sub-programs that are in there. And so they take into account the sort of variety of programs that any of us individually are managing. And then relative to payers and levers and rejoiners, we do now have, to your point, Lance, rejoined data -- rejoined our run-out data and being able to look at and confirm the view that, again, those rejoiners are coming back because they are in need of services. And then we see the normalization of their utilization patterns thereafter. And in fact, the idea that had we been receiving premiums for those members during the time that we had the gap, it would have normalized their HBR more than what we're seeing. So that -- all of that, again, continues to confirm the view that it's sort of this artificial pressure that's creating MLR uptick. And then I don't know, anything else on stairs and levers as those continue to run out? No? Yes. So still the same differences that we've been seeing and all of that data gets put into the mix in our advocacy with state partners."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Adam Ron with Bank of America. Please go ahead."
},
{
"speaker": "Adam Ron",
"content": "Hi. I appreciate the question. I was wondering if we could get a little more color on the Part D business. You mentioned you expect 1% margin next year. Wondering how that compares to this year. And then also, one of your peers mentioned that due to the IRA changes that partially took effect this year, they saw a greater utilization shift in some specialty drugs this year because the member cost sharing went down, and that happened after they priced 2025. And so, wondering if you were seeing that and if that had any risk for 2025 or if the voluntary program helps minimize some downside. Any color around all that would be helpful. Thanks."
},
{
"speaker": "Andrew Asher",
"content": "Yes. Thanks, Adam. No, we're really pleased with our positioning in PDP. So starting with 2024, we're right on track. I mean, we sort of knew the rules of the IRA. We thought about the member change in behavior, which will be different in 2025 than 2024, but we thought about it for 2024 as well and any sort of manufacture behavior changes that might be induced by the changing of the mechanics of the IRA. So we're right on track, as you can see in our aggregate Medicare segment. But underneath that, PDP is on track and in that same zone of margin for 2024. So sort of we expect a degree of consistency between 2024 and 2025. In the margin, although the revenue will be a lot higher in 2025 than 2024. So pleased with the positioning. The team did a really good job estimating the direct subsidy. Obviously, that was a big risk that we talked about going back to Q1 at a conference in March and then on the Q1 call, trying to make sure, quite frankly, that the industry was thinking through all of the elements that needed to be reflected in the bid and therefore driving the direct subsidies. So we would expect to grow in the open enrollment period, the annual enrollment period. Given our positioning, we're below the benchmark in 33 out of the 34 regions, which is a really good result, but consistent with where we've been in the past. And we continue to have zero premium products in the majority of states, in part, thanks to the CMS demo, which brought down that premium by $15. So pleased with the positioning. Not satisfied with the 1% margin, give or take. But I think that's the right area to a target for 2025. And then, we'll look to edge that up over the following couple of years."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Scott Fidel with Stephens. Please go ahead."
},
{
"speaker": "Scott Fidel",
"content": "Hi. Thanks. Good morning. First question, just I was hoping to circle back on Sarah's comment around the expected exchange market growth for next year at the mid-single digits. One of your large sort of ex market-focused peers had talked more about a mid-teens growth expectation for next year. And I know you did sort of call out a few sort of regulatory changes for next year. So it would be helpful maybe if you could maybe walk us through sort of how you would be thinking about like sort of, I guess, the gross Marketplace growth and then how some of these regulatory changes may sort of bring that down to the mid-single digits. Then just my follow-up question would just be around California. One of your peers has commented the last couple of quarters on a retroactive rate adjustment in Medicaid that's been pretty significant. I know you guys haven't really called that out to nearly the same degree, but just curious on sort of what you've been seeing on that front as well. Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, Scott, for the question. So long term, we're still very bullish on our view of growth in Marketplace, and we called out all of the drivers of that, that sort of increased stability and broker infrastructure, affordability awareness. As we think about this year, think about the fact that we're coming off of the tailwinds from redetermination. So that creates sort of a natural step down to a more moderated growth rate just to begin with. And then as you said exactly, the program integrity policies that are being layered in, and really, most of these are just policies that are being reintroduced that were sort of put on pause during the COVID era. One of the new ones is this agent of record lock policy, which requires a member to have a single broker throughout the enrollment period, which again we think creates a more stable enrollment experience. It's something that we put in place starting back in January. So that's not really new for us but maybe new for some folks in the industry. And then two additional policies that are sort of reinstatement, which is failure to report, which is sort of the IRS policy, making sure that the income level is correct relative to enrollment and the subsidies, and then the flag for overlap between Marketplace and Medicaid eligibility. And so those -- the introduction of those or reintroduction of those relative to this open enrollment is part of what creates sort of that downward pressure in this cycle. The other thing that I think is important to note is that, as we come through the redetermination process, we also anticipate less growth than we've seen in the past couple of years relative to the SEP period. And so, think about returning to more normal marketplace membership seasonality, which means growth during open enrollment, a peak sometime in Q1 and then sort of natural trailing of membership as you move through the rest of the year. And so, all of that nets out to our view of mid-single-digit growth for the market, our view of sort of more modest this year growth in open enrollment. But still believe that we will grow in open enrollment. And based on what we've seen -- obviously, open enrollment doesn't start for another week, but what we've seen in terms of the competitive landscape, still feel very good about being able to execute our strategy relative to delivering well within our target margins of 5% to 7.5%. And then, Drew, do you want to comment on the California dynamic?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. Never 100% sure exactly we're talking about the same thing. But similar to what you described, we were able to get -- adequate information to get a negative retro into our Q2 results."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question today comes from Michael Ha with Baird. Please go ahead."
},
{
"speaker": "Michael Ha",
"content": "Hi, thank you. Just wanted to quickly confirm, on your modest exchange growth expectations, does that imply Centene can grow higher than market to higher than sort of mid-single digit for next year? And then, I know there's been a few questions on Medicaid cost trend already. But just curious, what level of cost trend are you assuming for fourth quarter? Directionally, is it fair to assume your guide sort of implies the 4Q Medicaid trend is higher sequentially?"
},
{
"speaker": "Sarah London",
"content": "Yes. So I think, Drew, you covered the seasonality of HBR, but maybe just hit that again in Medicaid."
},
{
"speaker": "Andrew Asher",
"content": "Yes, Medicaid cost. I think the way to think about that, Michael, is that we expect Q3 to be the high watermark for Medicaid HBR. And yes, every quarter, we assume that there's typical trend in our books of business across all the businesses. But essentially, what we're doing is exiting the redetermination era at elevated medical expense PMPM relative to a year ago, obviously, and then trending on that going forward, which we expect to have those Q4 -- the benefit in Q4 of the 9/1 and the 10/1 rates. The benefit obviously is much greater in Q4 than Q3."
},
{
"speaker": "Sarah London",
"content": "And then just relative to Marketplace growth, so we haven't quantified the target growth, but do believe that we will grow in Marketplace. Our strategy and our strategy really for 2025 has been more about delivering margins well within that pretax range. And so, I wanted to give some color on what we see as overall market growth, and then look forward to providing a more detailed update at our December Investor Day on that front."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Dave Windley with Jefferies. Please go ahead."
},
{
"speaker": "David Windley",
"content": "Hi, good morning. Thanks for taking my question. I was going to switch topics to G&A. Sarah, you mentioned AI. And I wondered, I guess, one, if you would be in a position to quantify any of the AI benefits that you might expect to see. And two, are any of those projects shovel-ready at this point? And then three, on G&A. Are there any timing-related spending items that we should be thinking about on G&A, thinking like offsets to the higher Medicaid MLR, things like that, that we should think 2024 versus 2025 on G&A? Thanks."
},
{
"speaker": "Sarah London",
"content": "Yes. I'll let Drew cover timing more broadly relative to year-over-year. The one thing I will call out which you all know is that, SG&A naturally goes up in Q4 because we get into our selling periods for Marketplace and Medicare, so just something to keep in mind, but consistent with what you see every year. Broadly relative to operational efficiency, I think we've delivered great results and created momentum as we think about kind of closing out year three. And as you heard me say, I'm sort of even more excited about the fact that we didn't just deliver on the low-hanging fruit, but really starting to get to the second and third order opportunities, which I think reflects the fact that operational excellence is sort of increasingly baked into the DNA of the organization. The AI product I mentioned in particular is shovel-ready. But it's -- this is not the beginning. We've actually been layering in the use of AI across different parts of the business as we've come through the value creation work. And the benefit of doing so much work in terms of standardizing processes means that you can then flip over to automating process, and then you have access to the data allows you to layer in AI and really think about a different way to leverage the size and scale and the data of this organization to drive standardization and administrative processes that aren't necessarily differentiating, and then really focus the talent of the organization on those parts of the process that are differentiating. So lots of additional non-AI SG&A opportunities. You obviously heard us talk about that relative to Medicare. That's going to be another great lever to derisk Stars and drive the path to profitability in that business. But thinking about things like digital payments to providers, vendor consolidation, portal consolidation. All of these are things that are still ahead of us, and so feel good about the ability to continue to extract EPS improvement, frankly, from that 1% to 2% that comes from margin improvement over time."
},
{
"speaker": "Andrew Asher",
"content": "Yes. Then we'll bridge you off of the midpoint of 2024 is 8.6% at Investor Day, and it will be somewhat dependent on the mix of business. Obviously, Marketplace and Medicare carry a much higher SG&A load than Medicaid. And then we'll have to weave in the impact of the PDP revenue growth as well. So we'll be sure to do that at Investor Day."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from George Hill with Deutsche Bank. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Hi, thanks. This is [Maxi] (ph) on for George. Thanks for taking my question. The Medicaid PMPM seems to have grown much faster than your peers this quarter. How much of it is driven by rate adjustment? And any other main drivers beyond rate adjustments? And how sustainable is the PMPM growth at this rate going forward? Thank you."
},
{
"speaker": "Andrew Asher",
"content": "Yes. Thanks for the question. As you heard us talking about cash flow, it's not what you asked about but it's -- there's an interplay here with the cash flows being impacted and the DCP being impacted by state-directed payments, that works its way into the yield that you're probably calculating off the face of the disclosures that we have. So there's a fair amount of increase in state-directed payments in the quarter. And -- but you're right that the high 4s to 5% composite back half rate is helping that as well."
},
{
"speaker": "Operator",
"content": "Thank you. And this concludes our question-and-answer session. I'd like to turn the conference back over to Sarah London for closing remarks."
},
{
"speaker": "Sarah London",
"content": "Thanks, Rocco. I'll just close out by emphasizing what I think you've heard this morning, which is our business objectives and expected 2024 earnings power remain unchanged. We are pleased to be making progress matching Medicaid rates with acuity and generating positive momentum on RFP wins in the meantime. Relative to Medicare, we are marking gains on important strategic initiatives there, and we continue to lead in our marketplace business, which is a product where I think our depth of experience and execution is unparalleled. So we still have work to do. We still have a lot of opportunity ahead, and look forward to updating you again at our upcoming Investor Day in December. But in the meantime, thank you for your interest in Centene, and I hope you have a great weekend."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful weekend."
}
] |
cnc | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Thank you for standing by, and welcome to the Woodside Energy Group Limited Half-Year 2024 Results. All participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to Ms. Meg O'Neill, Chief Executive Officer and Managing Director. Please go ahead."
},
{
"speaker": "Meg O'Neill",
"content": "Well, good morning, everyone, and welcome to Woodside's 2024 Half Year Results Presentation. We are presenting from Sydney, and I would like to begin by acknowledging the traditional custodians of this land, the Gadigal people of the Eora Nation and pay my respects to their elders past and present. Today, I'm joined on the call by our Chief Financial Officer, Graham Tiver. Together, we will provide an overview of our half-year 2024 performance before opening up to Q&A. Please take the time to read the disclaimers, assumptions and other important information. I'd like to remind you that all dollar figures in today's presentation are in U.S. dollars, unless otherwise indicated. I am very pleased to present a strong set of half-year results today. They are a testament not just to our operating performance in the past six months, but also demonstrate how we are delivering on our strategy to thrive through the energy transition. This strategy is underpinned by three goals: providing energy, creating and returning value to our shareholders and conducting our business sustainably. During the first-half of 2024, we have delivered on all three. Our project execution capabilities have been demonstrated again with the safe startup and strong ramp-up performance at Sangomar and excellent progress at our Scarborough Energy project. Our reliable and cost-competitive base business has translated into strong financial performance and returns to shareholders with a fully franked interim dividend of $0.69 per share once again at the top end of our payout ratio range. With our disciplined approach to cost management, we have reduced our unit production costs by 6% in an inflationary environment. And we will continue progressing actions to ensure that we can fund growth, while supporting strong shareholder distributions. Looking across Woodside's global business, I've never been more confident in our ability to deliver reliable, affordable and lower carbon energy to a world that needs it today and into the future. Our key operational and financial metrics in the half-year results demonstrate how well our base business is performing. World-class LNG reliability of 98% and production of more than 89 million barrels of oil equivalent put us on track to deliver our full-year production guidance. We're pleased to have delivered net profit after tax of $1.9 billion, translating into strong earnings per share and a healthy interim dividend for our shareholders. Ensuring everyone who works at Woodside Goode, some safely remains our highest priority. Our commitment to continuous improvement means taking action to strengthen our safety culture, simplify our processes, and improve our systems. The full impact of these actions will take some time and our overall safety performance is not yet meeting our expectations. However, we are seeing some positive results. For example, the safe delivery of our Sangomar project included 30 million hours worked on the FPSO without a serious injury, a remarkable result and sets the standard for what I expect to see across the business. Let me now speak to the global market environment and our firm conviction that LNG will play an important role in the energy transitions. Starting with energy demand, the fundamentals are strong. As the world's population continues to grow and economies developed, the demand for energy is increasing. According to recent updates on progress towards the UN sustainable development goals, the number of people lacking access to electricity around the world remain significant. In 2022, this reached 685 million people the highest in over a decade. So while the precise pathway of the global energy transition remains uncertain, there is one thing we can bank on. demand for reliable, affordable and increasingly lower carbon energy will continue to grow. At the same time, we firmly believe that LNG will remain an important global energy source as countries seek to lower their emissions. When used to generate electricity, gas typically provides -- sorry, gas typically produces half the life cycle emissions of coal. Gas can also provide support for electricity grids powered by renewables and batteries. Therefore, for many economies, switching from coal to gas is often the most material and affordable way to reduce emissions, while maintaining a reliable source of energy to underpin modern living standards. For example, in the U.S. from 2022 to 2023, coal to gas switching accounted for two-thirds of the emissions reduction in electricity generation. While coal use in markets like Europe has already peaked, the Asia Pacific region currently accounts for more than 80% of global coal use and global coal consumption is approximately 8 times higher than global LNG. So we see a clear and sustained opportunity for coal to gas switching in key markets as they navigate the energy transition. These fundamental drivers for long-term demand also give us confidence that the so-called LNG glut forecast for later this decade is unlikely to have a sustained impact on demand or pricing. Recent history has shown that due to customers' energy security and decarbonization drivers, increased supply is continuously absorbed by the market with price remaining resilience. For example, international energy agency concerns expressed in both 2009 and 2016, of a sustained \"LNG glut\" with far-reaching impacts on gas prices did not eventuate. Looking forward, we believe demand will continue to keep pace as new supply comes online. Underpinned by these strong market fundamentals, our high-quality portfolio is well positioned to provide energy and create value now and into the future. Core to this is Woodside's continued world-class operational performance, which combines consistently high reliability with reduced operating costs. We are also making targeted investments to extend the production life of our key operated assets to ensure we continue to extract value from our base business. We achieved a major milestone in June with the start-up of our Sangomar project. This demonstrates clear delivery against our growth strategy, creating shareholder value, as well as significant economic benefits to Senegal. I'm pleased to report strong well and subsurface performance. Nameplate capacity of 100,000 barrels per day has been achieved, and all 24 wells have been drilled and completed. This achievement has relied on the creation of strong local relationships, including with our joint venture partner, Petrosen. We will operate this asset in the same way we do in all jurisdictions, maintaining full compliance with local requirements and positive relationships with regulators, while ensuring we protect shareholder value. Moving to Australia. We have made impressive progress with our Scarborough Energy project. Scarborough was 67% complete at the end of the period and is on track for first LNG cargo in 2026. Scarborough was also set to deliver domestic gas at a time the local Western Australian market needs it. The image on this slide shows the floating production unit, which reached a major milestone during the half, achieving structural completion of the top sides. Other key onshore and offshore activities are progressing well, and I look forward to taking some of our investors to see firsthand our progress at Scarborough during a site visit planned for later this year. We were very pleased to welcome LNG Japan to the Scarborough joint venture and look forward to completing the sell-down to JERA. This demonstrates our ability to attract high-quality partners at a competitive price to a Woodside operated project. Moving to Trion. We remain on track for first oil in 2028. Front-end engineering design on the FSO was completed in the period. We have also progressed engineering procurement and contracting activities, including the award of the Subsea marine installation contracts. While progressing our growth projects, we continue to look for opportunities to grow our portfolio into the 2030s and beyond to deliver long-term value for our shareholders. In July and August, we entered into agreements to acquire two significant energy projects on the U.S. Gulf Coast, which I will now turn to. Our proposed acquisition of Tellurian and its Driftwood LNG development positions Woodside as a leading independent LNG player with exposure to both the Pacific and Atlantic Basin. It has potential for significant future cash generation and reduction of the average Scope 1 and 2 emissions intensity of our LNG portfolio. As we engage with investors following the announcement, there was a desire for more clarity on Woodside's value drivers and expected returns from the Driftwood LNG opportunity. Driftwood is a pre-FID project, and we are confident it can achieve the returns of our capital allocation framework. Looking at the chart on the slide, the first two gray bars compare the return profile of a typical project finance development with the returns already achieved by some U.S. LNG players. Some are improving returns by increasing plant capacity selling some volumes at international pricing and extending the life of the project. We see even more potential for Woodside. Driftwood plays to our established strengths in project execution, operations and marketing. Our track record on reliability and train debottlenecking gives us the credentials to extract more value from assets, compared to other players. Another competitive advantage of Woodside is our global LNG marketing portfolio. This provides us with flexibility to serve our customers and enables global price indexation. Our long shipping position is another strength we bring to the opportunity. We've seen traditional U.S. LNG players building out shipping fleets to allow dead sales. This is, of course, strength of Woodside today. Driftwood is truly advantaged. It is the only fully permitted pre-FID opportunity in U.S. LNG and has Bechtel as the EPC contractor. We have a very compelling opportunity for sell-downs. Multiple inbounds have been received, and we are in conversations with interested parties. Importantly, however, we will be focused and find the right strategic partners for this opportunity as we did for Scarborough. Now to our proposed acquisition of OCI's Clean Ammonia Project. This is another investment that positions us to thrive through the energy transition. The project is under development with expansion potential. Construction is already 70% complete with ammonia production targeted for 2025 and lower carbon ammonia for 2026. Global ammonia demand is forecast to double by 2050 with lower carbon ammonia make nearly two-thirds of demand total. Market forecasts show that growing demand for lower carbon ammonia will be supported by policies in key energy markets, stimulating use of ammonia beyond traditional applications, to include power generation, marine bunkering and as a hydrogen carrier. Over the past two decades, we have seen the EU leading the charge in tackling climate change through incentives like the emissions trading scheme. Last year, it strengthened its lower carbon framework through the implementation of the carbon border adjustment mechanism. This policy combines a carbon intensity measurement with a mandatory carbon price further incentivizing use of lower carbon energy sources. Lower carbon ammonia is also being used in Japan and Korea to decarbonize power generation by co-firing ammonia with coal. I'll now hand over to Graham to take you through our financial performance."
},
{
"speaker": "Graham Tiver",
"content": "Thanks, Meg, and hello, everyone. Our financial performance and balance sheet have remained resilient because of our strong underlying business and our consistent approach to capital management. I would like to highlight here that our capital management framework remains unchanged. This framework provides the flexibility of funding value-accretive growth, while continuing to deliver strong shareholder returns. Underpinning our capital management framework is discipline. We run our business with consistent cost focus and have managed our unit production costs down despite inflationary pressures. We will further tighten our belts and continue to rationalize discretionary spend. We are disciplined with our investment decisions. The acquisitions of Tellurian and OCI's clean ammonia project are both aligned with Woodside's corporate strategy and our capital allocation framework. As the operator of these opportunities, we control the spend, allowing us to face the development, bring in partners at our determination and use the contractors we want. The sell-down of equity in the Scarborough joint venture bring quality partners into the project and back into the business. The sale proceeds of $910 million received from LNG Japan and an estimated total consideration of $1.4 billion coming from JERA. And we are disciplined in how we position the balance sheet to achieve our goals. We know the importance of dividends to our shareholders. And when we evaluate the financial scenarios, we assume a dividend payout ratio at the top end of our range, even a stress case pricing. We target a gearing range of 10% to 20% through the investment cycle. With the recent acquisitions, we expect to access debt markets in the near-term. Our gearing will likely go above the top of our range for a period of time. This is expected to reduce back to within our target gearing range by utilizing the various levers at our disposal. Moving to our financial performance in the period. Despite lower average realized prices, our base business continues to perform very well. Costs are down and we're demonstrating excellent operational discipline and resilience across our financial metrics. This is translating into a healthy dividend payment representing a half-year annualized yield of 7.3% at June 30. Cash flow generation through the first-half of 2024 was strong, delivering a cash margin above 80%, which has been sustained over the past five years. Importantly, we have achieved positive free cash flow of $740 million in a heavy capital investment year and with significant tax payments. This is in line with the previously provided outlook for free cash flow. We expect to update our outlook to include acquisitions and sell-downs once we complete the transactions. Our balance sheet is well positioned with our gearing at the lower end of our target range and a strong cash-generative portfolio of assets. This is how we have created and returned value to shareholders in the first-half. I'll now hand back to Meg."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, Graham. As I outlined earlier, conducting our business sustainably is one of the goals underpinning our strategy to thrive through the energy transition. While we were disappointed at the shareholder vote received on our climate transition action plan at our AGM. We respect the results, and we will continue seeking feedback from investors. During the half, we progressed the implementation of our asset decarbonization plans and remain on track to achieve our Scope 1 and 2 emissions reduction targets. We also announced a new complementary abatement target to take FID on new energy opportunities by 2030, with total abatement capacity of 5 million tonnes per annum of CO2 equivalents, as well as generating attractive investment returns, the acquisition of OCI's Clean Ammonia Project is a material step towards delivering on our Scope 3 investments and abatement targets. And beyond our own initiatives and investments. Woodside is also championing lower carbon initiatives across the sector. In January, we became the first Australian company to join the oil and gas methane partnership 2.0, a flagship international program aimed at improving the accuracy and transparency of methane emissions reporting. Conducting our business sustainably also extends to supporting community development wherever we operate. Woodside continues to be among Australia's top tax contributors, our total tax and royalty payments during the half to Australian governments was AUD2.7 billion. This demonstrates an ongoing and significant contribution to the economic prosperity of Australia. As described in our Northwest Community development report, we spent more than AUD2.4 billion with local businesses in Western Australia through the Northwest Shelf and Scarborough projects during 2023. In Senegal, our Sangomar project is providing significant local content opportunities creating jobs for more than 4,400 Senegalese people. I'd like to close by recapping on our strategic priorities for 2024 and demonstrating the strong investment case for our shareholders. We have a high-quality, cash-generative portfolio, and we are well positioned to supply growing LNG demands. We deliver strong and consistent returns to our shareholders and are on track to deliver our emissions reduction targets. And above all, we are committed to continuously improving safety. Our achievements in the first-half of 2024 demonstrate delivery of our strategic goals and give us great confidence that Woodside will thrive through the energy transition. Last month, we celebrated 70-years as an Australian company and reflected on our proud history and proven experience. Looking to the future, we have the strategy, the people and the portfolio to enable us to deliver shareholder value for decades to come. Thank you. I'll now open the call to your questions. Please limit your questions to two each. So everybody has an opportunity to ask their questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Your first question comes from Mark Wiseman with Macquarie. Please go ahead."
},
{
"speaker": "Mark Wiseman",
"content": "Good morning, Meg, Graham and team, congratulations on a strong result and a strong dividend. I just had a question on the cash flows, the operating cash flows. You paid more than we expected in tax. Are you able to give any breakdown of the $1.7 billion tax, how much of that's PRRT versus income tax?"
},
{
"speaker": "Graham Tiver",
"content": "Hi, Mark, thank you, Graham here. So yes, so effectively, of that $1.7 billion paid in tax in the cash flow statement, $1.5 billion was related to income tax and the remainder being PRRT. What I'd point to Mark is if you have a look at the end of December as a part of our full-year results in the balance sheet, we had a tax payable liability of $1.1 billion. So effectively, that has been paid along with tax payments for the 2024 year. So hopefully, that provides some clarity. Importantly, we are one of the largest taxpayers in Australia. And as Meg touched on in her presentation, all up across all taxes and royalties in Australia, we paid AUD2.7 billion in the first-half."
},
{
"speaker": "Mark Wiseman",
"content": "Okay. Thanks, Graham. And just for my second question, just on hedging, with the two M&A deals that you're working on, the Driftwood FID coming up and maintaining the 80% dividend payout for now at least. What's your posture with hedging in '25 and '26? Thanks."
},
{
"speaker": "Meg O'Neill",
"content": "Yes. Mark, it's probably worth reminding you and the investors why we hedge. So we have been hedging plus or minus 30 million barrels of oil for the last couple of years in this period of higher capital spend. We also hedge our Corpus Christi contracts. So those are Henry Hub and TTF hedges, and that's really to manage the trading risk in that particular contract. So the hedging that -- I think asking you're asking about is the oil-linked hedging, and we do expect to continue hedging in 2025, and we will take a look in due course at 2026 as we firm up plans forward for Driftwood as we get better line of sight as to what exactly our capital spend is going to look like, that will inform our decisions as to whether or not we hedge in '26."
},
{
"speaker": "Mark Wiseman",
"content": "Okay. So would it be reasonable to assume all else equal, more CapEx commitment and more gearing on the balance sheet would point you towards more hedged volume?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. But again, well, look, I'd say not necessarily more. We've been targeting the 30 million barrels because we feel that's an appropriate level of hedging to protect our ability to cover our base costs as well as continue the investments that we've sanctioned. And so I wouldn't expect it to go above the 30 million barrels, but it really will be a question for 2026 of how much hedging is appropriate -- as we -- you'll recall, 2026 is when we expect to start LNG production from Scarborough. So spend ramps down, revenue starts to come in, but that will be kind of the critical year as we think about the cash balance going forward."
},
{
"speaker": "Mark Wiseman",
"content": "Okay, thank you. That’s clear and congrats on the result again. Cheers."
},
{
"speaker": "Graham Tiver",
"content": "Thanks, Mark."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Saul Kavonic with MST. Please go ahead."
},
{
"speaker": "Saul Kavonic",
"content": "Good morning. A couple of questions. Perhaps the first one is for Graham. Just in the context where you talk about gearing to go above the top end of the 20% gearing range for a period. Should we think about this providing time to enable targeted sell-downs of Driftwood perhaps another way of phrasing that once the -- if you -- once the 50% sell-down of Driftwood occurs, do you think you would then be -- may be below the 20% gearing range at kind of current $70, $80 oil prices?"
},
{
"speaker": "Graham Tiver",
"content": "So it's very early days. We are still working through one project completion of the actual acquisition, we're still reassessing the capital, the phasing of the capital, et cetera, and then the sell-down process. But to answer your question at a very high level, based on what we see today, it is highly likely that we will still pop up above 20% for gearing for a period of time in a 50% sell-down scenario. But having said that, and I caveat, there's still a lot of work to do between now and then."
},
{
"speaker": "Meg O'Neill",
"content": "And Saul, maybe it's worth elaborating on Graham's answer. We said our target gearing range is 10% to 20%, but it's not hard guardrails, it's a target range, and we may be above or below at periods in time. And you'd be well aware that we were below it last year when market conditions were in our favor. We again, with the investment in Driftwood may go above it for a period of a couple of years. But again, they're not hard and fast rules. It's more target range."
},
{
"speaker": "Saul Kavonic",
"content": "Okay. So I guess a follow-up to that is, in the absence of a Driftwood sell-down, are you still comfortable you can maintain this modeled 80% payout policy within the various scenarios you look at? Or is the pressure really on to have a sell-down to maintain that recent payout ratio?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. So what we said about Driftwood is we really want to put together the Dream team. We've had more inbounds than we can shake a stick at. So we've got the luxury of being able to really pick the partners we want to work with. And our intention, as we progress towards an investment decision there is we want to have line of sight to the partnership that we want. We may not have everything signed, sealed and delivered, but we do want to have line of sight to the partnership. If we didn't have anybody interested, I don't -- it would not be our intention to go forward at 100% with nobody queued up."
},
{
"speaker": "Saul Kavonic",
"content": "All right. Thanks. I also just have a question on Driftwood. It could be for you. I don't know if Mark's on the call maybe he's better to address it. But just looking at the steps you provided here to show how this can go from an infrastructure return to the 12%-plus rate of return. And you highlight debottlenecking and longer life, et cetera. But I just wanted to kind of holding on two elements. You talked about Woodside achieving greater than 95% reliability. Could you provide some, I guess, guidance on what the average U.S. LNG plan achieves that is what you think Woodside can achieve?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. Thanks for the question, Saul. We actually tried to get that hard and fast data. And unfortunately, it's a bit all over the map. There are some very high-quality operators in the U.S., who operate in that 95%-ish range reliability. There are other operators that struggle to keep their plants online. What we can speak to is our track record and part of why we highlight our LNG reliability every half-year and full-year is just to kind of confirm with the market the capability that we have in our organization to get the maximum value through the facilities that we have."
},
{
"speaker": "Saul Kavonic",
"content": "Thanks. And just a second point to touch on the -- I guess, the upside from the marketing position. Do you expect, for example, if you would have signed an FOB contract from Driftwood that you'll achieve a premium toll value versus kind of the more recent tolls that have been signed and our push, is it this like a $0.05 in MMBtu premium or $0.50 MMBtu premium?"
},
{
"speaker": "Meg O'Neill",
"content": "So Saul, one of the things that we're working on as we put together our dream team is making some of those decisions around how much equity LNG we want to maintain, how much equity in the plant we want to maintain and how much equity LNG we want to maintain. If – look, it'd be premature for us to speculate on how we would structure any contracts. There may be circumstances where we would sign FOB contracts. But in some ways, that really is linked to the infrastructure kind of model where you get that high confidence in the new stream, where we think we can really add value is actually by taking more of that into our portfolio. So our starting point is whatever equity position we take, we're going to take it into our portfolio because we think we can access better pricing by being able to sell it at either oil indexation, CTS indexation or JKM."
},
{
"speaker": "Saul Kavonic",
"content": "Sorry, just one more. My understanding is the approval..."
},
{
"speaker": "Meg O'Neill",
"content": "Saul, we've got a few others in the queue if we can -- if I can ask you to hop back in. Thanks, Saul."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Gordon Ramsay with RBC. Please go ahead."
},
{
"speaker": "Gordon Ramsay",
"content": "First of all, big congratulations on getting Sangomar up to 100,000 barrels a day. I think that's a terrific achievement considering the complexities of the project and particularly some of the subsurface infrastructure involved. Just on Sangomar, Meg, if you 100,000 barrels a day, obviously, that's the cap that you're working with on the project. Do you think that can push out the plateau volumes further than maybe than what you originally thought based on initial well performance?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. Thanks for the question, Gordon. And I appreciate your commentary. I know you've studied that quite closely, and you appreciate the complexities of the asset that we have there. We're really pleased with the well performance that we've seen to-date. What we haven't done yet is gotten water injection or gas injection up and running. And as you would well appreciate, we need those secondary recovery mechanisms to maintain the flow rates from the wells. So it's going to take us a bit of time to really understand how the field is plumbed together and how effective those secondary recovery mechanisms are going to be. So I'd say we're still in the -- too early to say stage. But very pleased with the well performance to date."
},
{
"speaker": "Gordon Ramsay",
"content": "Okay. And just one other operational question just on the unit production cost, bringing that down by 6% to $8.30 and a lower production compared to first-half 2023. What were the drivers to that? And could that be sustained going forward?"
},
{
"speaker": "Meg O'Neill",
"content": "It's a lot of hard work on a lot of different fronts as I'm sure you'd appreciate, to manage unit production costs, a lot of focus in base cost management through the business. just taking a look at everything we do and how we do our work. It's looking at things like how efficiently we're managing our turnarounds how efficiently we're executing maintenance, looking for synergies and things like helicopters and boats making sure we're efficient in our above field support. So there's no silver bullets. It's a lot of hard work on a lot of different fronts."
},
{
"speaker": "Gordon Ramsay",
"content": "Okay, thank you."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, Gordon."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Tom Allen with UBS. Please go ahead."
},
{
"speaker": "Tom Allen",
"content": "Good morning, Meg, Graham and the broader team. Are you comfortable that following the two big deals recently announced with Tellurian an OCI ammonia that Woodside's now added sufficient growth to the outlook? Or given that these deals haven't added upstream production, should we expect more? Woodside said that it wants to add growth in LNG, new energy and deepwater oil you've hit the first two parts of that plan with recent deals. So is adding further scale investment in deepwater oil still a near-term key growth ambition?"
},
{
"speaker": "Meg O'Neill",
"content": "Well, Tom, I'd say we already are taking steps to add growth in deepwater LNG with Sangomar and Trion. So we've got a project that's now in the operational phase, and then the Trion project 10% completes. So we actually have taken steps to increase our -- sorry, our deepwater oil portfolio. If you're trying to fish more generally as are we looking at other M&A opportunities. Look, nothing at this point in time. We're very pleased with the quality of the Driftwood and OCI Clean Ammonia Project Acquisitions, and we'll be very focused on finding a pathway to make the Driftwood FID decision in a way that delivers value for our shareholders."
},
{
"speaker": "Tom Allen",
"content": "Thanks, Meg. Just following an earlier question on Sangomar. The initial well performance outcomes read well. And so based on those initial outcomes and to guide how we think about cash flows over the next six to 12-months, can you please comment on -- when should we expect peak plateau production? And are the initial flows that you're seeing, recognizing it's early days, but are these supportive of around that 75,000 barrel a day plateau production level? Or is risk to the upside or downside from those levels based on what you're seeing so far?"
},
{
"speaker": "Meg O'Neill",
"content": "Look, Tom, as I said, really pleased with how the wells are performing. It's a new facility. And every time you start up the new facility, you always have to work through a few, we'll call it upsets and the team has been doing actually a fantastic job of as we bring new equipment on as we learn things, responding to those learnings. But it really is too early to draw any conclusions around the long-term reservoir performance Again, the key kind of challenge or question with Sangomar is the connectivity within the reservoir, and we need to get the water injection wells up and running and the gas injection wells up and running to understand our ability to sweep oil through the reservoir."
},
{
"speaker": "Tom Allen",
"content": "Okay, thanks Meg."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks Tom."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Nik Burns with Jordan Australia. Please go ahead."
},
{
"speaker": "Nik Burns",
"content": "Hi, thanks Meg and Graham. Look, I'm going to risk trying to ask another M&A question, but talk about risk management instead. Assuming you do complete both the Tellurian and ammonia plant acquisitions to move ahead with the Driftwood LNG project, by the time Driftwood comes online, you'll have considerable exposure to Henry Hub gas prices and input costs. Just wondering whether you're comfortable with that long-term exposure to Henry Hub? Or should we expect you might look to try and remove or mitigate that risk via the acquisition of more U.S. gas production assets such as shale gas?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. Thanks, Nick. Look, I appreciate a lot of interest in this topic. As we think about putting together our dream team, one of the capabilities we're going to be looking at our partners as you can bring connection into that upstream gas world because, as you know, it will be incredibly important for us to understand the U.S. onshore gas market and to have ability to ensure we get the gas feeding into the plant that we need at a price that remains affordable. But at this point in time, we have no intentions of going into the upstream. We would be very cautious if we were to do so, again, recognizing the skills and capabilities for onshore U.S. shale gas is quite different from the skills and capabilities we have. So in due course, we will continue to look at ways we can manage that upstream risk, but it is not a priority for us to get into upstream U.S. at this point in time."
},
{
"speaker": "Nik Burns",
"content": "Okay, that’s clear. Thank you. And then just a question on Scarborough. You recently increased the cost there by $500 million, and that was primarily associated with Train 1 mods. Just wondering if you can talk through your confidence in the current cost estimates now? And did the $500 million increase allow you to replenish your contingency budget? And just sort of looking ahead, how should we think about what are the residual key risks into the project? I understand it's quite complex. But if you can talk to that and maybe the further risk to cost and schedule from here?"
},
{
"speaker": "Meg O'Neill",
"content": "Sure. We've worked very hard before we put out that cost update to really understand the vulnerabilities of the Scarborough project to understand where we've spent the money to date and where we're tight and where we needed a bit of support I have a very high level of confidence that we will deliver the project within that $12.5 billion. I guess just for the market's understanding, I am personally keeping a couple of hundred million of that in my pocket. So the project team doesn't have that. So they've been challenged to deliver it for $12.3 billion as we think about ongoing risks, so very pleased with particularly how the onshore work is going with Pluto Train 2, pleased with how the offshore pipeline installation is going. The FTA always has been a critical path, and that remains on critical path. As you saw in the deck, the top side is structurally complete, but there's still many hours to go to get everything ready to go before we made it with the hole. So we watch from a project execution perspective, that's a key item to watch. The second thing that we are watching very closely and working very closely with the regulator on is the Scarborough operations environment plan. We have already passed the completeness check with a NOPSEMA, so we are continuing to work through their questions. But given the evolving rules around consultation, we wanted to make sure we got that into NOPSEMA well in advance of needing it to make sure that we are robust and have the approvals we need by the time we bring the FTU into Australian waters."
},
{
"speaker": "Nik Burns",
"content": "That's great. Thanks, Meg."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, Nik."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Your next question comes from James Byrne with Citi. Please go ahead."
},
{
"speaker": "James Byrne",
"content": "Good morning. I wanted to ask about the outlook for cash flows and whether the performance of the business has deteriorated at all relative to the prior expectations? And just bear with me like I'm just going to state a few things here. So the IBD last year 2024 free cash flow at $70 oil was sort of being indicated at around $600 million? If we take that up to $84 oil using your own sensitivity, we can kind of get to a number of about $1.5 billion for 2024, assuming second-half oil price is the same as first. CapEx, $5.5 billion, so that kind of gets us to operating cash flow is $7 billion for 2024. We have to adjust then for the asset sales LNG Japan, so probably more like $6 billion, right? First-half achieved less than $2.4 billion of operating cash flow. So there's a big delta there to get up to what you'd loosely guided to at the IBD next year. And yes, Sangomar is ramping up, but nonetheless, it's a very big delta. Secondly, at the Beaumont acquisition call, it was stated that gearing would go to the low-20s to mid-20s in a subdued oil price environment. And today, it sounds like it will go to the low to mid-20s in at Woodside's internal assumption of oil as opposed to necessarily a subdued stress test or price environment? And lastly, Sangomar is ramping up really well and yet the production guidance is unchanged. So if I triangulate those things, it kind of feels like there are parts of the business that might have deteriorated versus prior expectations. And I just wanted you to explicitly be able to say that, that was not the case."
},
{
"speaker": "Graham Tiver",
"content": "Thanks, James. I'm very happy to answer the cash flow question. As you've quite rightly pointed out, there are swings and roundabouts. We can go into all the different line items. But if we stand back, I'm very comfortable in saying that our half one free cash flow is on track as per our IBD ‘23, November ‘23 cash flow guidance. And when we extrapolate that forward for the full-year position, also very comfortable that we are tracking above that as you hit on, the prices are generally higher than what we've received to the mid case of 70 that we put forward in the IBD. So yes, we can go into the detail and happy to take that offline. But in terms of -- yes, there are swings around about in regards to prices, timing of CapEx, tax payments, et cetera. But when you stand back and look at it, the business is performing extremely strongly. And that's evidenced in our cash flow generation and the ability to pay strong dividends. We are in line with what we put forward at the November IBD and will likely exceed it."
},
{
"speaker": "Meg O'Neill",
"content": "And from a production perspective, so the guidance we put out, I think at that point in time, we would have said Sangomar start-up was expected in “mid-24”, which is what we've delivered. So yes, very pleased with how it's ramping up. But again, in any business, there's a number of different assets, and we still feel pretty -- well, we still believe and stand by the guidance we've put out for total production."
},
{
"speaker": "James Byrne",
"content": "Okay. Second question, just back around the gearing. To have the gearing go to sort of that low mid-20s percent. I'm actually getting -- this is very anecdotal, I'm getting credit investors that right to me with our concerns, along with equity investments that are similarly concerned. And my fear is that if the bondholders are pitted against the shareholders, then equity that's likely going to lose out. Now if I pick up, Graham, on what you mentioned in your opening remarks, you mentioned you have various levers that you can pull, and you sound quite intent on maintaining that strong dividend payout ratio, what levers would you describe as being able to pull in that instance that a normal oil price environment is still getting to that mid gearing mid-20s gearing range, a little low day bear market for oil. I'm just very interested in what levers you think you have to pull because it appears to me that and many in the market, by the way, that the path of least resistance is in fact the dividends."
},
{
"speaker": "Graham Tiver",
"content": "Yes. Thanks, James, and always good questions. And I think if we can go back to the work at OCI where we spoke around about the strength of the balance sheet and our gearing. I think it was sort of as I touched on with Saul's question, in our mid-price scenario, we will be above 20% and at the stress price. I'm not sure if that's what you mean by subdued. It was more around the mid-20s. What I would say, when we look at the levers, the first and foremost is just continued strong operational performance. We must continue for the underlying business to perform well and generate strong cash flows to support the balance sheet. We've always got opportunities around phasing of capital spend. We've got opportunities around cost reductions, tightening up on the OpEx and CapEx, discretionary spend, et cetera. We've already touched on the hedging program. We've touched on earlier on around our willingness or our plan to sell down a portion of Driftwood and that's a core part of it. So look, there's many levers, and we will assess them on their merits. And it's all a part of the work that has to take place over the next six months or so."
},
{
"speaker": "Meg O'Neill",
"content": "But James, at a high level, it's probably worth reinforcing that over the period, you would have seen that Woodside has a track record of taking care of both our debt holders and our equity holders. You would have seen we've been in and out of the debt market for probably the last 20 or 30 years. And we pay our debts as and when they're due. And for the last decade, we've continued to provide very healthy returns to our shareholders. So we've certainly got the ability to do both."
},
{
"speaker": "James Byrne",
"content": "So could I perhaps ask it a different way, though. So some of those levers sound very much business as usual, right, like operational performance, filling down Driftwood -- they're things that I think both equity and credit would expect management to undertake. But Graham, in your conversations with debt investors and rating agencies, would you say that they are comfortable with the trajectory of the balance sheet given the extension of the CapEx cycle?"
},
{
"speaker": "Graham Tiver",
"content": "Yes."
},
{
"speaker": "James Byrne",
"content": "Okay."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, James."
},
{
"speaker": "James Byrne",
"content": "That’s all from me."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Adam Martin with E&P. Please go ahead."
},
{
"speaker": "Adam Martin",
"content": "Yes. Good morning, Meg, Graham. Obviously, pretty strong market reaction post your two recent deals. Just perhaps just sort of summarize investor feedback, any differences in anything that surprised you? And I suppose, what the market might be missing here?"
},
{
"speaker": "Meg O'Neill",
"content": "Sure. Well, look, what I think we've had a couple of thematic questions, which we tried to address in this presentation. With Driftwood, there's been a lot of desire to understand what's different about how Woodside would do a U.S., LNG projects from how other U.S., LNG players have done their projects. And so that's why we put that slide in showing the sorts of activities that we believe we bring to the opportunity to create additional value and why we think it's compelling. And with OCI, look, I think there was an element of surprise. We've been saying for three years that we would spend -- that our intention was to profitably invest $5 billion in new energy products and services. I think the market just wasn't expecting us to do $2.3 billion this year. I think a lot of folks had probably built into their model that we would back-end weight that -- and look to be fair, we had probably signaled that as we had been focused on pursuing organic growth opportunities, which would have had a slower ramp-up of spend. So those are probably the key themes that we've been hearing, Adam."
},
{
"speaker": "Adam Martin",
"content": "Okay. Thank you. And just second question around decommissioning, sort of any updates around what you're thinking for North West Shelf? And then also just on the Bass Strait, I think Exxon have recently pulled the EP around 13 platforms that I think is issue around sort of leaving everything below 55 meters in the water. Just talk through what's going on in the Bass Strait, but also Northwest Shelf, please?"
},
{
"speaker": "Meg O'Neill",
"content": "Sure. Well, let me speak more broadly about decommissioning. We have a very significant decommissioning campaign underway this year. And this builds on activities we started last year with the build plug and abandonment campaign. We've got a large plug-and-abandonment campaign for Stybarrow this year. And we're taking steps to remove subsea flow lines, riser dirt mooring systems from a number of legacy assets, things like Griffin as well as Stybarrow. As we go to Bass Strait, the operator and joint venture has been working for many years on decommissioning their initial focus on plug and abandonments. So basically dealing with the wells so that the platforms can subsequently be removed safely. We have been working with the operator on a plan forward for removing a number of the steel pile jackets that are in place. And the work that we've done thus far would support that a better safety and environmental outcome would be to leave the parts of the steel pile jackets that are in deeper water in place. Now Australian law today requires full removal, and that's why the joint venture has pulled that EP with the intention of continuing to do the scientific work to document the positive environmental impacts associated with live in place. North West Shelf, I assume you're asking about train retirement dates. So we continue to monitor production from North West Shelf. The offshore is doing quite well. We're processing a fair amount of Pluto gas at the Karratha Gas Plant today and do expect to see ramp-up from Waitsia in due course. So we are continuing with our planning to take on LNG train offline either late this year or in the first-half of next year."
},
{
"speaker": "Adam Martin",
"content": "Okay, thanks for the detailed response Meg."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, Adam."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Dale Koenders with Barrenjoey. Please go ahead."
},
{
"speaker": "Dale Koenders",
"content": "Morning. Meg, Graham and team. Just wondering about Sangomar now that you started up. There's been obviously a lot of cost inflation in the industry. There's a little bit of uncertainty around depreciation rates. Do you think that we need to get guidance as a market on those numbers going forward? Or are you comfortable with how the consensus is forecasting those costs?"
},
{
"speaker": "Meg O'Neill",
"content": "I'll let Graham deal that."
},
{
"speaker": "Graham Tiver",
"content": "Yes. So Dale, we don't normally provide that level of detail, asset by operational level. hear your question. I think the key point is to -- as Meg touched on is around the ramp-up and we get a feel for the ramp up, how the connectivity is across the wells and then we can look to consensus and see how we're traveling."
},
{
"speaker": "Dale Koenders",
"content": "Okay, thank you very much for that. I'll leave it there."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks Dale."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Henry Meyer with Goldman Sachs. Please go ahead."
},
{
"speaker": "Henry Meyer",
"content": "Good morning. Just a question on the inclusion of asset sale proceeds and underlying earnings and dividends. Can you share how you determine the amount of sale proceeds that are included in underlying, I think that what we could assume going forward, for example, the $1.4 billion from Scarborough this half?"
},
{
"speaker": "Graham Tiver",
"content": "Yes. So Henry, just for clarity, on the $1.4 billion is the cash proceeds that will go into the cash flow statement once received, and that's estimated at this point in time. What we're talking about in the net profit after tax calculation is the profit or loss on the sale, which for both LNG Japan and for JERA sell-down, it will be a profit. And for LNG Japan, I think it was $110 million -- $120 million apologies. So it's not -- I want to be very clear, it's not the full cash amount that's going into the underlying dividend calculation. It's the profit on the sale."
},
{
"speaker": "Henry Meyer",
"content": "Yes, absolutely. And so that $120 million for LNG Japan, is that proportional to what would you expect from the JERA sale as well?"
},
{
"speaker": "Graham Tiver",
"content": "Roundabouts."
},
{
"speaker": "Henry Meyer",
"content": "Great. Okay, thanks. And last one for me at Sangomar, we're continuing to see headlines in the press from the Senegalese government looking to renegotiate contracts? I understand, of course, that it will be confidential, but could you share Woodside's perspective on any of these contents, any potential risks, changes timeline for any resolution that you see from here?"
},
{
"speaker": "Meg O'Neill",
"content": "Yes. At this point, Henry, we're very pleased with the relationship we've built with Petrosen and the relationship we've built with the government of Senegal. You would have seen in the past that photo, myself and the President of Senegal out on the FPSO, celebrating first oil. Look, we know every governments all around the world has the rights to determine the framework that governs resource development in their nations. In Senegal, we have a contract. We have a production sharing contract. We have a host government agreement. These were fairly negotiated with the government of that nation. And look, we're happy to have a conversation with the government, but we need to make sure that we're protecting the thesis, the investment thesis on which we entered the project. So at this point in time, we'll continue to have open discussions. I would note that the Presidents around the time of his appointments or his election. He made some very positive comments welcoming private investment to the nation of Senegal and Sangomar development is one of the nation's largest private investments. So I'll leave it there."
},
{
"speaker": "Meg O'Neill",
"content": "Okay. Thanks Meg."
},
{
"speaker": "Henry Meyer",
"content": "Thanks Henry."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Sarah Kerr with Morgan Stanley. Please go ahead."
},
{
"speaker": "Sarah Kerr",
"content": "Thanks so much and congratulations on the result. I was just wondering if there was any update for the timing on Perdaman contract? And if there's any impact to Woodside from the changes with the WA domestic gas policy?"
},
{
"speaker": "Meg O'Neill",
"content": "Look, you're probably better off asking Perdaman for the timeline. We need to be ready to supply them in 2026, and we will be. As to the pace of their ramp-up, that's really for Perdaman to communicate to the market. And in terms of the WA domestic gas inquiry. Look, we recognize this is an important matter for the state. We recognize that the domestic gas largely from the Northwest Shelf has underpinned a tremendous amount of economic prosperity in Western Australia. We intend to continue to work with the government on how to continue to get those positive benefits. It's probably worth Sarah noting that I know Browse has also received quite a bit of recent media attention. As we think about the State's gas needs in the 2030s, Browse is going to be an important part of solving what appears to be a growing supply-demand gap. So we'll continue to work with the government, both state and commonwealth on Browse to ensure that the state doesn't end up in a similar situation as these East Coast states."
},
{
"speaker": "Sarah Kerr",
"content": "Great. Thank you. And just staying on Browse. You have the Sunrise development concept to in the fourth quarter of this year. So I was just wondering how Woodside is thinking about and what takes priority over Browse versus Sunrise for possibly the next organic development in Australia?"
},
{
"speaker": "Meg O'Neill",
"content": "Look, I'd say that both of those developments have their challenges. So Browse, as you know, we've been working on environmental approvals for six years and continue to seek them. We're not going to make any significant capital investments until we have confidence in those approvals. Sunrise has a lot of complexity, straddling the border of both Australia and Timor-Leste trying to get all of the governing documents negotiated has complexities and then getting to the point where we've got an investable project. We've got a bit of work to do. So no priority. There are two horses that want to get into the race, but they're both in the training track right now."
},
{
"speaker": "Sarah Kerr",
"content": "Great thank you so much and congratulations again."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks Sarah."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Matt Chalmers with Bank of America. Please go ahead."
},
{
"speaker": "Matt Chalmers",
"content": "Thanks and good morning. Mig, just a quick question on Trion. Just with regards to Pemex and some of the world documented challenges that they're facing. Just keen to get your thoughts in terms of how you're thinking about how that may impact the overall development time line at Trion given the fact that they're your major partner in the project?"
},
{
"speaker": "Meg O'Neill",
"content": "Sure. So we've, over the past few years, established a very constructive working relationship with Pemex. They have quite a bit of deep expertise having been the sole proponent of the Mexican oil and gas sector for many years. They do have financial challenges, and that's part of why the Trion contract was structured with a carry. So we continue to carry Pemex for their share of investments through this calendar year. We've worked very closely with both Pemex and the government to ensure there's clarity around Pemex’s needs to pay their fairway starting in 2025. And at this point in time, we've received all assurances from the government and Pemex that they will do so."
},
{
"speaker": "Matt Chalmers",
"content": "Got it. Okay. And just one last question for my end. Just with regards to the lower production unit costs during the year I noted from relatively speaking compared to H1 '23, those costs were elevated and understand that royalties were lower and duties have like given the lower LNG prices in this half. just can understand if there's any further cost out that you managed to take out of those Australian operations that can speak to that cost discipline during the course of this year?"
},
{
"speaker": "Graham Tiver",
"content": "Yes. Thanks, Matt. A couple of things. The unit costs are really just focused on the production cost. So we're not necessarily. We don't include royalties, et cetera, but you're right, royalties are lower. This is the raw production costs of producing our products. When you normalize across the two years -- the 2.5 years, whether turnaround for interconnector, it doesn't matter how you look at it, our costs for the first-half of ‘24 below those of FY '23 for the first-half. And as Meg touched on, is there one particular point that stands out where we press the button and it all unfolded. No, it is hard work. It's constant process and energy plugging away at the underlying cost base and just really strong alignment across our businesses and focus on cost scrutiny in the business."
},
{
"speaker": "Matt Chalmers",
"content": "Got it. So there is actual costs out there. It's not just because it's coming off a higher base in H1 '23, right?"
},
{
"speaker": "Graham Tiver",
"content": "Absolutely. The underlying costs have decreased across Woodside, obviously, ups and downs between operations. It depends what's going on. But across the business, a very broad theme of strong cost improvement."
},
{
"speaker": "Matt Chalmers",
"content": "Thanks Graham, appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Your next question comes from Rob Koh with Morgan Stanley. Please go ahead."
},
{
"speaker": "Rob Koh",
"content": "Good morning. Morgan Stanley's way of getting more than two questions in at a time, I guess. Just a question about your climate transition action plan, which you acknowledged you continue and reflect. Can you give us a sense of where the feedback came from? Were people looking for more ambition or less ambition or was the technical issues around offsets? And then as a subsidiary question, does the future made in Australia program helped with H2Perth?"
},
{
"speaker": "Meg O'Neill",
"content": "All right. Well, thanks, Rob. So look, this seems on the climate transition action plan, we're probably thematically oriented towards wanting more rather than wanting less really a broad range of areas of interest from various investors though. Some wanted to see more detail and clarity on Scope 1 some expressed concerns around offsets, some themes around demand resilience for LNG and part of why we included the chart in this presentation showing coal demand is to make that point around the role for LNG and helping the world decarbonize. Some more questions around our ambition on new energy, which the OCI Clean Ammonia Acquisition, I think, addresses pretty elegantly. There are really a wide range of feedbacks. In terms of the future made in Australia, look, probably less of a connection to H2Perth. But what I would say, Rob, is if we're thinking about a future made in Australia, just as if we think about it today made in Australia, we need gas. If you look at how the manufacturing sector in Australia has grown over the decades, it's been underpinned by access to reliable and affordable gas. So not just a future made in Australia, but it today made in Australia need natural gas."
},
{
"speaker": "Rob Koh",
"content": "Okay. Great, thank you. And then maybe just a small flyer question. Any update on your thinking on exploration in Namibia?"
},
{
"speaker": "Meg O'Neill",
"content": "Nothing's changed. So we still have our option to come as operator on one block there. We continue to look at the opportunity space there. Obviously, a lot of kind of interest across our industry with some of the other discoveries, but we're going to be patient and disciplined as we are with all of our exploration opportunities."
},
{
"speaker": "Rob Koh",
"content": "All right, you sounds good. Thank you so much."
},
{
"speaker": "Meg O'Neill",
"content": "Thanks, Rob."
},
{
"speaker": "Operator",
"content": "Thank you. There are no further questions at this time. I'll now hand back to Ms. O'Neill for closing remarks."
},
{
"speaker": "Meg O'Neill",
"content": "All right. Well, thanks everyone, for joining the call. I really appreciate your interest in Woodside and appreciate your support of the business. We look forward to engaging with you in future days to further discuss and share with you our strategy of how we're delivering on our goal to thrive through the energy transition. Thank you."
},
{
"speaker": "Operator",
"content": "That does conclude our conference for today. Thank you for participating. You may now disconnect."
}
] |
cnc | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Centene First Quarter 2024 Financial Results Conference Call. [Operator Instructions] Please note, today's event is being recorded."
},
{
"speaker": "",
"content": "I would now like to turn the conference over to Jennifer Gilligan, Senior Vice President, Finance and Investor Relations. Please go ahead."
},
{
"speaker": "Jennifer Gilligan",
"content": "Thank you, Rocco, and good morning, everyone. Thank you for joining us on our first quarter 2024 earnings results conference call. Sarah London, Chief Executive Officer; and Drew Asher, Executive Vice President and Chief Financial Officer of Centene, will host this morning's call, which also can be accessed through our website at centene.com. Ken Fasola, Centene's President, will also be available as a participant during Q&A."
},
{
"speaker": "",
"content": "Any remarks that Centene may make about future expectations, plans and prospects constitute forward-looking statements for the purpose of the safe harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by those forward-looking statements as a result of various important factors, including those discussed in Centene's most recent Form 10-K filed on February 20, 2024 and other public SEC filings. Centene anticipates that subsequent events and developments may cause its estimates to change. While the company may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so."
},
{
"speaker": "",
"content": "The call will also refer to certain non-GAAP measures. A reconciliation of these measures with the most directly comparable GAAP measures can be found in our first quarter 2024 press release, which is available on the company's website under the Investors section."
},
{
"speaker": "",
"content": "With that, I would like to turn the call over to our CEO, Sarah London. Sarah?"
},
{
"speaker": "Sarah London",
"content": "Thanks, Jen, and thanks, everyone, for joining us as we discuss our first quarter 2024 results."
},
{
"speaker": "",
"content": "This morning, we reported first quarter adjusted EPS of $2.26, ahead of our previous expectations for the period. As a result of this strong start to the year, we are increasing our full year 2024 adjusted EPS guidance to greater than $6.80. Drew will cover the quarter and our updated financial outlook in further detail in a few moments. While there is still more work to do, we are pleased with the first quarter results, and we'll look to harness the positive momentum we are generating in our core businesses as we move through the balance of the year."
},
{
"speaker": "",
"content": "In 2024, Centene's focus remains on our work to streamline and modernize the underlying infrastructure of our company and to assemble the people, processes and tools necessary to deliver best-in-class experiences to our members, providers, regulators and state partners. Let me share a couple of examples of progress here."
},
{
"speaker": "",
"content": "During the first quarter, we completed an important initiative to simplify our prior authorization process by automating our real-time source data. This simplification improves the timeliness of authorization decisions, ensuring our members get the care they need quickly and removing friction from the process overall for both members and providers."
},
{
"speaker": "",
"content": "Q1 also saw the accumulation of months of thoughtful and thorough go-live preparation in Oklahoma. Our team obtained perfect scores in our readiness review from the state, and we are thrilled to be serving Oklahomans statewide as of April 1."
},
{
"speaker": "",
"content": "Finally, our improved operational agility also allowed Centene to mobilize quickly in support of our members and provider partners in the wake of the Change Healthcare cybersecurity incident. This included launching a national provider outreach campaign that spans Centene's provider network across all products, Medicaid, Medicare and Marketplace, and has included targeted efforts to support those disproportionately impacted by the outage, including FQHCs, safety net hospitals, rural health clinics and behavioral health providers. We appreciate the focus on and support for last-mile providers from HHS and CMS throughout this process as these clinicians represent a critical component of the infrastructure through which our members access high-quality health care."
},
{
"speaker": "",
"content": "Now on to our business lines. We are roughly 90% of the way through redeterminations, and our Medicaid franchise continues to demonstrate resilience as we navigate the complexities of this unprecedented process. As you can see from today's release, our first quarter membership tracked slightly higher than our expectation at Investor Day in December. Overall, we continue to be well guided with respect to membership and rate by the projection model we built state by state more than a year ago and that we continue to refine as we move through the redeterminations process."
},
{
"speaker": "",
"content": "As we've noted before, 2024 represents an important year for blocking and tackling through acuity shifts and corresponding rate discussions with our state partners to ensure we are positioned to provide high-quality services for our members. We are actively engaged in that process and are seeing solid results thus far with opportunities still ahead. As we move through the remainder of the year, we expect these discussions to increasingly represent the regular back-and-forth dialogue we maintain with our state partners in the normal course of managing the dynamics around each individual Medicaid program we serve."
},
{
"speaker": "",
"content": "At the same time, we have been executing on important reprocurements, and the early months of 2024 delivered notable data points. Most of the key RFP results are now public, positioning us well to generate continued Medicaid growth in a post-redeterminations world. Centene reprocured one of our largest contracts with the recent announcement of intended awards by the state of Florida. Although the protest period is ongoing, Centene is well positioned based on Florida's determination that Sunshine Health is among those that will provide best value to the state."
},
{
"speaker": "",
"content": "In Michigan, we were thrilled to be selected to continue serving the vast majority of our existing membership with some opportunity to grow. And we look forward to our continued collaboration with the state."
},
{
"speaker": "",
"content": "In Texas, our protest remains ongoing. We are honored to have served Texans for 25 years and intend to defend Superior Health's ability to provide access to affordable and high-quality health care for our members in the Lone Star state."
},
{
"speaker": "",
"content": "We are proud of the way our health plans and business development team have delivered so far during this critical cycle of reprocurements. The Centene value proposition remains a powerful one, built on more than 4 decades of experience serving Medicaid communities, an unwavering local approach and a commitment to innovation in the services and support we bring to our members. We are honored to provide access to care as well as community-based support to improve the lives of those we serve in 31 states across the country."
},
{
"speaker": "",
"content": "Moving to Medicare. The Medicare Advantage macro landscape remains challenging. Consistent with our prior view, we see final 2025 funding levels as insufficient with respect to general medical cost trend expectations. Drew will provide some early commentary around our strategy to navigate Medicare in 2025 as a result."
},
{
"speaker": "",
"content": "Medicare Advantage STAR ratings remain the single most powerful lever to drive performance in this vital business and continue to represent a top priority across the organization. As we drive to our goal of 85% of members in 3.5 STAR contracts by October of 2025, we continue to see improved progress and stability in our performance and expect those to be reflected in our results come October."
},
{
"speaker": "",
"content": "We are tracking year-over-year improvements in our core operations as well as in the ways we support our members as they receive care. And we are carrying forward this positive momentum into 2024 as our teams are clearly focused and aligned on quality."
},
{
"speaker": "",
"content": "Longer term, Medicare Advantage remains an important business for Centene. The strategic link between Medicare and Medicaid has only become more explicit since our last earnings call. Recent CMS rule-making included final requirements to better coordinate dual special needs plans, or D-SNP, participation with important milestones beginning in 2027. By the end of the decade, a Medicaid footprint will be a prerequisite to D-SNP growth. Centene is perfectly positioned to gain positive momentum from this growing bond between Medicare and Medicaid."
},
{
"speaker": "",
"content": "Finally, Marketplace. This business continues to represent a unique and powerful growth segment for Centene, and our teams are executing well against the opportunity. With approximately 4.3 million Marketplace lives at the end of the first quarter, Centene's Marketplace membership has more than doubled in size compared to just 2 short years ago. This exceptional growth has been accompanied by consistent margin expansion as our deep product knowledge and staying power in the market enable us to forecast pretax margins well within our targeted range of 5% to 7.5% for 2024."
},
{
"speaker": "",
"content": "We are pleased with the traction our Ambetter health products are generating and see additional room to expand the reach of Health Insurance Marketplace offerings overall. In 2024, the source of our membership growth is widely diversified. Based on a survey we conducted following open enrollment, nearly 40% of new members identify as previously uninsured. Approximately 25% joined us from another Marketplace carrier, and approximately 10% chose Ambetter after losing access to an employer-sponsored plan. This is in addition to those members who selected Ambetter after losing Medicaid coverage."
},
{
"speaker": "",
"content": "As we look to the future of Marketplace, we expect new member growth to be driven by an increasingly addressable and accessible uninsured population and the evolution occurring as employers consider alternative options for providing employer-sponsored insurance."
},
{
"speaker": "",
"content": "Centene has been rapidly evolving as an organization over the last 2 years. We have been resolute in creating focus, trimming the organization down to the core strategic assets that give us the strongest platform for future growth. We are executing against our strategic plans, fortifying and modernizing our infrastructure and successfully delivering access to affordable, high-quality health care for millions of Americans. Our strong first quarter results demonstrate the power of our diversified earnings drivers as we deliver on our financial commitments, maintain our posture of disciplined capital deployment and continue to invest to support long-term growth."
},
{
"speaker": "",
"content": "As always, we want to thank our nationwide workforce of nearly 60,000 for showing up every day committed to improving the lives of our members and transforming the health of the communities we serve. This CenTeam is the engine that ultimately powers our results and amplifies our impact."
},
{
"speaker": "",
"content": "With that, let's turn the call over to Drew for more details around our performance in the first quarter and our updated financial outlook for 2024. Drew?"
},
{
"speaker": "Andrew Asher",
"content": "Thank you, Sarah. Today, we reported first quarter 2024 results, including $36.3 billion in premium and service revenue and adjusted diluted earnings per share of $2.26 in the quarter, 7% higher than Q1 of 2023. This result was better than our expectations, and we are increasing full year 2024 adjusted EPS guidance by $0.10 to greater than $6.80. This quarter is a good example of the benefit of a diversified business with multiple levers to drive results."
},
{
"speaker": "",
"content": "Our Q1 consolidated HBR was 87.1%, which is right on track for our full year guidance. Here's an example of the benefit of that diversification since we provide you with transparency into the line of business components. Medicaid at 90.9% was a little higher in the quarter than we expected as we continue to work through the appropriate matching of rates and acuity in the short term. Redeterminations are certainly front and center in the acuity rate match process, but getting the right match for other circumstances such as states changing pharmacy programs or behavioral health practices are also important initiatives in a handful of states."
},
{
"speaker": "",
"content": "On the other hand, our commercial HBR at 73.3% was a little better than we had planned in the quarter driven by the continued strength of our Marketplace business. And our Medicare segment at 90.8% was right on track in the quarter. All of this netting out to 87.1%, a good result."
},
{
"speaker": "",
"content": "Going a little bit deeper into each of our business lines. Medicaid membership at 13.3 million members was slightly better than the 13.2 million members we forecasted as of Q1 -- for Q1 as of our Investor Day. Drivers of membership for the remainder of the year include, one, new wins such as Oklahoma and Arizona LTSS; two, the return of slight growth in markets once redeterminations are complete, plus the rejoiners dynamic; net of, three, the substantial wind-down of redeterminations over the next 3 to 4 months. Upon reforecasting the sloping of membership and revenue for 2024, including Q1 membership being a little bit higher than planned, we added $1 billion of Medicaid premium revenue to our 2024 guidance. The overall composite rate is running a little above the 2.5% we last referenced, and we have over 75% member month rate visibility into the 2024 calendar year."
},
{
"speaker": "",
"content": "Regardless of the temporary work to match rates and acuity, our long-term goal remains to return to the high 89s HBR as we look out over the 2025, 2026 time frame. All things considered, we are pretty pleased with the performance of our Medicaid business 1 year into a very complex redetermination process. And as Sarah covered, we cannot be more pleased with our performance in recent Florida and Michigan Medicaid RFPs. The Texas protest process still needs to play out."
},
{
"speaker": "",
"content": "Our commercial business performed very well in the quarter in terms of both growth and HBR. Consistent with previous comments, we grew from 3.9 million Marketplace members at year-end to 4.3 million at the end of Q1. For the past 2 years, we have consistently delivered a combination of growth, coupled with improving margin. Our guidance assumes that we stay at 4.3 million Marketplace members for the rest of 2024. If we can grow during the special enrollment period, which we've been able to do in the past 2 years, there would be upside to our premium and service revenue guidance. So stay tuned."
},
{
"speaker": "",
"content": "Our current 2024 guidance assumes about $16 billion of Medicare Advantage revenue, representing 12% of total premium and service revenue guidance, and approximately $4 billion of PDP revenue. I previously mentioned at a conference that Medicare inpatient authorizations were higher than expected in January and February. March authorizations ended up being lower than February, though still elevated from Q4. And Medicare outpatient trend continues at the elevated level we first saw in Q2 of 2023, though reasonably steady."
},
{
"speaker": "",
"content": "Nonetheless, the performance in the quarter for the Medicare segment was in line with our expectations, and our full year view has not changed. We had good performance with our new pharmacy cost structure and executed well on other operating levers."
},
{
"speaker": "As we look ahead, I feel like we are making 2025 decisions with our eyes wide open",
"content": "inpatient and outpatient trends, complex pharmacy changes from the Inflation Reduction Act, an insufficient 2025 rate environment based upon the final rate notice and a risk model being phased in beginning in 2024 that is punitive to partial and full duals. It also seems like many of our peers should have more religion in setting benefits at sustainable levels given these headwinds."
},
{
"speaker": "",
"content": "I'll repeat what I said on the mic at a conference in March. To accomplish our strategic goals with our Medicare Advantage business, it doesn't matter if we ultimately level off at $14 billion, $15 billion or $16 billion of Medicare Advantage revenue. What is strategically important is the alignment with Medicaid and those complex populations we want to serve, especially given where the puck is heading with regulations pulling duals and Medicaid closer together. We're still in the process of making 2025 county-by-county decisions, and we'll finalize and submit Medicare bids in early June. So we'll provide you with more 2025 Medicare commentary on our Q2 call."
},
{
"speaker": "",
"content": "We expect Medicare to be a good business for us in the long run, and it's an important part of our overall portfolio. We need to deliver on STARS improvements, clinical levers and SG&A actions over the next few years, and those efforts remain on track."
},
{
"speaker": "",
"content": "Going to other P&L and balance sheet items. Our adjusted SG&A expense ratio was 8.7% in the first quarter, consistent with our updated mix of business, including growth in Marketplace. Cash flow used in operations was $456 million for Q1, primarily driven by net earnings, more than offset by the timing of risk corridor payments, a delay in March's premium payment from one of our large state partners subsequently received in early April and slower receipt of pharmacy rebates as we transitioned to a new third-party PBM in January of 2024."
},
{
"speaker": "",
"content": "From January 1 through mid-April, we repurchased 3.4 million shares of our common stock for $251 million. Our share repurchase goal for 2024 is unchanged at $3 billion to $3.5 billion. Our debt to adjusted EBITDA was 2.9x at quarter end, consistent with year-end. And during Q1, we were pleased to maintain our S&P BBB- rating under the updated S&P rating model."
},
{
"speaker": "",
"content": "Our medical claims liability at quarter end represented 53 days in claims payable, down 1 day from Q1 and Q4 of 2023. DCP was actually up due to Change Healthcare claims receipt delays, then back down due to an acceleration of state-directed payments to providers and lower pharmacy invoices outstanding at quarter end. You'll see in the reserve table that our 2024 Medicare Advantage PDR is up $50 million in the quarter. This progression in the 2024 PDR was expected and planned for due to quarterly seasonality in Medicare Advantage."
},
{
"speaker": "",
"content": "Though it's early in the year, we are comfortable adding $1 billion of premium and service revenue and $0.10 of adjusted EPS to our 2024 guidance. You'll also see some mechanical changes to total revenue driven by pass-through premium taxes and the GAAP effective tax rate due to the Circle divestiture. We also expect investment income to be a little bit above our previous forecast of $1.4 billion while still providing for a few rate cuts in 2024."
},
{
"speaker": "",
"content": "Q1 was a quarter of momentum. We put another quarter of redeterminations behind us. We reprocured one of our largest contracts and are well positioned in Florida. We executed well in the Marketplace annual enrollment period and put up a strong quarter of both growth and margin. We delivered on the January 1 PBM conversion, and our businesses and customers are benefiting from an improved cost structure. We continue to advance our multiyear operational improvements, and Centene continues to attract talent. And all of this resulted in strong Q1 results and increased 2024 guidance."
},
{
"speaker": "",
"content": "While there is plenty more to achieve, we are off to a good start in 2024."
},
{
"speaker": "",
"content": "Thank you for your interest in Centene. Rocco, please open the line up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Today's first question comes from Kevin Fischbeck with Bank of America."
},
{
"speaker": "Kevin Fischbeck",
"content": "I just wanted to go into your margin commentary on the exchanges because, I guess, from our expectations too, it came in a little bit better. I guess that's the fastest-growing part of your business, which always potentially lowered the visibility into claims receipts. And obviously, you had a change going on at the same time. So I mean, I guess, how comfortable are you -- or what points do you look at to give you comfort that, that MLR outperformance is true and durable rather than potentially some issue around rapid membership growth or change disruption?"
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, Kevin. I think 2 important points there. One is just the confidence in the overall HBR. And I think as we look back over the last 2 cycles, we have seen rapid growth in the market overall and, obviously, growth in our book. It's more than doubled in the last 2 years. And I think we've tracked very well to the HBR implications of that. So understanding where SEP growth may have pressured margins in year, but then the fact that the sophomore effect of that growth that we accumulated last year starts to play out this year is consistent with our expectations."
},
{
"speaker": "",
"content": "So again, I think the team has demonstrated a really solid ability to track the moving parts, which gives us confidence in the performance of that book. We've also, as we've talked about in the past, implemented a really strong program around clinical initiatives. And so that has continued to mature, which I think also helps overall management of the book."
},
{
"speaker": "",
"content": "And then relative to the visibility on change, maybe I'll just hit that sort of broadly because I think that question probably applies across lines of business, and as I said in my remarks, just incredibly proud of how the teams mobilized here in our response, demonstrating operational agility prioritizing member access to care and then a huge push around getting out to providers and finding every way possible to get them reconnected as fast as possible so that they could get paid and they can support our members, which is priority #1. And then, of course, we can have the visibility that we need."
},
{
"speaker": "",
"content": "And on that point, throughout that process, we had very solid visibility from an inpatient perspective because [ OPPS ] were not disturbed at any point during that process. Centene also has a long-standing practice of using received claims, not paid, which Drew has talked about before. And so outpatient visibility was good coming into that incident on a relative basis and then being able to catch up quickly as a result of providers reconnected. So the highest point, we were missing mid-teens percentage of our claims. So by the time we closed the quarter, the impact was very modest, and we accounted for that in our financial processes."
},
{
"speaker": "Operator",
"content": "And our next question comes from Stephen Baxter at Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "I wanted to ask about the revised premium and service revenue guidance first. It seems like based on what you saw in the first quarter that you'd annualize to something closer to around $145 billion versus the revised guidance of $137 billion. So wondering if there's anything we should be keeping in mind. Just as another kind of call out, the Medicaid premiums in the quarter were well above our model. So I don't know if there's anything there that's influencing it."
},
{
"speaker": "",
"content": "And then from the Medicaid MLR perspective, how are you thinking about Medicaid MLR progression through the year from the starting point and the factors that are influencing that?"
},
{
"speaker": "Andrew Asher",
"content": "Yes, Stephen, in Q1, we did have a fair amount of state-directed payments. In fact, some states, we believe, in response to the Change incident, accelerated a number of those. That actually also had about a 20-basis-point impact on our Q1 Medicaid HBR relative to our expectations of a normal level of state-directed payments. So that also showed up in our premium revenue. So you can't quite annualize Q1."
},
{
"speaker": "",
"content": "And there could be a little bit more -- we expect a little bit more redetermination attrition through Q2, maybe a little bit into Q3. But then on the flip side, we've got some growth coming in as well. So that would be the progression of Medicaid revenue throughout the rest of the year."
},
{
"speaker": "",
"content": "Medicare, probably a little bit more attrition throughout the year as we prepare for our 2025 bids and the bid decisions we're going to make in terms of where we want to emphasize, where we want to deemphasize products, PBPs, states, age contracts for '25. So we will probably have a little bit more attrition in Medicare Advantage as planned throughout the year. So those are some of the things to think through."
},
{
"speaker": "",
"content": "Marketplace, we're assuming flat at 4.3 million members. Hopefully, there is some upside there, to your point, in premium and service revenue if we can grow during the SEP. But we just didn't want to bet on that in guidance."
},
{
"speaker": "",
"content": "You also asked about Medicaid HBR. Yes, so we came in at 90.9% for the quarter. We definitely expect 20 of that sort of being pressed on by the state-directed payments above our expectations. But we've got some work to do. We've got initiatives to drive down the HBR from the Q1 level. Remember that half of our rates -- about half of our rates show up in that 7/1 to 10/1 time frame. I think that's a little bit higher distribution than the industry broadly in Medicaid. But so far, so good there in a number of cases."
},
{
"speaker": "",
"content": "And there's always states where we've got to make sure that we're presenting the data, whether it's a PBM carve-out or behavior health costs and changes in state practices that we're getting paid for that, but that's more normal course stuff. So we do expect to drive down that 90.9% throughout the rest of the year."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Justin Lake with Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "First, I just wanted to ask given your update here, where do you expect your exchange margins to come in this year relative to your 5% to 7.5% target? And then more broadly, on your PDP strategy, right, they're getting a lot of questions here. There's a ton of changes coming in 2025."
},
{
"speaker": "",
"content": "Drew, would love to understand kind of how you see the moving parts for 2025. And maybe you could just tell us if you're going to take on a lot more liability, you're going to have to price up for things like bad debt. Can you tell us if -- even if your membership didn't change, how much more premium would you have? Like, how much premium do you have in '24? And then how much would you have in 2025 in terms of Part D premium? Just so we could think about the order of magnitude at flat membership."
},
{
"speaker": "Sarah London",
"content": "Thanks, Justin. Yes, as we said before, our expectation for Marketplace is that we will be well within our target 5% to 7.5% range in 2024. That has not changed."
},
{
"speaker": "",
"content": "And then I'll let Drew get into the details on PDP."
},
{
"speaker": "Andrew Asher",
"content": "Yes. So PDP, and I hit this at the Barclays conference, which -- for which the replay is available. But let me go over more of this because it's a really good question. And you're right, the impact of the Inflation Reduction Act, we had some of that this year in '24 -- 2024. But the real larger change is coming '25, to your point, Justin. So for '24, the direct subsidy went up for the first time since 2010, and it went from $2 to $29. And to your point, that drives revenue yield because the direct subsidy is what the federal government pays to the payer based upon all the payers' bids."
},
{
"speaker": "",
"content": "And so for '25, we actually think, now that we've gotten risk scores by member since that March conference, we can rip through the mechanics of cost share and the changes around how quickly the members can get to the maximum amount of pocket, it's likely more than $100 increase to that $29. And that's driven by, to your point, the catastrophic phase going from 20% to 60%. So we're underwriting that now. And the good news is we've been in this business since 2006. We've got all the data. So we're just taking a slice of risk that we've been administering anyhow."
},
{
"speaker": "",
"content": "I mentioned the member out of pocket. You had to think through that and any behavior changes in the members. Very good point on the bad debt. Hopefully, people are thinking about that, the MPPP program, where the members can essentially smooth out the cost share. You do have to assume, yes, some bad debt. We've got data from our Marketplace business that we're using to triangulate where we think that should be bid. And then manufacturer behavior with all the changes to the IRA impacting manufacturers, thinking about what they might do with some of their behaviors."
},
{
"speaker": "",
"content": "So you're right, all of that goes into the bid process, and it should drive the direct subsidy up significantly, which will drive the yield up. And we will think about the balance between membership retention in PDP because you're right. Naturally, that business is going to grow a fair amount from a revenue standpoint based upon the direct subsidy going up. So thanks for asking about that."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Josh Raskin with Nephron."
},
{
"speaker": "Joshua Raskin",
"content": "I wanted to go back to Medicare Advantage and 2025 bid strategy with an understanding you're not going to submit your bids for another couple of months here. But would that allusion to $14 billion, $15 billion or $16 billion a suggestion that you would expect membership to be sort of flat to down based on what you know today? And then do you expect to book another PDR in terms of where you think margins would be for next year?"
},
{
"speaker": "",
"content": "And then lastly, I heard some commentary. I don't think we've heard this before, sort of depending the idea that Medicare Advantage is still an important segment. But is there a scenario where MA is not a core operating business for Centene? I understand the advantage with the Medicaid footprint becoming more important. But is there a scenario where just contribution to earnings and even revenues is not large enough to justify the infrastructure?"
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, Josh. Maybe I'll take the last question first and say that as we look at the landscape today the -- again, the tie between Medicare and Medicaid and what that produces in terms of long-term growth opportunity, we see as very compelling. And so we're always evaluating how the landscape changes, but we're very committed to rebuilding our Medicare franchise focused on the low-income complex members and using that to drive growth across both lines of business. Obviously see opportunity for earnings contribution and then longer-term growth in that business."
},
{
"speaker": "",
"content": "Relative to 2025, certainly a more challenging rate environment than I think most might have expected. But again, we're really focused on building a high-quality sort of durable franchise that will allow us to remain agile as the landscape shifts. What hasn't changed for us is -- and the things that we can control are STARS, as Drew said, the biggest lever being 2/3 of performance improvement for Medicare and then SG&A and clinical initiatives, which we remain focused on and are on track."
},
{
"speaker": "",
"content": "Obviously, too early, as you said, to discuss bid strategy. But we do continue to see volume as the lever as we sharpen the focus of the book, position to support those quality improvement efforts and make county-by-county decisions to improve profitability. I think it's also too early to weigh in on a PDR, but we're obviously taking into account all of the factors as we think about the guidance that we set and sort of the balance of the year as we come through finalizing those decisions over the next 6 to 8 weeks."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Andrew Mok with Barclays."
},
{
"speaker": "Andrew Mok",
"content": "Just wanted to follow up on the Medicare MLR. And just given the strong growth in PDP combined with the strong MLR seasonality of that business, can you give us a sense for underlying trends there and how that's supposed to impact the balance of the year on the Medicare MLR?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. You're right on seasonality of the PDP business in our Medicare segment. So unlike a commercial business where you got deductibles in the beginning of the year and your HBR goes up through the year, it's the opposite in PDP. So we still feel good about the range around 90% for our Medicare segment HBR for the full year."
},
{
"speaker": "",
"content": "Underneath that trend, outpatient still elevated but consistent with that higher level since Q2 of '23. And we've got assumptions of that perpetuating throughout '24 embedded in our forecast. Inpatient, as I said earlier, a little bit of a tick-up in authorizations in January, February. It's good to see a little bit of relief in March relative to February, but still elevated relative to Q1. So we've thought about that going forward as well."
},
{
"speaker": "",
"content": "And then we've got good performance in Medicare. There's other clinical initiatives that we've been able to execute on and getting paid the right amount of revenue as well that have helped sort of curtail some of that inpatient authorization. So I feel pretty good about Q1 and expect that to sort of carry on through the year."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Nathan Rich at Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"content": "I wanted to stick on Medicare Advantage. I guess, I think duals are about 1/3 of your membership right now, and obviously, you highlighted the opportunity there. I guess could you give us a sense of maybe where margins are currently on that population relative to nonduals and when -- if you're thinking about changes that need to be made in terms of bid design for 2025, how you're approaching that population given the prioritizing and serving this population longer term?"
},
{
"speaker": "Sarah London",
"content": "Yes, Nathan, thanks for the question. So we -- and we talked about this a little bit earlier this year, but we intentionally came into the 2024 cycle redesigning our product offerings with the duals population, again, low-income complex population more broadly in mind. And we're really pleased with how the team executed during AEP. And that is inclusive of product design, but it's also being really thoughtful about what distribution channels best reach those members and the experience that really drives loyalty among that population."
},
{
"speaker": "",
"content": "And so saw an uptick in the concentration of duals in our overall population in this AEP, consistent with what we were looking for. And I think that bodes well in terms of our team's ability to really understand that population to leverage the local knowledge that we have and that synergy across the Medicaid and Medicare population in serving these members, those local community resources that matter in terms of driving health outcomes."
},
{
"speaker": "",
"content": "So all that is to say, I think it bodes well in terms of being able to design products as we go into the 2025 cycle and drive further focus in the book on that population to continue to yield those members to whom we feel like we're going to deliver the best value over the long term."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Sarah James at Cantor Fitzgerald."
},
{
"speaker": "Sarah James",
"content": "I wanted to go back to Medicare. So given where rates came out and your evolving strategy around overlapping footprint, do you still think the couple of hundred basis points of SG&A leverage on Medicare is the goal point? I think you guys rolled that out at I-Day. And then how do you think about the SG&A framework for your Medicare business overall? Because typically, I think about it being a couple of percent higher than Medicaid would run. But given the scale that you're targeting, is that still a fair ballpark for where the overhead costs would run for that business unit?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. So you're right. We need to take out, I said, at least 200 basis points of SG&A over the next few years to be -- to get to sort of where we want to get to in Medicare Advantage. And the plans are on track to do that. Think about -- WellCare had well below 1 million members, well below 1 million members when WellCare came into the Centene combination. And WellCare was at scale and operating effectively and efficiently. So the scale -- we're not really concerned about scale issues with Medicare even as we expect a little bit more attrition as we prioritize the strategic goals of being in Medicare and the tie-in to Medicaid, to your point, the footprint matching up as well as prioritizing margin recovery over the next few years, driven predominantly by STARS but other levers like SG&A that we're talking about here and clinical initiatives."
},
{
"speaker": "",
"content": "So it's certainly a much higher SG&A ratio than Medicaid because you've got distribution costs and open enrollment costs and things like that. And Marketplace is actually a little bit higher than Medicare itself. So that does mechanically work its way into our SG&A rate. So we're not concerned about being subscale in Medicare Advantage. We want that business to sit side by side with our Medicaid business to seize the opportunities of the future later on in the decade, and we'll power through 2025, even if that means some attrition."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Gary Taylor at TD Cowen."
},
{
"speaker": "Gary Taylor",
"content": "Actually, I just kind of wanted to follow up, I guess, on that last comment for just a second. We're just looking at total employees down 12% sequentially, 8,000 sequentially. I was just trying to think through what the implications are sequentially into 2Q, 3Q in terms of G&A or even some of those employees might be medical support in the [ MedEx ] line."
},
{
"speaker": "",
"content": "And then just my second question would be just to clarify on the -- when we see the $50 million additional PDR for Medicare in the 10-Q, is that an additional $50 million that ran through the P&L this quarter and impacted the reported EPS and weighed on the reported Medicare MLR this quarter?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. Good questions. Most of the change in the employee base is the divestiture of Circle. That was pretty employee-intensive in Great Britain. So that was a result of divestiture. Although we are constantly managing the right amount of resources, it's our job to, on behalf of taxpayers, on behalf of the federal and state governments, managing efficiently, matching resources with the business that we have and trying to do that efficiently and effectively. But that big move was due to divestiture."
},
{
"speaker": "",
"content": "And you're right, the $50 million, while we expected it as we mapped out the seasonality of Medicare during the year, and that has the PDR sort of pushing up a little bit in Q2, maybe a little bit more in Q3 and then being relieved completely relative to the 2024 policy year in Q4, that $50 million did hit the P&L. It did make its way into the loss ratio for the Medicare segment. But it was exactly as -- it was as planned, so it wasn't a surprise to us."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Cal Sternick with JPMorgan."
},
{
"speaker": "Calvin Sternick",
"content": "I had a couple of clarifications. First, on Medicaid, did you see fewer disenrolled members than you anticipated in the quarter? Or was there a higher reconnect rate? Just curious if you could give a little more color on what the drivers of the higher membership were in the quarter and how do you see those developing over the rest of the year relative to that 13.6 million membership number you previously guided to."
},
{
"speaker": "",
"content": "And then second, on the Medicare -- on the Medicaid composite rate, the 2.5%, just want to clarify, is that the core is running a little bit better than you expected? Or is that 2.5% inclusive of the accelerated state payments?"
},
{
"speaker": "Andrew Asher",
"content": "Yes. On membership, we still expect to be in that mid-13s by year-end. And so I think 100,000-member difference on 13 point -- to 13.3 million, some may call rounding, but luckily, it's rounding in the right direction, right? But it's probably more timing of precision around redeterminations, and some of that will carry into Q2. And there's even a few states that will tail off into Q3 as they've stretched out the redetermination process. But all of that is in the mid-13s estimate of membership by year-end, which includes a couple of nice growth opportunities too that we seized, Oklahoma, which commenced 4/1. And as you heard in Sarah's remarks, that went really well operationally. And then subject to protest, the Arizona LTSS win, low membership but high revenue."
},
{
"speaker": "",
"content": "And then your question on composite rate, the 2.5%, yes, we're a little bit above that. And that's sort of an all-in view of a composite rate, whether the rate relates to acuity, whether the rate relates to redeterminations or just general trend."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Scott Fidel with Stephens."
},
{
"speaker": "Scott Fidel",
"content": "Just had a couple of modeling questions that would be helpful. One, just on investment income, if you can sort of walk us towards what you view as sort of the run rate for the second quarter and for the balance of the year. I know there were a few gains included in the first quarter investment income. And then also on operating cash flow, obviously that was noisy in the first quarter for the reasons you mentioned. If you wouldn't mind just giving us an update on the full year CFFO expectation and then how you're thinking maybe about the second quarter given that you did get that state payment came in, in April."
},
{
"speaker": "Andrew Asher",
"content": "Yes. Investment income, if you peel away gains, we disclosed those throughout the Q, which we just filed. So understandably, you haven't ripped through that yet. You get a little bit over $400 million in the quarter. But you can't just multiply that by 4. We expect the full year to be above -- a little bit above the $1.4 billion that we guided to at Investor Day. But the difference between that and just annualizing is we've got multiple rate cut scenarios built into our forecast. Maybe those play out to be conservative, but the Federal Reserve will decide that."
},
{
"speaker": "",
"content": "You also saw that we had a lot of payables. Look at our balance sheet, we relieved a lot of payables in the quarter. We accelerated state-directed payments on behalf of our providers. So obviously, when you relieve payables and you're building up pharmacy rebate receivables, that has an impact on investment income as well. But pleased that we're going to come in -- we expect to come in a little bit above that $1.4 billion."
},
{
"speaker": "",
"content": "On the operating cash flow, as you know, in this business that bounces around quite a bit. A large state decides pay us on 4/2 versus 3/31, and you have a big flip between quarters. Just mentioned some things that impact cash flow as well, the timing of pharmacy rebate receivables or payable invoices. So it's sort of maybe a fool's errand to try to predict that quarter-to-quarter in terms of how that will play out. What really matters in this business is the dividends from subs, the cash flow, not only GAAP cash flow statement but the cash that comes from subsidiaries to parent such that we can deploy capital. And we expect that to pick up, as you'll see in the Q, over the next few quarters. And that will drive our capital deployment later in the year for share buyback and some debt -- a little bit of debt reduction as well. So that's what we're looking forward to."
},
{
"speaker": "Operator",
"content": "And our next question today comes from A.J. Rice at UBS."
},
{
"speaker": "Albert Rice",
"content": "A couple of quick things here. Appreciate the reiteration of the long-term target of the high 89s for your Medicaid HBR. I wondered, if you think you're finishing up on redeterminations largely in the second quarter, the disenrollments and maybe a little spills in the third quarter, when do you think you get visibility once and for all on how that whole process has impacted the risk pool? And are you still thinking -- I think at Investor Day, you said that you could get 30 basis points of margin improvement '24 and '25 in Medicaid. Is that still your thought at this point?"
},
{
"speaker": "Sarah London",
"content": "Yes. Thanks, A.J. You're right. So we're 9 -- roughly 90% of the way through redeterminations from a membership standpoint. Obviously, the cumulative member months impact sort of trails that a little bit. And we do think that the tail of membership will run through Q2 and Q3 and sort of largely be complete by that point."
},
{
"speaker": "",
"content": "I would say the nice thing is that I don't think that we have seen -- we've not had to wait to see sort of the shifting risk pool. We've been watching that really closely, and that's part of the preparation of the team did leading into this process over a year ago, which allowed us to have those proactive modeling conversations with our state partners through the rate cycles in the last year. And we're mirroring that same process as we move through the rate updates that Drew talked about between 7/1 and 10/1."
},
{
"speaker": "",
"content": "And so really sort of trying to address the bolus of any dislocation between rate and acuity in that cycle, but obviously leaving open, as we said before, the idea that some of that tailwind of margin will get picked back up in '25 and possibly trailing a little bit into '26. And that's where we see the recovery in terms of that basis point on the margin."
},
{
"speaker": "Operator",
"content": "And our next question today comes from Dave Windley with Jefferies."
},
{
"speaker": "David Windley",
"content": "So just maybe a brief one on that last comment, last point. On the rate visibility, I think you called out 75%. You talked about matching acuity which, Sarah, you just commented on. Is the matching of acuity and getting those payments squared up, is -- should we think about that being in the remaining 25% that you don't have rate visibility on yet? Or are you expecting some amount of kind of retro catch-up from states where you actually have already had rate discussions? And just kind of understanding the mix of that is what I'm hoping to do."
},
{
"speaker": "Sarah London",
"content": "Yes -- okay."
},
{
"speaker": "Andrew Asher",
"content": "Okay. Sorry. The 75% is a member month view of what we know for the 2024 calendar year member months, and the 25% would be there's 7/1 rates we don't know. We certainly don't know 9/1 or 10/1 rates, but they have a limited impact on the 2024 calendar year. To the macro point, we need -- ultimately, we're going to need to have rates match acuity, and that -- we expect that to shake out. It may not be perfect in this rate cycle, which means sort of the 2025, 2026 time period is when we would expect to get back into the high 89s based upon today's mix of business."
},
{
"speaker": "",
"content": "So there might be a couple of retros. It seems like different companies have different definitions of retro. We're only waiting on a couple of retros. There might be adjustments going forward where the state realizes and their actuaries, \"Hey, we missed the mark last time. Let me fix this going forward.\" But we are still expecting a couple of retros as we talked about at Investor Day and on the Q1 call."
},
{
"speaker": "",
"content": "But it's largely getting the rates correct and matching acuity going forward. And that's why we're not expecting to move into the -- back into the high 89s immediately. It may take a rate cycle or so. But that does remain a margin expansion opportunity. On a company that's performing well on a consolidated basis, actually that creates some capacity for margin expansion in Medicaid as we look at '25, '26."
},
{
"speaker": "Sarah London",
"content": "Yes. And the only thing I would add, which is just that as we've watched the team sort of work through the complexity of this process where we have encountered those targeted dislocations, I've just been really impressed with how our teams have stepped up to that dialogue. There is clarity on the drivers. It's a very data-driven approach. They've clearly built really solid collaborative dialogue with our state partners and are really solutions-oriented in how they step into those conversations. And so I think building credibility with our state partners as we work through this process has been consistent throughout and, I think, again sort of creates the framework to get back to a matching state and get that tailwind opportunity."
},
{
"speaker": "Operator",
"content": "And our next question today comes from George Hill with Deutsche Bank."
},
{
"speaker": "George Hill",
"content": "Just 2 quick ones for me. I guess as you talked about the progress and the STARS goals for 2025, I would just love, at a high level, if you could talk about kind of the strategy and the progress towards achieving that goal. And Drew, as you were talking about kind of all the changes to Part D for 2025, I didn't hear you talk about the new Part D risk model. I would just be interested if you could make quick comments on how you think the new risk model in Part D kind of impacts the ability to drive revenue in that part of the business."
},
{
"speaker": "Sarah London",
"content": "Sure. Thanks, George. So quality, obviously a top priority for the organization regardless of line of business. But we remain very focused on STARS because of the impact it has for the Medicare trajectory. Very pleased with the work underway, engagement across the organization. We're leveraging a comprehensive governance process, and that has given us great visibility in terms of progress on initiatives at a detailed level."
},
{
"speaker": "",
"content": "Based on what we know today, we believe that we have maintained last year's progress and made additional advancements on admin and ops programs and metrics, which, you'll remember, was sort of the focus in the first cycle. And then in this past cycle, HEDIS and CAHPS were most in focus for us. We're in the middle of those processes. Those will wrap up in the next 30 to 60 days. We also have TTY that's still in flight."
},
{
"speaker": "",
"content": "So those are the last pieces that will land here towards the end of Q2 and then allow us to sort of rerun projections with a high degree of -- higher degree of confidence as we look to October. And so expect more detail in terms of what we're looking for in October on the Q2 call. But overall, just really pleased with how the team continues to show up, and again, alignment across the organization that this is a critical priority."
},
{
"speaker": "Andrew Asher",
"content": "Yes. And you're absolutely right. The risk model bifurcation between PDP and MAPD, that's a factor as well that needs to be worked into the bid cycle. And I think I did mention that we were able to run risk scores by member and the mechanics and how that rips through the -- not just the risk scores but also the timing of members with cost share and getting to the maximum out of pocket, or the MOOP. Those are all important things to think about. And really, the message is -- that's why there's reason for cautiousness for the industry in bidding PDP for 2025."
},
{
"speaker": "Operator",
"content": "And our next question comes from Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Can you talk a little bit about the PBM migration? And in particular, I was interested in if all the savings levers turned on, on January 1, if there should be a ramp of that over the course of the year with things like formulary alignment, et cetera, and if any of that might spill into '25. And maybe then as a broader question, just on your ongoing dialogues with states, how are they looking at GLP-1s and kind of adding coverage to that?"
},
{
"speaker": "Sarah London",
"content": "Thanks, Lance, for the question, mostly because I don't think I can brag enough about our pharmacy team and the phenomenal job they did in such a massive undertaking. We've talked before about how well that went, January 1. But I think everybody who's been through something that significant knows that you don't just drop the mic the next day. And so these folks have continued to work tirelessly over the last couple of months to make sure that, that process just gets smoother and smoother for our members. We've had great collaboration with ESI. And so trajectory on that front just continues to be really positive."
},
{
"speaker": "",
"content": "And then I'll let Drew talk a little bit about the step-up in the economics and some of the GLP-1 activity."
},
{
"speaker": "Andrew Asher",
"content": "Yes. So we didn't want to wait for economics. So we do have a stairstep benefit on behalf of our state and federal customers and our members as of 1/1/24. But we're constantly working with our partner at ESI to figure out ways to deliver value to our customers and manage costs. So we expect sort of normal course improvements from that point forward, and we'll continue to try to drive efficiencies in the pharmacy ecosystem."
},
{
"speaker": "",
"content": "On GLP-1s, not a lot of uptake yet by states. There's a couple of states where -- have decided to allow GLP-1s for the weight loss indication. Obviously, GLP-1s for the diabetes indication, we could see the volume coming through there. But for the weight loss indication, there's only a couple, and we're quick to go share the data with them to show them what it's costing them, but it's not that material to the company as a whole. And that's where the states control the formulary, the preferred drug list and make the decisions that we then administer and take risk for. And we just need to make sure that the states have the data so they can match rates with the cost that they choose to allow in their benefit plans."
},
{
"speaker": "Operator",
"content": "And this concludes our question-and-answer session. I'd like to turn the conference back over to Sarah London for any closing remarks."
},
{
"speaker": "Sarah London",
"content": "Thanks, Rocco, and thanks, everyone. Appreciate the time and interest this morning. Overall, we are pleased with how we're powering through a dynamic landscape and with the progress that we've demonstrated so far. So appreciate you joining us, and we'll see you next quarter."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day."
}
] |
cnp | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to CenterPoint Energy's Fourth Quarter and Full Year 2024 Earnings Conference Call with Senior Management. During the company's prepared remarks, all participants will be in a listen-only mode. There will be a question-and-answer session after Management's remarks. [Operator Instructions] I will now turn the call over to Jackie Richert, Senior Vice President of Corporate Planning, Investor relations and Treasurer. Ms. Richert?"
},
{
"speaker": "Jackie Richert",
"content": "Good morning and welcome to CenterPoint's fourth quarter 2024 earnings conference call. Jason Wells, our CEO, and Chris Foster, our CFO will discuss the company's fourth quarter and full year 2024 results. Management will discuss certain topics that will contain projections and other forward-looking information and statements that are currently based on management's beliefs, assumptions and information currently available to management. These forward-looking statements are subject to risks and uncertainties. Actual results could differ materially based on various factors as noted in our Form 10-K, other SEC filings and our earnings materials. We undertake no obligation to revise or update publicly any forward-looking statements. We reported $1.58 and $0.38 for the full year and fourth quarter of 2024 respectively, on a GAAP basis. Management will be discussing certain non-GAAP measures on today's call. When providing guidance, we use the non-GAAP EPS measure of diluted adjusted earnings per share on a consolidated basis referred to as non-GAAP EPS. For information on our guidance methodology and reconciliation of the non-GAAP measures used in providing guidance, please refer to our earnings news release and presentation on our website. We use our website to announce material information. This call is being recorded. Information on how to access the replay can be found on our website. Now I'd like to turn the call over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Jackie, and good morning, everyone. I would like to begin by extending my sincere appreciation to all of our frontline personnel that work through the unprecedented winter weather we experienced across our various service territories. We experienced sub-zero temperatures in Minnesota, freezing rain in Indiana and record-breaking snowfall in the Houston area. Through it all, our team worked to keep the lights on and the gas flowing for our customers. On today's call, I'd like to address four key areas of focus. First, I'll touch on the fourth quarter and full year 2024 financial results. Second, I'll provide a broader regulatory update, including highlights of our recently filed system resiliency plan for Houston Electric and touch on the significant progress we've made in our various rate cases. Third, I'll share an overview of the transaction we have proposed to ERCOT that we believe benefits all stakeholders. And lastly, I want to highlight the impressive growth drivers across the Houston area and how that growth informed the substantiated load filing we recently submitted to ERCOT. Now starting with our fourth quarter and full year financial results. This morning, we announced non-GAAP EPS of $0.40 for the fourth quarter and $1.62 for the full year. Chris will provide additional details of these strong results in his section. The $1.62 per share translates to 8% growth over our 2023 actual results. This is now the fourth consecutive year of meeting or exceeding our annual non-GAAP EPS guidance. It is also important to note that we have rebased our long-term growth targets off these higher earnings levels each year as we seek to deliver value for our investors each and every year. Consistent with this approach, we are reaffirming our 2025 non-GAAP EPS guidance range of $1.74 to $1.76, which equates to 8% growth at the midpoint from our delivered 2024 non-GAAP EPS of $1.62. Over the long term, we continue to expect to grow non-GAAP EPS at the mid- to high end of 6% to 8% range annually through 2030. We also expect to grow dividends per share in line with earnings growth over the same period of time. Now turning to my second key area, and update on our broader regulatory efforts, starting with our recently refiled system resiliency plan at Houston Electric. In line with our commitments, we refiled our system resiliency plan at the end of January. This filing proposes a total spend of $5.75 billion from 2026 through 2028 to improve system resiliency. $5.5 billion of this spend is related to capital expenditures. Chris will discuss the associated capital expenditure increase from our previous plan in his section, but I want to briefly touch on the system improvements we are focused on in this filing. Our plan outlines 39 specific resiliency measures that are designed to strengthen tens of thousands of miles of our transmission and distribution system. The investments included in our filing represent the largest single investment in grid resiliency in our company's history, as we work to improve the customer experience for those that live and work in higher-risk areas. As a result of our planned work through 2028, we expect that our transmission system will be fully hardened with no remaining wood structures and that nearly all substations will be elevated above the 500-year floodplain. I am proud to say that with our accelerated pace in less than a year since Hurricane Beryl, we will have more than doubled the number of circuits that have automation on our system, and we won't stop there. With our system resiliency plan in another three years, we will triple the number of automated devices since Hurricane Beryl. We estimate that our actions over the next several years will save customers more than one billion outage minutes in extreme weather events. In addition to contributing to an improved customer experience, beginning in 2029, these investments are anticipated to result in an estimated $50 million of reduced storm-related costs per year which naturally support lower electric delivery charges over the long term. As I've mentioned before, this is not the beginning of our journey to a more resilient system but an acceleration of what we started a few years ago when we targeted hardening and modernizing the electric transmission backbone as well as some of our substations prone to flood risk. We believe that these investments, combined with the other actions outlined in our Greater Houston resiliency initiative, set us on a clear path to become the most resilient coastal grid in the country. Next, I want to focus on the continued regulatory progress at Houston Electric. As many of you recently saw, we reached a settlement in our 2024 rate case. We believe that the proposed settlement is constructive for both our customers and our investors. The proposed settlement, if approved, includes an annual revenue requirement decrease of $47 million, which translates to a reduction of approximately $1 per month in the average electric delivery charge for our residential customers. It also includes an increase to both our return on equity and equity ratio. These improvements strengthen our competitiveness in the capital markets that we regularly access to efficiently fund capital investments for the benefit of our customers. This unique outcome of lower customer bills with improvements of both the cost of capital and capital structure comes despite the fact that we've increased our vegetation management spend by 45% over the last few years. It also exemplifies our ability to improve customer outcomes while also efficiently executing O&M reductions throughout the business. We'd like to thank all of our stakeholders for working together to submit to the PUCT what we believe is a constructive settlement for all parties. Beyond the rate case, we've also made progress on our traditional interim mechanisms and storm cost recovery filings at Houston Electric. Chris will provide further details regarding these items in his section. Now turning to Indiana Electric. A few weeks ago, we received a final order in our Indiana Electric rate case. The final order was approved in line with the settlement filed in May of last year, which included a total annual revenue requirement increase of approximately $80 million and a 9.8% return on equity. We believe this is a fair and balanced outcome as we have continued to invest for the benefit of our customers, while also being conscious of the impact of our capital investments on the customer bill. Our move away from older generation facilities has enabled us to eliminate nearly $40 million of O&M directly benefiting our customer bills. We also previously securitized the remaining book value of one of our aging facilities forgoing profits related to this plant for the benefit of our customers. Moving forward, we will continue to be mindful of our customer bills and the reliability needs and work with stakeholders to achieve balanced outcomes for all parties. Moving to our Minnesota Gas rate case. During the fourth quarter, we reached an all-party settlement in our Minnesota Gas rate case. The settlement includes a total revenue requirement increase of nearly $104 million for 2024 and 2025, which reflects over 75% of our proposed revenue increase of approximately $136 million. Interim rates for the 2024 increase went into effect in January of last year, and interim rates for 2025 went into effect last month. These rates closely mirror the increased revenue requirement included in the proposed settlement that is now pending a final order for the Minnesota Public Utilities Commission. The commission has a statutory deadline of July 1 to issue its final order in this case. We also want to thank all stakeholders for working together to achieve what we believe is a strong outcome for all parties. Finally, I want to briefly touch on our rate case for Ohio Gas. At the end of October, we filed our Ohio gas rate case application, which included a revenue requirement increase of $99.5 million. Over the last several years, we've had one of the lowest customer bills in the state. Our request reflects an investment recovery rate that will put us more in line with our Ohio peers. In addition, this larger revenue requirement increased will allow us to more efficiently fund and continue to prioritize pipeline modernization investments that we believe contribute to the overall safety and efficiency of the system. Before closing out my remarks on our regulatory progress, I want to put into context what has been a very busy and constructive regulatory cycle. Over the last 18 months, our teams have been busy as they have filed five rate cases. Of the five, we have received final orders in two and are awaiting approval of settlements for our Houston Electric and Minnesota Gas businesses. Together, these four rate cases represent over 80% of our enterprise rate base. Should these cases be improved in line with their current proposed settlements, we will have been able to improve our consolidated return on equity and equity ratio, which naturally increases the earnings power of the company. I want to thank all of our teams for their hard work and dedication for working with stakeholders to achieve such strong outcomes for both our customers and our investors. Now I'd like to provide an update on our proposed temporary generation transaction. Through engagement with a diverse set of stakeholders, it is clear that there is no longer a desire for transmission and distribution utilities in the state to invest in large temporary generation facilities to mitigate the impact of large load shed events. In response to this, we have worked with the same set of stakeholders to develop what we believe is a truly unique Texas solution that benefits Houston Electric customers, other ERCOT customers and CenterPoint investors. I will briefly walk through the contours of this transaction, and Chris will provide additional details related to the financial impacts. Our proposal to transfer the use of our units to a Texas Pier utility will provide a temporary bridging solution for summer peak reliability needs in the San Antonio area. We will make these units available for this purpose for up to two years, starting this spring. After that, we intend to market the 15 large units to third parties at what we expect to be prevailing higher market rates. Given current market demand, we believe that the revenues earned from marketing these units after the period that they are in San Antonio will exceed the foregone revenues during the period these units are donated to ERCOT at no cost. We truly believe this Texas solution is a win for all stakeholders. As part of this solution, we will make an unprecedented contribution of value for the benefit of the ERCOT grid. Houston Electric customers will be made whole on charges related to the large temporary units. And finally, our shareholders will receive the benefit of their investment when we take into consideration the anticipated profit from marketing after the period these units operate in the San Antonio area. We appreciate all stakeholders for providing their feedback and working collaboratively to identify this unique solution that ultimately benefits everyone. Now switching gears. I want to highlight the strong organic growth we continue to see, especially in our Texas service territories. While my earlier commentary focused on capital investments related to resiliency enhancements on our system, I want to emphasize that we continue to experience significant electric demand growth across Texas and particularly the Greater Houston area. We are proud to partner with both existing and potential new customers to support their energy needs as our region continues to experience rapid economic development. It is these discussions that have informed our estimated electric load forecast for the Houston region that we recently submitted to ERCOT. I want to briefly touch on what we included in our submission and equally important, what we excluded. Last year's ERCOT load report was largely focused on Texas electric needs outside of the Greater Houston region. We are excited to have now submitted our expected load increase for the greater Houston region this year. Like our peers, we've experienced an unprecedented level of interest in connecting to our grid. In fact, we have received approximately 40 gigawatts in load interconnection requests. Those load requests are incremental to our current peak of about 21 gigawatts. While we're actively pursuing this full set of load interconnection requests, we believe our submission is a more realistic reflection of the load growth that will materialize by 2031. Currently, we are forecasting a nearly 50% increase in peak demand from 21 gigawatts today to nearly 31 gigawatts by the end of 2031. To put that in perspective, the 10 gigawatt increase we are forecasting over the next seven years is more than the increase that Greater Houston region has experienced over the last 25 years. Our rigorous approach to forecasting load demand gives us confidence in our projections. Our outlook also benefits from the fact this growth is not driven by a single industry or theme. Houston has clearly earned its reputation as the energy capital of the world, but our types of economic expansion go well beyond this core sector. It may come as a surprise to some that today, energy constitutes only a little more than one third of the area's economy. When looking at Houston's low drivers, we see three economic activities as the catalyst for significant long-term load growth. First, Houston is a major logistics hub for the United States. Boasting the largest port by waterborne tonnage, Houston is a gateway for goods coming from and going all over the world. We forecasted opportunities for port electrification, fleet electrification and other associated projects will drive approximately 20% of the 10 gigawatt increase through 2031. Second, Houston is home to the largest medical complex in the world, and it is only growing. It continues to expand not only its offerings for patients who come from all over the globe for treatment, but continues to pioneer medical innovation and medical manufacturing. We forecasted its continued expansion as well as other commercial activities, including data centers, will drive 30% of our anticipated load growth by 2031. Third, Houston is and will continue to be at the center for energy refining and energy exports. As the global energy mix continues to evolve, Houston will play a central role in the development and exportation of that energy. This significant growth will certainly require continued and increased investments in electric infrastructure, especially with respect to the transmission system. As a reminder, Houston makes up just over 2% of the geographic area of Texas, but is approximately a quarter of ERCOT's peak load. On any given day, we import as much as 60% of the electricity consumed in the Houston area. Prior to formalizing our capital investment plans related to this immense growth, we need the feedback and final decisions from the Texas Public Utility Commission regarding the 765 kV or 345 kV standard for transmission build-outs. We anticipate further clarity on this topic by May of this year. Regardless of the direction the PUCT takes, the continued growth of the Houston area is undoubtedly a long-term tailwind and is one that is truly unique to CenterPoint. The diverse underlying fundamentals driving Houston growth gives us continued confidence in our belief that we have one of the most tangible long-term growth plans in the industry. This growth will continue to drive investment opportunities for years to come. but also provide a sustainable platform for our customers whose charges will continue to benefit from the ever-growing population. We are privileged to serve such a growing and vibrant area and look forward to continuing to partner with customers, communities and other stakeholders to further enable this truly remarkable growth. And with that, I'll hand it over to Chris."
},
{
"speaker": "Chris Foster",
"content": "Thanks, Jason. Before I get into my updates, I want to echo Jason's gratitude for not only our CenterPoint coworkers, but also the external frontline crews who aided in the restoration in Indiana and kept energy flowing for our customers throughout our various service territories. This morning, I will plan to cover four areas of focus: first, the details of our fourth quarter and full year financial results; second, I'll touch on our capital deployment execution for the year as well as our upwardly revised capital plan that now reflects our recently filed system resiliency plan and an update on our other capital investment trackers. Third, I'll go into further detail on our temporary generation proposal and the associated financial impacts; and finally, I'll provide an update on where we completed the year with respect to our balance sheet. Let's now move to the financial results shown on Slide 8. On a GAAP EPS basis, we reported $0.38 for the fourth quarter of 2024. On a non-GAAP basis, we reported $0.40 for the fourth quarter of 2024 compared to $0.32 in the fourth quarter of 2023. Our non-GAAP EPS results for the fourth quarter remove the impacts associated with the sale of Louisiana and Mississippi Gas LDCs. In the fourth quarter, these impacts included an $8 million deferred tax remeasurement reflecting a slightly lower effective state income tax rate post sale. Now taking a closer look at the quarter, growth in rate recovery contributed $0.05 when compared to the same quarter last year, which was driven by the ongoing recovery from interim mechanisms for which customer rates were updated in addition to approved interim rates related to our Minnesota Gas rate case. In addition, O&M contributed $0.05 of favorability when compared to the comparable quarter of 2023. This favorability was primarily driven by the approximately $0.03 of work that was pulled forward in Q4 of last year that we did not replicate this quarter. In addition to O&M and rate recovery, weather and usage contributed an additional $0.02 favorability quarter-over-quarter. Interest expense and financing costs were $0.03 unfavorable when compared to the comparable quarter in 2023. These $0.03 were primarily driven by the $3 billion of net new debt issuances quarter-over-quarter. And despite the headwinds we faced this year, we were still able to deliver for our investors our full year 2024 and non-GAAP EPS target of $1.62. I want to take a step back to discuss how we're thinking about O&M. Over the last few years, we've been able to reduce our O&M by nearly 2% annually. We are now committed to continuing to do more vegetation management work at Houston Electric, where we are now proposing to transition from our current five-year vegetation management cycle to a three-year cycle. This positions us well given the long seasonal growth periods and has us leading statewide in Texas and among the few in our industry that seek this level of proactive vegetation management. This more aggressive cadence will naturally reset our O&M levels in the near term. However, we will be laser-focused on continuing to take costs out of the business elsewhere and continuing to target 1% to 2% O&M reductions from these higher levels, ultimately benefiting customer charges. For example, as Jason pointed out earlier, starting in 2029, we anticipate saving roughly $50 million of storm costs annually from the investments outlined in our recently filed system resiliency plan. This overall level of execution gives us confidence in reiterating today our full year 2025 non-GAAP EPS guidance target range of $1.74 to $1.76. The midpoint of this range represents annual growth of 8% from our actual 2024 non-GAAP EPS of $1.62 as we seek to deliver value for our shareholders each and every year. Next, I'll touch on our capital investment execution for 2024, as shown here on Slide 9. In the fourth quarter of 2024, we invested $1.2 billion of base work for the benefit of our customers and communities. For the full year, we invested $3.8 billion, exceeding our 2024 capital expenditure target of $3.7 billion, and this is despite multiple diversions from performing base work due to storm restoration. As Jason touched on, our recently filed system resiliency plan includes capital investments of $5.5 billion. This updated plan results in a $500 million increase to the $47 billion capital investment plan that runs through 2030. As such, we are updating our capital investment target to $47.5 billion through the end of the decade, and we will fund our incremental capital investments consistent with our prior guidance. As such, you should assume we will fund in line with the enterprises approximate consolidated capital structure of 50% equity and 50% debt. Separately, we are back now in our more traditional rhythm of seeking ongoing capital plan recoveries using existing mechanisms. At the same time, we continue to make progress on storm recoveries. Related to those recoveries, we are focused on progressing through the securitization process here in Texas and are currently ahead of plan. That is because we have now reached a settlement in principle on our major ratio event cost. As part of the proposed settlement, we will recover 98% of the cost attributable to the storm. This is a great outcome and one that further illustrates the constructive business and regulatory environment in which we operate here in Texas. We're also still on track to make our cost recovery filing related to Hurricane Beryl in the second quarter. In addition, we continue to advance on our capital recovery mechanisms at Houston Electric. During the fourth quarter, we filed both our transmission and distribution trackers. In our transmission tracker or TCOS, we requested a revenue increase of approximately $63 million, which was approved and rates were updated to reflect this increase in mid-January. Our distribution tracker or DCRF, was filed at the beginning of December and reflected a requested revenue increase of approximately $100 million. We recently withdrew this filing because we're updating it with the revised figures to reflect the capital investments included in the rate case filing. We will also incorporate incremental capital investments through the end of December 2024 in our revised filing that we anticipate filing by the end of the first quarter. I'd now like to discuss the expected financial impacts for customers and investors associated with our temporary generation transaction that Jason referenced. First, I want to take a step back and walk through how we're thinking about our investment relating to the lease of our large temporary emergency generation units. There are essentially three periods, with the lease running through June of 2029. First, the period where the units were available to our CenterPoint customers to mitigate potential large load shed events. Second, the period the units will serve our fellow Texans. And third, the period where we will seek to market all 15 large temporary generation units to third parties at prevailing market rates. When crafting our proposal, our focus, first and foremost, was on our customers. We intend to be responsive to stakeholders that have expressed a desire for us to offset collections from regulatory recoveries of roughly $475 million. That's approximately the amount we'd seek to offset for our customers. Let me summarize how we would go about doing that. There are three components of customer benefit at a high level. First, in the spring of this year, we are proposing to make all of our 15 large temporary emergency generation units available to serve the San Antonio area to support reliability needs identified by ERCOT ahead of the summer load peak. We will make an unprecedented contribution for the benefit of Texans of approximately $180 million of value for an up to two-year period. That's the time in which we would propose the large temporary generation unit will serve ERCOT customers, resulting in us not seeking future recovery of this balance for Houston Electric customers as they will cease to be a regulated investment. Second, our Houston Electric customers will receive the benefit of the Houston Electric rate case settlement. When approved, saving customers around $250 million over a roughly five-year period. And third, as we highlighted in the third quarter, we performed significant incremental work related to both the May storms and Hurricane Beryl recovery, and we will not seek recovery for roughly $110 million of these costs. We anticipate that during the time the units are serving as a statewide system benefit, cash flow will be slightly lower as collections from customers will be reduced to account for the foregone recovery related to the future use of these units. At the end of that time, the third period will begin, where we seek to market all 15 large temporary generation units to third parties at prevailing market rates. The market has and continues to move favorably for mobile power units such as these, where we have seen market rates that are roughly double our original lease rate. As I briefly touched on, once these units move to the San Antonio area, we will not earn a regulated return with respect to our investment in them. Given the unregulated nature of this investment going forward, we will remove the impacts, both favorable and unfavorable from our non-GAAP earnings numbers. Although we project the earnings and cash flow profile, have the potential to equal or better the prior regulated investment profile. This is now largely a timing item. And the asymmetric earnings profile of this investment is not consistent with our core regulated business. I will reiterate Jason's sentiments with respect to this Texas-centric solution. We believe this transaction is a tremendous outcome for all stakeholders. Finally, I want to touch on our balance sheet and how we're thinking about funding our increased capital plan. As of the end of the year, our adjusted FFO-to-debt ratio based on the Moody's rating methodology was 13.6% when removing storm-related costs. This is slightly below our target range of 14% to 15%. But as a reminder, it is transitory in nature as we anticipate receiving approximately $1 billion in cash proceeds next month from the closing of our Louisiana and Mississippi LDC sale. We also expect an additional $500 million of securitization proceeds by the end of June, and we continue to expect to file for securitization of the $1.1 billion of storm costs related to Hurricane Beryl within the next few months, with proceeds anticipated coming by the end of the year. We will continue to stay laser-focused in supporting balance sheet health, while also investing for the benefit of our customers and communities. With now four consecutive years, meeting or exceeding expectations, we continue to reaffirm our non-GAAP EPS target of 8% this year and the mid- to high end of 6% to 8% thereafter through 2030. And with that, I'll now turn the call back over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Chris. In summary, I'm proud of our team for persevering through 2024, which marks our fourth year of meeting or exceeding our financial guidance. This performance places us in the top decile within our utility peer group. In addition, we have a strong foundation in place for 2025 and beyond, a foundation that includes a comprehensive plan to deliver the most resilient coastal grid for our customers. Incremental CapEx announced today of $500 million driving 10% rate base growth through the end of the decade, which is one of the highest in the sector, constructively settling four rate cases representing over 80% of enterprise rate base, giving us clear line of sight for the next four years. And the privilege to serve one of the fastest-growing regions in our country with an expected peak load increase of approximately 50% in the Houston area through 2031, powered by a diverse set of economic drivers. This load growth undoubtedly provides incremental CapEx tailwinds to an already industry-leading plan. We look forward to sharing more comprehensive details about the long-term investment opportunities later this year."
},
{
"speaker": "Jackie Richert",
"content": "Thank you, Jason. Operator, we're now ready to take Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, we will begin taking questions. [Operator Instructions] Our first question comes from Steve Fleishman with Wolfe Research. Your line is open."
},
{
"speaker": "Steve Fleishman",
"content": "Yes, hi, good morning. Thanks. Can you hear me?"
},
{
"speaker": "Jason Wells",
"content": "Yes."
},
{
"speaker": "Steve Fleishman",
"content": "So just, I guess, you kind of talked to this at the end, Jason, but just on the growth forecast that you gave, is there any way to kind of compare what you gave to what you -- to what ERCOT might have used last year for this? And then also, how to think about how much of this growth kind of in your capital plan or what's still like upside, including the transmission decision that you mentioned coming up?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Happy to shed a little color on that. As it relates to the ERCOT submission, as we've discussed over the course of last year, that was largely related to West Texas really a focus on the Permian originally. So last year, I think we submitted roughly -- it had to be less than a gigawatt of interconnection demand. We basically had -- we weren't a participant in last year's study effectively. So this will be the first time that the growth in the Houston area is really going to be reflected in our costs substantiated load filing moving forward. So it will be a 10 gigawatt increase to what they were projecting last year. We've also talked about, I would have to imagine that some of that load last year that was submitted, it was submitted under a standard that was designated as a speculative load. ERCOT is trying to tighten the planning parameters and have moved to more of a substantiated load, essentially a higher level of confidence in that load materializing. And so there may be a little bit of downward pressure on the total ERCOT market. But undoubtedly, we will add about 10 gigawatts of new demand to what otherwise existed last year. So hopefully, that provides the context around the ERCOT emission. As it relates to CapEx, as I mentioned, this is an incredible tailwind for the company. It's still a little early to size it. It really is going to come down to the decision on voltage, whether we pursue a 765 kV standard or 345 kV standard. What I would say though, because we are a load pocket here in Houston, in any given day, we're importing 60% of our energy needs. This will undoubtedly drive at least another $3 billion in electric transmission CapEx that's not in the plan. I would really be surprised if it's not higher than that. But ultimately, we need a policy direction on the voltage standard to refine that estimate. And so we'll be providing more of an update as we get through the course of the year."
},
{
"speaker": "Steve Fleishman",
"content": "Okay. That's very helpful. And then on the -- any update on kind of rating agency views? I know you gave the metrics just when -- are they going to -- are they mainly going to be focused on the recovery from Beryl to kind of see stabilizing of the ratings?"
},
{
"speaker": "Chris Foster",
"content": "Steve, I think it's probably three factors. First is just the constructive nature of the Texas regulatory environment, which I think we've been able to already showcase our interim capital recovery mechanisms as a key area of progress there. Two, it's the Houston Electric rate case, again, for the certainty that, that provides. I think that, as you've seen there, we have an all-party settlement and ideally, hoping for action there at the PUCT, either March 13 or 27 here would be ideal in their next public meetings. Third is certainly the securitizations of the prior storm costs. What I would point out there is we are actually ahead of plan and have been sharing that with the rating agencies, meaning the $500 million associated with the May storm impacts, we have now achieved a settlement in principle which puts us ahead of plan in terms of being able to execute towards the end of this quarter -- excuse me, towards the end of the second quarter, the actual securitization. Finally, I do think it's going to be important for them to see progress. the prudency review step associated with the Hurricane Beryl-related costs, and we'll get that filing filed at the PUCT here in the next few months. So ultimately, I think those are the three factors that they're watching, and I think we're already able to show progress on certainly two of the three, if not three of the three."
},
{
"speaker": "Steve Fleishman",
"content": "Great, thanks. Very helpful."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Shahriar Pourreza with Guggenheim Partners. Your line is open."
},
{
"speaker": "Shahriar Pourreza",
"content": "Hey guys, good morning. Just to follow up on Steve's question. Jason, have you committed to an Analyst Day, any sense of timing there? And are you going to know enough around the 50% load growth upside that you guys kind of highlighted for Houston to embed that in the capital plan for the Analyst Day?"
},
{
"speaker": "Jason Wells",
"content": "Yes, it's a great question, Shar. And yes, we are committed to update and rolling forward what will be a new 10-year plan for capital investment this year. We do want to make sure that we incorporate this policy decision or direction that Texas will make in terms of the voltage standard. We anticipate that by May this year. And so our update to the market will likely follow that so that we can incorporate a better estimate of the transmission CapEx increase associated with serving this really just tremendous load growth here. So we haven't set a date, but we're committed to providing an update to the market here this year. I would also say that while we're talking a lot about the electric transmission opportunities here in Texas, which are significant, as I mentioned, they are not our only set of CapEx tailwinds. We continue to see, I think, really constructive opportunities for our customers around some localized transmission here in the Greater Houston area on the gas side of the business, and we're going to be pursuing some electric transmission opportunities up in Indiana. And so I think the tailwinds from a CapEx standpoint are significant, and we look forward to sharing them a little later this year when they come into better focus."
},
{
"speaker": "Shahriar Pourreza",
"content": "Okay. Perfect. And then just in terms of financing needs. I know you guys -- obviously, there's a slight change in language around the ATM use versus equity content. Can you just elaborate on the range of options and timing of equity funding? And is kind of asset optimization still in avenue, given the impetus we're seeing in your core Houston jurisdiction? Thanks guys."
},
{
"speaker": "Chris Foster",
"content": "Sure. I think if you look just at the immediate year itself, we have indicated we've taken care of the equity needs for 2025 for the plan. As you go beyond that, we have consistently said and they're staying there that we'd be utilizing the ATM to take care of our modest equity needs going forward. And as we mentioned, today, you should assume we continue to fund the business, the enterprise at 50% debt, 50% equity. And I'll just say again, we consistently evaluate the most efficient way to fund this growth CapEx going forward. I mean really just like the Louisiana, Mississippi Gas LDC sales that we referenced will actually be closing this quarter. So I think you've seen here the team demonstrate that ability to look at multiple different options, everything from utilizing the base ATM to the hybrid structures and engineer subordinated notes that we utilized as well as the potential for transactions when they are the most efficient way to produce -- to pursue this financing."
},
{
"speaker": "Jason Wells",
"content": "So this will also be a big part of the update that we have later in this year. We're committed to funding any of the equity needs efficiently as we have demonstrated, and we're also committed to preserving the balance sheet creating a healthy cushion before -- between that downgrade threshold and where we are running the business. And so that will be part of this comprehensive update that we'll provide later this year."
},
{
"speaker": "Shahriar Pourreza",
"content": "Yes. And I appreciate it. And then you guys have been fairly successful in the asset optimization side, which is why I asked the question. Thanks, guys. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from James Thalacker with BMO Capital Markets. Your line is open."
},
{
"speaker": "James Thalacker",
"content": "Good morning. Can you guys hear me? I just want to touch quickly on your cost control program and target to keep the O&M at like a 1% to 2% decline across your plan, given the increase in resiliency spending including the higher vegetation management spending. Could you talk a little bit about the discrete levers you are looking at or identified to allow you to kind of deliver on the O&M reduction program as you go forward?"
},
{
"speaker": "Chris Foster",
"content": "Sure. James, I think if you look at what we talked about this morning, we will have a substantial increase, which is needed for our system for a much more aggressive vegetation management standard. But really nothing has changed in terms of our focus on taking out 1% to 2% per year. We have delivered that clearly over the last three years and actually just shy of 2% per year. Going forward, there's probably a couple of areas I would touch on. I know we mentioned in our prepared remarks the ability to actually reduce O&M as a direct result of the capital that we'll be putting on the system for the system resiliency plan. And the basic way to think about that is we'll have fewer truck rolls because we'll have automated devices on our grid, which allow for self-healing, right? In those instances where otherwise, you would have to roll a truck for our frontline team members to take care of a fuse on the system or otherwise be reenergized. A second area of focus for us will be on really legacy systems and standardization across the footprint that we have. We have the ability in certain instances to sync up our IT systems and network systems as well as at standards that are utilized that are slightly different in the different states that we serve. And we're utilizing the lean operating system here together to really focus on ensuring that we've got strong standardization that we've got, in some instances, vendor rationalization and other steps we can take to reduce costs year-over-year. And then the third, I would say, is really just our focus on empowering those closer to the word, ultimately, James. That allows us to really allow for year-over-year improvements on everything from empowering our coworkers to be able to evaluate existing standards take out those costs and just make the process as simpler to get the work done. So when you look across those three areas, we have a high level of confidence. We'll continue that track record of 1% to 2% out per year over the plan."
},
{
"speaker": "James Thalacker",
"content": "That's great. We appreciate the color, Chris, and congratulations on a great quarter."
},
{
"speaker": "Chris Foster",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Jeremy Tonet with JPMorgan Securities. Your line is open."
},
{
"speaker": "Jeremy Tonet",
"content": "Hi, good morning. Just want to come back to the mobile gen a little bit more. Thank you for all the details on how that would look on the financial side, I was just wondering if you might be able to expand a bit more, I guess, on how conversations have evolved with regulators, with other stakeholders in the state. Just wondering kind of state of affairs as you can share."
},
{
"speaker": "Jason Wells",
"content": "Yes, Jeremy, I appreciate the question. We continue to have dialogue with all stakeholders. And I think folks recognize the value here. ERCOT has signaled a real need in the San Antonio region if otherwise wasn't addressed, it could impact the entire ERCOT market. We want to be a constructive partner and have said that from day one. I think our commitment to donate these units effectively at zero cost to help, the ERCOT market reflects that. And I think people, stakeholders as we've had these conversations recognize that, that is a pretty significant gesture on behalf of the company. We also have heard loud and clear the demands to make our customers whole for the period where our customers benefited from this equipment. And I think we've worked hard to find a great solution there that Chris outlined. And so I'm optimistic that we are moving to a path where collectively, this is a win-win for all stakeholders. I think the next time this will be addressed is at the special meeting for ERCOT on February 25. ERCOT really wants these units in place before the summer season. So I'd expect this to get resolved here over the coming month or so, so that we can get these units in place by this spring."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. That's helpful there. And then going to the legislative session in Texas, a little bit more. Any proposals that are out there that are on your radar right now and really kind of thinking about the proposed SB 6 regarding large load and transmission charges. Just wondering if passage happens here, how this could impact CenterPoint in your mind?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Thanks for the question. It's -- the Texas legislature is really now just starting to kick off and pace is going to really increase from here. A lot of the work to date has been to many assignments and kind of policy orientation. What I would say, Jeremy, is we were pretty active in the '21, '23 legislative sessions. We'll probably be less active in this one. obviously working to support constructive legislation that continues to help drive resiliency of our system as well as help support this incredible growth that Texas economy is experiencing. With respect to Senate Bill 6, look, I really look at that as making sure that large loads pay their fair share is sort of a cost allocation focus. Those large loads in encompass a lot of our largest customers here in the Greater Houston region given our strong industrial base. And so we're going to work constructively with obviously our legislators, regulators, customers to find what is a fair cost allocation for everyone. I think it's early days in that regard, but we're working with all parties to find as I said, a constructive outcome."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. We'll stay tuned there. And just a real quick last one, if I could. Any guardrails you could put on the transmission opportunity depending on ERCOT's 765 decision?"
},
{
"speaker": "Jason Wells",
"content": "Jeremy, guard rails in terms of where do I think they're going to land or how much in terms of incremental CapEx, just tell me kind of what the direction of..."
},
{
"speaker": "Jeremy Tonet",
"content": "CapEx, sorry."
},
{
"speaker": "Jason Wells",
"content": "Yes. Look, I think the 765 kV standard will result. And obviously, more capacity on the system, but at a higher cost, right? And so when I threw out that we think it will be at least $3 billion, if not more, I think that's reflective of more of a 345 kV standard. Also, there's still some work to be done on the specific routes. But I think the number -- we will push well north of that under a 765 kV standard at or above that level under a 345 kV."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Thank you for that."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Durgesh Chopra with Evercore ISI. Your line is open."
},
{
"speaker": "Durgesh Chopra",
"content": "Hey, team. Good morning. I just had one question on 2025 guidance. Maybe just, Chris, can you -- for our models, can you help us bridge in 2024, what was included for temporary generation? And in 2025, what are you excluding, that's what the release says, I don't think the language has changed. But just want to make sure that we have the right pieces, I assume there will be some write-downs and you're excluding that. But just what is in '24? And then what is in '25 and going forward? Thank you."
},
{
"speaker": "Chris Foster",
"content": "Sure. Happy to paint it for you, Durgesh. In short, what was in the prior recoveries you can see and tie back directly to what we filed for recovery of and the TEEF filing for sure, it's temporary emergency electric facilities, right? So we had filed for that. You can already see there you would have logically the lease base cost, the associated rate base and the equity and debt return. As it relates to going forward, once these units in the spring are provided to the San Antonio area, we'd essentially be removing what remains from rate base. We would also, from an earnings standpoint, be excluding, as I referenced this morning from non-GAAP, any of the related future benefit as well as the interim period, or roughly two years while they're in San Antonio would be excluding that detriment, including we would start in 2025."
},
{
"speaker": "Jason Wells",
"content": "If I could add, Durgesh, here, just as a point of reference, the temporary generation equipment was being amortized over a short period of time. And so the equity earnings is rapidly decreasing each year. So as we're now several years into this, it's less of a material driver or was originally going to be a material drag as Chris said, we're going to take this, obviously, at a rate base but it's a manageable level of equity earnings on the regulated side to overcome. You had mentioned a write-down. I don't anticipate a write-down. The value of this equipment has effectively doubled in the market. And that's why we feel like we can be constructive here in the state by donating this equipment to help our cost for two years and then more than make up that difference on the back end when we can market this equipment to third parties. As Chris said, we don't -- when we send these units to San Antonio, we're effectively creating an unregulated subsidiary that does not reflect the ongoing earnings power of the company. So we intend to exclude the loss during the period there in San Antonio. We won't have any revenue, but we'll still have the lease expense. We will also similarly exclude the gains then, and those gains will well exceed the cost when we market at the end. We just don't think it's a reflective of the ongoing earnings power of the company. Net over time, we expect to fully recover that investment just begin because, as I mentioned, the market has moved so fundamentally on the value of those units."
},
{
"speaker": "Durgesh Chopra",
"content": "That's helpful. Okay. So, there's no underlying change in the value of the assets. It's just the earnings contribution is going to be regulated versus nonregulated. And your kind of splitting that out of your core earnings, right? Is that a fair way to put it?"
},
{
"speaker": "Jason Wells",
"content": "That's a fair way to put it. What would have remained as regulated earnings is very manageable because it's been -- this equipment has been -- being amortized so quickly. So we will no longer have any more regulated earnings on it after the spring of this year. And then as we look out, then it will effectively be an unregulated portion of our business for a short period of time, and we will exclude that from our non-GAAP earnings because it's just not reflective of the underlying earnings power of the business."
},
{
"speaker": "Durgesh Chopra",
"content": "Okay, very clear. Thanks so much. I appreciate the time."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from David Arcaro with Morgan Stanley. Your line is open."
},
{
"speaker": "David Arcaro",
"content": "Hey, thanks so much. Good morning. I was wondering on the load growth outlook that you've laid out, could you frame the status of the projects and the customer requests in that 61 gigawatt load growth level. It's such a huge potential pipeline there through 2031. Is that something that year-by-year, we might see even more of these projects come in? Are they very early stage and very -- or lower probability?"
},
{
"speaker": "Jason Wells",
"content": "I think you summarized it well there at the end in terms of lower probability, maybe the way to think about it is we've had requests totaling roughly 40 gigawatts to connect to our system. Some of those are exploratory in nature, so lower likelihood of occurring. Some of those are early stage and may materialize later. And so, what we wanted to frame here was the potential growth is really incredible. It's double our peak that we currently see today. We just are trying to take a more realistic point of view of what's likely between now and 2031, and that's what we think the 10 gigawatts. I think over time, to your point, we will see some of that incremental, I'll call it, than 30 gigawatts. Some of it may come in. There will also be new projects that come to knock on our door. And so there will constantly be a churn. We think the 10 gigawatts that we folded into the substantiated is the most realistic point of view today, and we're going to be annually updating this number moving forward. It's just a reflection of the fact that there is, again, a significant desire to connect to the grid here in Texas, well, nearly double what our current peak is. And it's just what's realistic over the next few years is probably something closer to 10 gigawatts."
},
{
"speaker": "David Arcaro",
"content": "Okay. Great. Yes, absolutely. That's helpful. And then I was just also curious, are you able to provide an update on within that outlook, how much of a data center pipeline that you're seeing, any refresh numbers versus the 8-gigawatts that I think you talked about before?"
},
{
"speaker": "Jason Wells",
"content": "Yes. We continue to see an increase in demand from data center activity. It's now north of 11 gigawatts here just in the greater Houston area. Again, I would put that 11 gigawatts as part of the 40. So some of those conversations are exploratory in nature, some of those conversations are data centers that are pursuing interconnection requests throughout Texas and other states. So, I wouldn't anticipate that all 11 gigawatts materializes. But suffice it to say, the level of activity continues to accelerate from where we were just a year ago. I'd also say we continue to see data center activity up in Indiana, which has been a little bit less of a focus just given the substantiated load process that we recently filed under here in Texas. But up in Indiana, it remains a central market for a number of hyperscalers. We have a vertically-integrated business up there with the ability to quickly convert our simple cycle, gas C2 to a combined cycle really giving kind of incremental capacity in that region. And so, we continue to see data center demand up there. I'd be surprised if we're not talking about landing in some portion of our business. significant hyperscaler opportunity at some point. But we're -- we, like many of our peers are in the middle of these conversations as we speak."
},
{
"speaker": "David Arcaro",
"content": "Awesome. Thanks for all that color. I'll keep an eye out for that."
},
{
"speaker": "Jackie Richert",
"content": "Operator, given we are getting close to the end of the hour, we'll take one more."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from Julien Dumoulin-Smith with Jefferies. Your line is open."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Hey, good morning, team. Thank you, guys, very much. Appreciate the time. Maybe just to come back to maybe a little cleanup on a couple of things that were mentioned here. First, just with respect to mobile generation. I just wanted to make it very crystal clear about this. With respect to what's assumed from a cash perspective, not from an earnings perspective, you're effectively assuming full recovery of the -- whatever expenses are incurred here with any pro forma counterparty. And then related, if you can speak to it. Obviously, you mentioned the Feb 25 ERCOT special meeting, to the extent to which that were or were not to prevail, can you speak a little bit to the market depth. Certainly, we're seeing this mobile generation subject mushroom in other circumstances, if you can speak to kind of backup plans as well on the margins."
},
{
"speaker": "Jason Wells",
"content": "Yes. With respect to the first issue on cash flows, there will be some variation between years, but kind of net over the life. I see this is actually a cash flow tailwind for the company. As I said, the market on this equipment has doubled. We had originally prepaid this lease, and so we have the opportunity to market under significantly higher rates roughly two years from now when this equipment is done. So, if anything, I think of it as a potential cash flow tailwind for the company. As it relates to the special meeting. Look, I think this is a great solution for everybody. ERCOT has said that they have a need in that San Antonio market. We are happy to step up and provide that equipment at no cost. I think that's an incredible offer a really constructive outcome for immediate solution. If for whatever reason, though, ERCOT decides to take a different direction, we have heard loud and clear that this equipment will come out of our regulated operations. And we will turn and begin to market this equipment to third parties as an alternative. And so I don't look at that necessarily as a downside, if anything, gives us the opportunity to turn to a market that I said is incredibly quite favorable for this equipment. As you know, there's only a handful of manufacturers of this type of equipment, and there's really no new significant capacity coming online for the next several years. And so we think the value will hold up over this period of time."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Yes. No, absolutely. And then lastly, a quick cleanup item. With respect to the store recoveries, you're obviously making a filing for the subsequent storm here in 2Q as you alluded to. Any reason to think that there is a meaningfully different outcome than what you saw here with the first storm arrangement. Any specific nuances that we should be watching on that front, just to set expectations?"
},
{
"speaker": "Chris Foster",
"content": "Sure, Julien. I think it's -- the short answer is no. I think we will be planning, as you said, to file Q2. This will be for roughly $1.1 billion for Hurricane Beryl response. The why behind my answer is that, ultimately, a lot of the costs themselves were driven by the incredible mutual aid and other crews that help our teammates restore power timely, right? And so that's the major driver, both the materials and the labor associated with getting the light back off for our customers. And so, from that standpoint, we think from both a timing and resolution standpoint, we should be on plan."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Wonderful. Excellent. All right, guys. Congrats on everything. See you soon. Stay warm."
},
{
"speaker": "Jason Wells",
"content": "Thanks, Julien."
},
{
"speaker": "Chris Foster",
"content": "Thank you."
},
{
"speaker": "Jackie Richert",
"content": "Thanks, Julien, and thanks, operator. With that, that will conclude our call for today. Appreciate everyone dialing in and look forward to speaking with everyone soon."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes CenterPoint Energy's Fourth Quarter and Full Year Earnings Conference Call. Thank you for your participation. You may now disconnect."
}
] |
cnp | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to CenterPoint Energy Third Quarter 2024 Earnings Conference Call with Senior Management. [Operator Instructions] I will now turn the call over to Jackie Richert, Senior Vice President of Corporate Planning, Investor Relations and Treasurer. Ms. Richert, please go ahead."
},
{
"speaker": "Jackie Richert",
"content": "Good morning, and welcome to CenterPoint Energy's third quarter 2024 earnings conference call. Jason Wells, our CEO; and Chris Foster, our CFO, will discuss the company's third quarter results. Management will discuss certain topics that will contain projections and other forward-looking information and statements that are based on management's beliefs, assumptions and information currently available to management. These forward-looking statements are subject to risks and uncertainties. Actual results could differ materially based upon various factors as noted in our Form 10-Q, other SEC filings and our earnings materials. We undertake no obligation to revise or update publicly any forward-looking statements. We will be discussing certain non-GAAP measures on today's call. When providing guidance, we use the non-GAAP EPS measure of diluted adjusted earnings per share on a consolidated basis referred to as non-GAAP EPS. For information on our guidance methodology and reconciliation of the non-GAAP measures discussed on this call, please refer to today's news release and presentation on our website. We use our website to announce material information. This call is being recorded. Information on how to access the replay can be found on our website. Now I'd like to turn the call over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Jackie, and good morning, everyone. I'd like to begin by extending our deepest sympathies to our families and communities impacted by the devastation caused by Hurricane Helene and Hurricane Milton. The destruction caused by this year's hurricane season is undoubtedly tragic. However, it is times like these that truly bring out the best in our industry. A few weeks ago, we saw the utility community come together to send more than 50,000 utility workers from at least 43 states, the District of Columbia and Canada to support hurricane restoration efforts across the Southeast. From CenterPoint, we contributed to the effort by sending personnel representing nearly 1/3 of our electric frontline workforce to assist in the restoration efforts for Helene and Milton. As many of you know, the Greater Houston area benefited greatly from the same mutual assistance framework during Hurricane Beryl, where we called upon 13,000 workers from approximately 30 states to help restore power to more than 2 million customers. I want to thank all of our frontline teams as well as others throughout the industry that answered the call to help get the lights back on for the millions of people impacted by the destructive hurricanes we've experienced this season. On today's call, I'd like to address five key areas of focus. First, I'll briefly touch on the third quarter financial results. Second, I'll discuss the progress we've made and future goals with respect to our Greater Houston Resiliency Initiative or GHRI. Third, I'll provide an update on our various regulatory efforts. Fourth, I'll highlight the organic growth we continue to experience, particularly in the Houston Electric Service Territory. Lastly, I'll conclude with the initiation of our earnings guidance for 2025. Today, we reported non-GAAP EPS of $0.31 per share for the quarter. In addition, we are reaffirming our full year 2024 non-GAAP EPS guidance range of $1.61 to $1.63 per share. This represents 8% growth at the midpoint from our 2023 results. Chris will provide additional details on our financial results in his section. Now I'd like to provide an update on our ongoing execution of our electric operational plan, the Greater Houston Resiliency Initiative, which we launched in early August. As you may have seen, we have already made significant strides towards strengthening the resiliency and reliability of our grid in the first phase of GHRI as well as enhancing our communications with our customers. These actions have been informed by learnings from internal and external reviews, engagement with stakeholders and benchmarking with high-performing sector peers. During the third quarter, we took immediate action and accelerated our plans to deliver an unprecedented level of work. This includes removing higher-risk vegetation across 2,000 line miles, replacing over 1,100 poles with new poles capable of withstanding extreme wind and installing over 300 automated reliability devices to help reduce the number and duration of customer outages. We accomplished all of this work before the end of August and ahead of schedule. With respect to improving our communications, we launched our new and updated outage tracker on August 1. This tool is designed to enhance the customer experience during times of service disruptions. Additionally, we've stated our commitment to hire senior emergency preparedness and response and communications leaders to bolster our leadership team. I'm pleased to share we have hired leaders for both of these positions that bring a wealth of industry experience and will accelerate our efforts to improve our preparedness and response in our customer experience during emergency events. We believe our more proactive communications approach is already positively impacting the customer experience through more timely information. These are great first steps, and I'm proud of the progress thus far. But we have heard the call to action, and we are committed to doing even more in the second and third phases of GHRI for the benefit of our customers and our communities. These next two phases will focus not only on reducing the number of outages, but also reducing the outage time customers' experience through investments designed to create a self-healing grid. I want to underscore, however, that GHRI does not represent the beginning of our enhanced resiliency investments. This is merely a continuation and acceleration of the work we started well ahead of this year's events. Over the last few years, we have focused our resiliency investments in our electric transmission system, which is the backbone of our grid. Our transmission resiliency work included upgrading our transmission structures to better withstand extreme winds, elevating our substations to mitigate flood risk and converting our older 69 kV transmission lines to a more robust 138 kV standard. This work has already produced tangible results. During the derecho in May and Hurricane Beryl in July, our hardened transmission system withstood the extreme winds and sustained relatively little structural damage. In fact, while other Texas utility customers sustained prolonged outages due to damage on their transmission system from Hurricane Beryl, we did not experience any customer outages due to our transmission system. As we now turn our attention to accelerating investments in the distribution system in the next two phases of GHRI, we believe we are well positioned to make rapid improvement. Currently, a little over 46% of our Houston Electric distribution system is underground, which on a proportional basis, is more than twice the industry average. Our opportunity is to harden above ground feeders to those communities through smaller, more targeted investments that should yield impactful results for approximately 60% of the customers that are served by underground service. This feeder blitz is expected to have the additional benefit of substantially reducing the total outage numbers and accelerating restoration for other customers as resources can focus on the remaining circuits earlier in the restoration process. Another area we believe we can make meaningful improvements on our distribution system is with respect to increased circuit segmentation and automation. Equipment such as intelligent grid switching devices and trip savers help create a self-healing grid by isolating outages to fewer customers, rerouting power around impacted areas and automatically restoring power without manual intervention where there is no structural damage. Presently, approximately 30% of Houston Electric's overhead circuits have at least one automation device. As part of Phase 2 of GHRI, we anticipate installing 4,500 trip savers and 350 intelligent grid switching devices before the next hurricane season which will allow us to nearly double the number of distribution circuits with automation devices in the Greater Houston area. Our investments in work during this phase are anticipated to save our Houston area customers over 125 million outage minutes annually. Over the next five years, we plan to not only deploy even more devices, but also optimize their capabilities by employing AI-based modeling. We plan to share additional details regarding our future resiliency investments on our fourth quarter call, which will take place after we have filed our system resiliency plan. As a reminder, our revised system resiliency plan will include approximately $5 billion in resiliency investments from 2026 through 2028, an increase of approximately $2.5 billion over our previously withdrawn system resiliency plan. Chris will go into more detail in his section, but I want to highlight that even with the inclusion of these incremental resiliency investments, we anticipate Houston Electric's customer delivery charge increases will track in line with the long-term rate of inflation over the next 10 years. Turning to an update of our broader regulatory efforts, starting with Houston Electric. As many of you likely saw on August 1, we filed our notice to withdraw our Houston Electric rate case filing. This withdrawal allows us to continue to focus our attention on near-term plan execution and long-term system resiliency plan development as we are laser-focused on year-over-year improvements. If the withdrawal is approved, we have stated that we will file a new Houston Electric rate case no later than June 30, 2025, based on a 2024 calendar test year. Outside of the rate case filing, we intend to continue to seek recovery of capital investments made for the benefit of our customers. In the fourth quarter this year, we anticipate filing to start recovery of both our recent transmission and distribution investments through our TCOS and DCRF capital trackers. The efficient recovery of these investments is crucial to our ability to efficiently fund future investments. This is why we remain focused on reducing regulatory lag across all of our jurisdictions. Our latest earnings monitoring report highlights the regulatory lag we continue to experience at Houston Electric. For 2023, our weather-normalized earned return on equity was nearly 150 basis points lower than are allowed. In addition to filing for a recovery of our investments, we will also make the initial filing for the recovery of approximately $450 million in storm costs related to the May derecho. Now turning to the Indiana Electric rate case. A little over a month ago, we filed our proposed order with respect to our nonunanimous settlement proposal. The Indiana Utility Regulatory Commission has a statutory deadline to issue its final order by February 3, 2025. We want to thank all stakeholders for their contributions to the case as we seek to reach a fair outcome for all parties. Moving next to the filed Minnesota Gas rate case. As some of you may have seen, intervenor testimony was filed a few weeks ago. Since then, we have had constructive settlement talks with stakeholders and intend to continue in the settlement negotiations leading up to our rebuttal testimony deadline of November 12. As you may recall, we have settled our previous three rate cases in our Minnesota Gas jurisdiction. Absent a settlement, the Minnesota Commission may consider interim rates for 2025 toward the end of this year. Finally, I want to touch on our upcoming rate case application for Ohio Gas. In August, our Ohio Gas business filed its Notice of Intent with the Public Utility Commission of Ohio regarding our upcoming general rate case application, which we intend to file tomorrow. Over the last several years, we have had one of the lowest customer gas bills in the state. Our upcoming ask reflects an investment recovery rate that will put us more in line with our Ohio peers. In addition, this larger revenue requirement increase will allow us to more efficiently fund the continued pipeline modernization investments, which we believe contributes to the overall safety and efficiency of the system. Now I want to highlight the strong organic growth we continue to see, especially in our Texas service territories. While much of my earlier commentary focused on our investments in resiliency and reliability, I want to emphasize that we continue to experience significant growth across Texas and in particular, the Greater Houston region. Over the last few decades, the Greater Houston region has grown at one of the fastest rates in the nation. We see that growth not only continuing but accelerating through the remainder of this decade and beyond. In fact, we believe our peak load of approximately 22 gigawatts in 2024 could increase by more than 30% by 2030. This potential growth is driven by continued population growth, acceleration of electrification and increases in data center activity. Houston continues to be an attractive city to live and work. Over the last five years, housing starts have increased over 9% per year on average, which is more than 3x the national average. We see this growth continuing as businesses and people like continue to migrate to the Houston area. Our industrial load growth drivers are both large and diverse. Our substantial potential future load growth is underpinned by industrial electrification and energy exports, including hydrogen. Houston remains an ideal location for hydrogen developers as it already boasts the largest hydrogen infrastructure in the world in addition to proximity to the largest port by waterborne tonnage in the United States. Although we still are in the early stages of hydrogen development, we are working with approximately 3.5 gigawatts of projects that are well into the advanced engineering phase. Outside our more traditional load drivers of energy and energy exports, we see growing potential incremental load from other sectors. Notably, over this summer, we have seen a fundamental shift in data center development. In fact, our interconnection queue for data centers now sits at over 8 gigawatts. While we recognize that not all of this will be developed, it is yet another tailwind in what we continue to believe is one of the most tangible long-term growth stories in the industry. It is with this growth in our customer-driven capital investments that we've made over the last couple of years that gives us conviction to initiate our 2025 non-GAAP earnings guidance target range of $1.74 to $1.76 per share. The midpoint of this range represents 8% growth from the midpoint of our 2024 guidance range of $1.61 to $1.63. Beyond 2025, we are also reaffirming our longer-term guidance where we expect to grow non-GAAP EPS at the mid- to high end of our 6% to 8% range annually through 2030 as well as targeting dividend per share growth in line with earnings per share growth over that same period of time. For our customers, this strong Houston area growth gives us confidence that we will keep increases in electric delivery charges, roughly in line with the forecasted rate of inflation over the next 10 years. We recognize the privilege and responsibility of being an energy delivery provider for our customers. We will be laser-focused on both enabling growth and advancing system resiliency for the benefit of our customers through the work that we've outlined in GHRI as well as the investments we will propose in our new system resiliency filing. We look forward to continuing to work with our customers, regulators and others to make improvements for the benefit of all of our stakeholders. And with that, I'll turn it over to Chris."
},
{
"speaker": "Chris Foster",
"content": "Thanks, Jason. Before I get to my updates, I want to echo Jason's gratitude for not only our CenterPoint coworkers, but all utility and contractor employees that aided in the restoration efforts during this very active hurricane season. It was truly remarkable to witness the dedication to a safe response and the speed of the restoration efforts that took place after two devastating hurricanes hit the southeast within two weeks of each other. I want to thank the roughly 1/3 of our internal CenterPoint line crews that made the journey to other sector peers to help get the lights back on after those hurricanes. For the quarter, I'd like to cover four areas of focus. First, the details of our third quarter financial results, including our reaffirmation of 2024 guidance. Second, the initiation of 2025 non-GAAP EPS. Third, I'll touch on our capital deployment status this quarter and forecasted storm costs. And finally, I'll provide an update on our financing plans, including an update to our plans to increase our equity guidance to fund our incremental $2.5 billion, which will be included in our system resiliency plan totaling at least $5 billion in cumulative resiliency investments from 2026 through 2028. Let's now move to the financial results shown on Slide 7. On a GAAP EPS basis, we reported $0.30 for the third quarter of 2024. On a non-GAAP basis, we reported $0.31 for the third quarter of 2024, compared to $0.40 in the third quarter of 2023. Our non-GAAP EPS results for the third quarter removed the costs associated with the sale of Louisiana and Mississippi Gas LDCs. The reduced earnings quarter-over-quarter was primarily driven by increased and accelerated O&M that was completed as part of Phase 1 of the GHRI. When compared to the comparable quarter of 2023, O&M was $0.11 unfavorable. This $0.11 not only represents the $70 million of vegetation management for which we will not seek recovery, but also the work we pulled forward from the fourth quarter to increase readiness for future potential inclement weather that could impact the Houston Electric system. In addition to the headwinds from O&M, weather and usage contributed an additional $0.06 of unfavorability quarter-over-quarter, $0.02 of this unfavorable variance was driven by reduced usage caused by outages from Hurricane Beryl along with a considerably milder summer in the Houston Electric service territory as compared to 2023. We continue to recover on our customer-driven investments, which contributed $0.09 of favorability this quarter when compared to the comparable quarter of 2023. This is primarily driven by the ongoing recovery from various interim mechanisms for which customer rates were updated last year as well as the interim rates in our Minnesota Gas business that went into effect on January 1 of this year. In addition, the Houston area continues to see strong organic growth, extending the long-term trend of 1% to 2% average annual customer growth. As Jason referenced, this dynamic aids in keeping future increases in our customer electric delivery charges, roughly in line with the forecasted rate of inflation over the next 10 years. Interest expense and financing costs contributed $0.01 of favorability when compared to the comparable quarter in 2023 due to moderating interest rates and the favorable variance from the redemption of the Series A preferred stock in September of last year. Despite the headwinds we faced this quarter, we continue to reaffirm our full year 2024 non-GAAP EPS guidance range of $1.61 to $1.63. Our confidence in reiterating our full year 2024 guidance today is driven by the O&M work on the system that we accelerated into the third quarter. Our updated work plans are reflected in the $0.11 of unfavorability I mentioned as the work otherwise would have been spread across the third and fourth quarters. This is a departure from last year where we highlighted some higher O&M costs in the fourth quarter, reflecting work, including incremental vegetation management. In addition to reaffirming full year 2024 non-GAAP EPS guidance, today, we are also initiating our 2025 non-GAAP EPS guidance target range of $1.74 to $1.76 per share. The midpoint of this range represents annual growth of 8% from the midpoint of our 2024 non-GAAP EPS guidance target range of $1.61 to $1.63. Our 2025 figures are a byproduct of the significant investments we've made across our various jurisdictions over the last couple of years. As you may recall, we accelerated investments in the Houston Electric service territory last year, and we continued a strong investment profile across our jurisdictions this year. These investments have resulted in a rate base CAGR of more than 11% over the last two years. The strong foundation of organic growth with the new capital investments, combined with rates we are anticipating through our interim rate mechanisms and rate case outcomes, give us the conviction in our 2025 non-GAAP earnings guidance initiated today. Next, I'll touch on our capital investments execution as of the quarter in 2024, as shown on Slide 8. In the third quarter of 2024, we invested $900 million of base work for the benefit of our customers and communities. This excludes spending related to storm restoration. Year-to-date, we have invested approximately $2.6 billion which represents over 70% of our original 2024 capital expenditure target of $3.7 billion. We remain on target to meet our base capital plan investment despite the interruptions of normal capital deployment from the storms we've experienced this year. I'd also like to provide a quick update on where we stand with storm costs related to the May derecho event and Hurricane Beryl. With the majority of costs accounted for, we are now able to refine our estimate to the low end of the previously disclosed $1.6 billion to $1.8 billion range as we now estimate costs for both storms to total $1.6 billion. We intend to make our filing for cost determination in connection with the securitization for the May storm costs in the coming weeks and storm registration costs associated with Hurricane Beryl in the first half of next year. I'll now turn to our capital investment targets for 2025 and beyond. For 2025, we are targeting to invest $4.9 billion across various jurisdictions for the benefit of our customers and communities. Looking to the remaining five years of our original 10-year capital investment plan that runs through 2030, we are now targeting to deploy approximately $26 billion of capital, of which $21 billion is anticipated to be in the state of Texas. This brings our 10-year total capital investment plan up to $47 billion. This $47 billion is a $2.5 billion increase from our previously stated $44.5 billion. Our incremental investment is expected to all be deployed in our Houston Electric service territory and will be reflected in our upcoming system resiliency plan that we have committed to filing by January 31, 2025. We anticipate these investments will enhance the customer experience, but we remain cognizant of the impact of our investments on customer bills. However, based on the total current average Houston Electric residential bill, we estimate that our investments, combined with the estimated impacts of the to-be securitized storms, should result in customer bill increases roughly in line with the forecasted long-term rate of inflation over the next 10 years. As a reminder, our Houston Electric residential customer delivery charges were the same in 2014 as when we started 2024. This build trajectory is a result of our continued focus on efficiency and our O&M activities in addition to the consistent customer growth we've seen in the Houston area for the last three decades. Finally, I want to touch on our balance sheet and how we're thinking about funding our increased capital plan. As of the end of the third quarter, our calculated FFO to debt was 13.8% when adjusting for the storm costs on a pro forma basis, based on our calculation aligning with Moody's methodology as shown here on Slide 9. We've demonstrated our continued focus on preserving our balance sheet strength while executing our capital plans despite incremental storm cost pressures this year. Our efforts included the acceleration of $250 million of common equity into this year and the issuance of equity credit from hybrid debt securities. We plan to maintain that same philosophy as we work to efficiently fund investments and preserve credit health, both in the near term and beyond as we continue to focus on our long-term target of maintaining a cushion of 100 to 150 basis points above our downgrade threshold. We also have substantial cash inflows as part of our plan, starting in 2025. Looking over roughly the next 12 to 18 months, we anticipate approximately $3 billion of gross cash proceeds from the divestiture of Louisiana and Mississippi Gas LDCs and storm-related securitization issuances. And with regard to those anticipated securitization issuances, as a reminder, the State of Texas has seen 11 utility securitization transactions since 2008. So there's a strong history under this existing construct underpinning our conviction. We expect these combined proceeds will be a part of our strengthening story as we execute on additional customer-driven investments. As we look to the long-term financing plans through 2030, I also want to provide an update today on our equity guidance. With respect to the incremental $2.5 billion of resiliency investments, we expect to follow our previously provided guidance of funding incremental investments with 50% equity and 50% debt. As such, you should expect that we will raise an incremental $1.25 billion of equity in addition to the $1.25 billion issuance through 2030 we previously guided to. This takes the total equity plan guidance to approximately $2.5 billion through the remainder of the decade. You should expect that the equity issuances associated with these incremental expenses will likely come towards the latter part of our remaining 5-year plan. In the near term, and as I mentioned previously, the approximately $3 billion of cash inflows should allow us flexibility and mitigate the need for common equity in 2025. Although we do not foresee the need for common equity issuances through 2025, we plan to continue to be opportunistic in strengthening the balance sheet through credit-enhancing instruments like those we issued earlier this year. We will, of course, focus on the most efficient ways to raise that equity, be it through common equity issuances, incremental equity content such as hybrids or recycling proceeds. As we look across the states that we are fortunate to serve, we remain confident in the continuation of our long-term plan, with a consistent focus on improving customer outcomes, delivering affordable service and building towards the most resilient coastal grid in the United States. And with that, I'll now turn the call back over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Chris. Regardless of the challenges we face, this management team remains firmly committed to delivering for all of our stakeholders, our customers, our communities, our regulators and legislators and our investors."
},
{
"speaker": "Jackie Richert",
"content": "Thank you, Jason. Operator, we're now ready to turn to Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Thank you. And one moment for our first question. And the first question will come from Shar Pourreza with Guggenheim. Your line is now open."
},
{
"speaker": "Shar Pourreza",
"content": "Hi, guys, good morning."
},
{
"speaker": "Jason Wells",
"content": "Hi, good morning, Shar."
},
{
"speaker": "Shar Pourreza",
"content": "Good morning, Jason. So just on '24 looks like it's in good shape as we're sort of thinking about '25 guidance. There's kind of a lot of moving pieces there, including sort of the GRC withdrawal requests, tracker filings, potentially maybe higher O&M. I guess, where's the level of confidence here, and what happens if the GRC withdrawal request isn't approved? Which I guess we'll know in a couple of weeks. There's just a lot of moving pieces in some key events. It'd be great to maybe if you can bridge it a little bit further for us? Thanks."
},
{
"speaker": "Jason Wells",
"content": "Yes, thanks, Shar, for the question. Obviously, we have a high degree of confidence in terms of initiating '25 here. There are a few points that I want to highlight that support that confidence. The first is we've invested significantly for our customers over the last two years, and have a rate base CAGR over the last two years of about 11%. That creates a solid foundation for the 8% guide on earnings growth. Second thing that I'd probably highlight is, as you know, we will have new base rates in three of our jurisdictions in '25 Texas Gas, Indiana Electric and Minnesota Gas. And I think what's notable about Minnesota Gas is as you recall, over the past we have filed rate cases every other year in Minnesota. And that profile created a dynamic where in every odd year, we had zero increase in revenues in Minnesota. When we filed this multiyear rate case last year, we filed with a request to increase revenues here in '25. And so that smooths the profile for both earnings, but also for rate increases for our customers. And so, I think that's a pretty notable change. And then third, you touched on this. We believe we have access to all the recovery mechanisms for our capital spend with the exception of Ohio. Where we will be in the middle of that rate case. And so, I think those are the drivers that give us confidence for the '25 earnings guidance. You mentioned the withdrawal of the Texas rate case. And as you recall, we had filed a modest revenue increase in that case, about $60 million. And what we have historically said, is that we expected that to be a rate case that resolved itself with flat, potentially maybe a small decrease in revenues. And so, I don't think the timing of the Houston Electric rate case is a real driver for '25, given those other factors I mentioned."
},
{
"speaker": "Shar Pourreza",
"content": "Okay. That's perfect, thanks. And then just lastly on equity, obviously it's increased by another $1.25 billion, so $2.5 billion through 2030. I mean, obviously you talked a little bit about the shape of that equity being more back end loaded. But can you prefund the needs? Is there an opportunity there to remove the overhang, and our asset sales still an opportunity with the LDCs, or capital markets aren't there for that? Thanks."
},
{
"speaker": "Jason Wells",
"content": "Yes, thanks again for the question, Shar. What I would say is we've established, I think a pretty strong track record of efficiently raising the equity that, we need with a series of transactions in the past. You can count on us doing the same here. We will efficiently fund this equity. I don't necessarily think it comes in the form of prefunding, but we will look at the most optimal way to finance these needs. And as Chris mentioned, I think we're in a pretty strong position with having $3 billion of cash inflows, over call it the next 12 to 18 months. That really gives us quite a bit of flexibility here, as we think about the best possible way to efficiently raise the equity."
},
{
"speaker": "Shar Pourreza",
"content": "Okay. That is perfect. Thanks guys. Appreciate it. See you in a couple weeks."
},
{
"speaker": "Jason Wells",
"content": "Yes, thanks."
},
{
"speaker": "Operator",
"content": "And the next question comes from Steve Fleishman with Wolfe Research. Your line is now open."
},
{
"speaker": "Steve Fleishman",
"content": "Yes. Hi. Good morning."
},
{
"speaker": "Jason Wells",
"content": "Good morning, Steve."
},
{
"speaker": "Steve Fleishman",
"content": "So hi, so first, just the detail on the Texas load growth, and the 30% growth in peak through 2030. Is that kind of include all the updates that you owe to I think ERCOT for early next year for kind of load growth plans? Is that the kind of range that we should be expecting?"
},
{
"speaker": "Jason Wells",
"content": "No, there's the potential for incremental load growth in that update with ERCOT. That process with ERCOT, is really trying to capture kind of all speculative load in the 30% figure that I highlighted, was a subset of that speculative load where we have a much higher degree of confidence. And so, as we look at and work with a number of companies in this region. As an example, hydrogen related activity could be multiples of what's included in that number, as one example. So, we will be working to categorize, kind of all of what I'll call speculative load activity. And then providing various degrees of confidence, for each of those categories. And I think the headline number should be higher, but we feel a high degree of confidence in at least 30% through 2030."
},
{
"speaker": "Steve Fleishman",
"content": "Okay. And then just maybe you could just give us an update on maybe a little more color on where things stand with the rating agencies, and what they're keying off of from here. Is it just the metrics, or is there other things that they are watching and care about? Thanks?"
},
{
"speaker": "Chris Foster",
"content": "Sure. Steve, good morning. I think it's really both pieces to start with the numbers, you saw us come out this morning with we're consistently measuring against Moody's and the 13% downgrade threshold there. We came out with the adjusted number today of 13.8%. We're confident that as we continue to go forward, what we're really going to see change there over the next year. Is the combination of the Louisiana, Mississippi Gas LDC proceeds as well as the securitization related proceeds. So it's certainly the case, the rating agencies are watching closely those securitization filings as well, with the ultimate goal of, of really just seeing the really strong Texas Regulatory construct work, right. That's why you saw us today really highlight two things. First, again, the securitization process with a long history here in Texas, of approvals of 11 different securitizations. And the second is the opportunity, without the rate case in front of us, to pursue the traditional capital trackers, which we do intend to do."
},
{
"speaker": "Steve Fleishman",
"content": "Okay. Great. Thanks. Appreciate it."
},
{
"speaker": "Chris Foster",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from Durgesh Chopra with Evercore. Your line is open."
},
{
"speaker": "Durgesh Chopra",
"content": "Hi, good morning, team. Thanks for giving me time. Hi, Chris, just to kind of follow-up on the credit metrics discussion, maybe just can you help us maybe a little bit more detail on the timing of the securitization proceeds in 2025? And then, just directionally speaking, where do you, on a Moody's basis where you're expecting 2024 metrics to be and then 2025. I'm thinking if they dip towards the end of the year, and then pick back up in 2025 as you receive those proceeds. But just more color there? Thank you, Chris."
},
{
"speaker": "Chris Foster",
"content": "Sure Durgesh. Happy to do it. Let me just remind everybody again, the highest order, the focus of the company for the long-term, is the focus on a cushion of 100 to 150 basis points as we go. But let me unpack the securitization pieces for you in particular. First, you should assume that we filed two different securitization requests. The first will be for the associated May storm or derecho related storm costs. We'll file that soon. As a result, I think you should generally assume a roughly Q3, resolution and associated proceeds of 2025. Second, we'll file the Hurricane Beryl related costs. We're generally targeting roughly Q2 of next year once we get all those costs in, to file for those Beryl-associated requests. Cumulatively, what we did this morning, is we updated toward the low end of the cost themselves. Previously our guide was $1.6 to billion $1.8 billion. We updated today given the greater certainty we have now at $1.6 billion. So ultimately Durgesh, I'd say the first piece roughly Q3, '25, second component of Hurricane Beryl related costs either late Q4, or early Q1, 2026."
},
{
"speaker": "Durgesh Chopra",
"content": "Thanks Chris. And just so, I guess by the end of next year are you sort of in that 14% to 15% I mean, you're very close to it as of the end of 3Q. I'm just thinking about CapEx picking up next year, and these securitization proceeds. Where do you shake out in that 14% to 15%? Are you going to be solidly in that range next year, or is that more of a '26 event?"
},
{
"speaker": "Chris Foster",
"content": "Yes, I think it's ultimately once we get the securitization proceeds and Durgesh, we'll be stepping back into that substantial cushion, right. So you'd ultimately probably be looking at Q1, 26. Once we've got all that done. Keep in mind that we've also emphasized this morning, the consistent focus we've got on the balance sheet. You saw us pull forward even the 2025 equity, kind of being front footed at that point. So you're just going to consistently see the focus here from the team."
},
{
"speaker": "Durgesh Chopra",
"content": "Understood. Really appreciate that detail, color. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jeremy Tonet with JPMorgan Securities. Your line is open."
},
{
"speaker": "Jeremy Tonet",
"content": "Hi, good morning."
},
{
"speaker": "Jason Wells",
"content": "Good morning, Jeremy."
},
{
"speaker": "Jeremy Tonet",
"content": "Just want to start off I guess looking at the state as a whole, how things stand in Texas. How have stakeholder conversations trended there, since completing your GHRI Phase I work versus the initial aftermath of the storm?"
},
{
"speaker": "Jason Wells",
"content": "Yes, no thanks Jeremy for the question. I think things continue to improve. I mean, we've concocted obviously extensive outreach, elected officials, customers, our communities, community leaders. And what we've heard inconsistently is that, everybody wants a more resilient system. They want improved communications. I think they saw improved communications as we prepare for Francine. And I think they have appreciated the progress that we made in August, and that we're carrying forward with the resiliency investments in the second phase of GHRI. As I highlighted on the call, I think the area where we can make the single biggest sort of improvement in a short period of time is on this concept of segmentation and automation. And the plan that we've got here in the second phase. When it's all implemented, will save our customers about 125 million outage minutes annually. And I think that's the direction that our stakeholders want to see us go in. And so, obviously there's more to be done. It is a focus of ours, to continue to re-earn trust. We know that we've got to continue to lean into those conversations. Both with elected officials as well as our communities. But I think, we're heading in a direction that everybody wants. That's again, a more resilient, reliable grid and much better communication."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. That's helpful there. Thanks. And just moving to 2024 guide real quick here. Despite the $0.11 O&M drag this quarter, reaffirming 2024 whole, this suggests, I guess, a lot of offsets in 4Q. Just wondering if you could, walk us through that a bit more. What is contemplated there as far as the offsets and then I guess how does, this position for 2025?"
},
{
"speaker": "Chris Foster",
"content": "Sure. Good morning. I think there's a few pieces to keep in mind there, which informally the confidence of maintaining our guide. I think the first piece again, is just the consistency of the trackers that we've got. The last couple quarters there have seen a benefit of roughly $0.09 to $0.10 quarter-over-quarter related to those trackers specifically. And so, we're going to expect that trend to continue really across our jurisdictions relative to the fourth quarter of last year. The second piece, and I hit this one in my prepared remarks specifically, but I'll again just reiterate, we did a lot of incremental work on the system in Q3, certainly highlighting the critical vegetation management work during the sprint, we undertook during August of this year. And a lot of that work was incremental to the year. But keep in mind some of it was an acceleration from Q4, so I'd expect that to result in about $0.01 benefit to Q4 as well. And on top of that recall last year that we had pulled forward work into the fourth quarter, and so that work was about $0.03 from 2024 to 2023. And so that again should benefit us here, as we look at Q4, 2024, when you do the quarter-over-quarter look all-in-all confident here for the year."
},
{
"speaker": "Jeremy Tonet",
"content": "Okay. Great, helpful. Thank you."
},
{
"speaker": "Chris Foster",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from David Arcaro with Morgan Stanley. Your line is now open."
},
{
"speaker": "David Arcaro",
"content": "Hi. Thank you. Good morning."
},
{
"speaker": "Jason Wells",
"content": "Good morning, David."
},
{
"speaker": "David Arcaro",
"content": "Wondering if you could give an update on kind of where you stand with the proposal that you put forth, regarding the temporary gen recovery, or what the next move is with that, with that proposal?"
},
{
"speaker": "Jason Wells",
"content": "Yes, just as a quick reminder. I think the real focus of the state's attention on the temporary generation portfolio, is really on the large units. And when we look at the amount of investment in those large units, there's a little less than $100 million of profit, or equity earnings that has not yet been recognized on those units. And the proposal that we made in August was basically to forgo the equivalent, a little bit more than the equivalent of that remaining profit. We put forward a proposal, where we would forego about $110 million of profit. Clearly I think stakeholders saw that as a good step forward, but I think there's still discussion around the use of these units. And as we've indicated on many occasions, we are working with everybody in the state to find a solution that works, a solution that works for our customers in times of load shed. We still have an obligation to rotate power once every 12 hours in a load shed event. And given our industrial load profile, critical facilities like the Texas Medical Center, we believe that we need those large units to comply with that order. But if the state wants us to, state wants to change that requirement or wants us to look at these units differently, we're happy to work with the state in that regard. So there's no prescribed timing. We attempted to address the concerns on the profit, the remaining profit on the large units, and we'll work with the state to find final resolution."
},
{
"speaker": "David Arcaro",
"content": "Okay. Got it. Appreciate the update there. And then maybe on the transmission outlook in the state, there are a couple of big programs out there. We've got the Permian plan potential for 765 kV investments. Wondering if you could talk about how you could be involved there? When might we see some of the potential projects, or upside opportunities start to crystallize for your plan?"
},
{
"speaker": "Jason Wells",
"content": "I think more directly the opportunities around the 765 kV project, there are a couple of our substations that would tie into that project. And as you know, the standard here in Texas is right of first refusal for the lines that connect into our substations. And so, we see the opportunity for significant investment in the 765 kV lines that are outside, or not incorporated in the $47 billion CapEx plan that we've highlighted here. So that's potential upside. I think there's less potential upside with the Permian Basin directly. That's really focused kind of outside of our service territory. What I would say indirectly, though, and back to my response earlier, ERCOT will update the speculative load study in early '25. At that point, they will incorporate an estimate of speculative load in the Greater Houston region. Given the explosive growth that we talked about, I have to believe that there are going to be more transmission lines that are needed, to serve that increasing load as a reminder. On any given day, we're importing about 60% electricity needed to serve our customers. And as that electricity demand grows, there will be more need for incremental transmission lines and substations. And so, we see electric transmission as being sort of a long-term tailwind for our CapEx plan. And I'd like to really start to kind of see that, come into greater focus probably in '25 along, around this speculative load update."
},
{
"speaker": "David Arcaro",
"content": "Okay. Great, that's helpful. Thanks so much."
},
{
"speaker": "Jackie Richert",
"content": "Operator, I think we have time for one more if there's another in the queue."
},
{
"speaker": "Operator",
"content": "All right. Our last question will come from Julien Dumoulin-Smith with Jefferies. Your line is now open."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Hi, good morning, team. Thank you guys very much. It's nice to chat with you guys again. If I can follow-up on a few different things, just a little bit pick here from the call thus far. With respect to mobile generation, I mean, just to understand the contract terms and the permutations here. How do you think about any strategic avenues here to the extent to which it ultimately the state, whether the legislative session, or otherwise ultimately effectively pushes you into a decision to effectively divest, if you will, in the broadest terms? How do you think about what is possible within the construct that you have here?"
},
{
"speaker": "Jason Wells",
"content": "Yes, thanks."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Especially for a state that's short."
},
{
"speaker": "Jason Wells",
"content": "I think that's the key to it, your last comment, right? There's been very little net generate - dispatchable generation build. Clearly, there's been a lot of generation build when we think about intermittent renewables. But on a net basis, in terms of new build less retirements. The state has really seen very little in the way of dispatchable build. And so, I think the focus for the state is really trying to. In particular, these days, find a path for the winter peak. We saw the benefit of the battery storage deployment here this past summer. I think those battery storage investments are really helping kind of the summer peak, where we're talking about hours. They're not necessarily as helpful in the winter peak, where we're potentially short for days. And so, I think what we're looking for is a solution that could help address dispatchable needs here in the state. That could mean subleasing our equipment to others, so that it doesn't leave the state, but is an available resource at the same level. Otherwise, obviously, we will work with our elected officials if they have a different point of view. And so, I don't think there's a definitive path forward, but I think everybody is trying to find a solution that protects customers in the event of load shed, but also does so sort of optimally from a cost standpoint, and we're happy to find that balance with everyone."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Excellent. And just a quick nitpick on the last response. Just a transmission update from ERCOT here. Obviously, ERCOT released their own load forecast here recently. You talked about this 8 gigawatt number on the call momentarily ago. How does that inbound, again, I get this is a fluid situation, reconciled against ERCOT's demand? And effectively, are you suggesting as a further sort of net uptick in ERCOT's demand and/or that updated load forecast that came up, with doesn't necessarily yet reflect their transmission expectations? I'm just trying to understand, I think you're suggesting that there's an uptick in both the demand as well as their transmission planning, to reflect the 8 gigawatts that you just alluded to on data center specifically potentially?"
},
{
"speaker": "Jason Wells",
"content": "Yes, Julien, I think that's the short of it. It's an uptick both on demand and transmission. The updated numbers still don't reflect, the potential development here in the Greater Houston region. That update, as I mentioned, really is coming kind of in early '25. What we have seen this summer is like a fundamental shift in data center activity. Up until early summer, we had about 1 gigawatt of demand in the queue. And now it's over 8 gigawatts as of the time of this call. And I think that really reflects the fact that as we talk to developers and hyperscalers, latency becomes less of an issue as it move more development to AI-driven data centers. Texas remains very attractive in terms of being able to build new transmission lines, new generation. Our interconnection timelines compare very favorably in a state that, can move quickly with large infrastructure investments. And so, I think that's why we've seen it dramatically change this summer. All of that, to your point, will get incorporated into ERCOT's low forecast early next year. And just given the point that I've recently highlighted, we continue to highlight that 60% of our electricity is important on any given day, that's likely going to mean more transmission here for the Greater Houston region."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Right. So even accelerating in the last quarter despite ERCOT's update even the last couple of months here, it seems like there's an upward bias there?"
},
{
"speaker": "Jason Wells",
"content": "Yes, yes."
},
{
"speaker": "Julien Dumoulin-Smith",
"content": "Awesome. Excellent guys. Thank you for the time and clarifying that."
},
{
"speaker": "Jason Wells",
"content": "Thanks, Julien."
},
{
"speaker": "Jackie Richert",
"content": "Thanks, Julien. And with that, operator, I think that will conclude our Q&A for today. Thanks, everyone, for participating in this quarterly call."
},
{
"speaker": "Operator",
"content": "This concludes CenterPoint Energy third quarter 2024 earnings conference call. Thank you for your participation. You may now disconnect."
}
] |
cnp | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to CenterPoint Energy Second Quarter 2024 Earnings Conference Call with senior management. During the company's prepared remarks, all participants will be in a listen-only mode. There will be a question-and-answer session after management's remarks. [Operator Instructions]. I will now turn the call over to Jackie Richert, Senior Vice President of Corporate Planning Investor Relations and Treasurer. Ms. Rickert?"
},
{
"speaker": "Jackie Richert",
"content": "Good morning and welcome to CenterPoint Energy's second quarter 2024 earnings conference call. Jason Wells, our CEO, and Chris Foster, our CFO, will discuss the company's second quarter results. Management will discuss certain topics that will contain projections and other forward-looking information and statements that are based on management's beliefs, assumptions, and information currently available to management. These forward-looking statements are subject to risks and uncertainties. Actual results could differ materially based upon various factors as noted in our Form 10-Q, other SEC filings, and our earnings materials. We undertake no obligation to revise or update publicly any forward-looking statements. We will be discussing certain non-GAAP measures on today's call. When providing guidance, we use the non-GAAP EPS measure of diluted adjusted earnings per share on a consolidated basis, referred to as non-GAAP EPS. For information on our guidance methodology and reconciliation of the non-GAAP measures discussed on this call, please refer to today's news release and presentation on our website. We use our website to announce material information. This call is being recorded. Information on how to access the replay can be found on our website. Now, I'd like to turn the call over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Jackie, and good morning, everyone. Before spending most of my time discussing the impacts of and our response to Hurricane Beryl, I will very briefly touch on our results for the second quarter. I'll then turn it over to Chris for a regulatory update and a more detailed recap of our financial results. For the second quarter, we reported GAAP and non-GAAP EPS of $0.36 per share. In addition, we are reaffirming our full year 2024 non-GAAP EPS guidance range of $1.61 to $1.63. Beyond 2024, we are also reaffirming our long-term guidance, where we expect to grow non-GAAP EPS and dividend per share growth at the mid-to-high end of our 6% to 8% range annually through 2030. Now, to turn to our primary area of focus. Earlier this month, Hurricane Beryl impacted our entire 5,000-square-mile service territory in the greater Houston area, causing power outages for nearly 2.3 million of our customers, or approximately 80% of our Houston electric customer base. We began tracking Hurricane Beryl and preparing for a possible impact nine days before Beryl made landfall. Initial forecasts showed that our service area in greater Houston would be spared a direct impact by the worst of the hurricane. Nonetheless, we remained vigilant and planned for impact. We initially secured 3,000 mutual assistance crew members from locations safely outside of the projected path of the storm. We also coordinated with utilities across Texas and the region to ensure resource availability. As the forecast trajectory changed, we quickly called on additional mutual assistance resources, ultimately activating and deploying over 15,000 CenterPoint mutual assistance crew members. Early in the morning on Monday, July 8, Hurricane Beryl made landfall as a powerful Category 1 hurricane with heavy rains, flooding, and up to 97-mile-hour winds that reached further inland than any storm experienced in Houston since 1983. As part of our response, we restored power to over 1 million customers within 48 hours, replaced over 3,000 distribution poles on our system, walked over 8,500 circuit miles to repair damage, and deployed mobile generators at 28 sites across the greater Houston area to various critical facilities. Impacts to our distribution lines and facilities from vegetation, such as uprooted trees and related debris carried by the very high winds, were the primary cause of customer outages. In recent years, trees in the Houston area have been weakened due to a combination of high rainfall, prior drought conditions, as well as winter freezes. We trimmed or removed approximately 35,000 trees during our restoration process. Through discussion with one of our largest vegetation management companies, 60% of the vegetation it removed were trees that had fallen from outside of our rights-of-way. Over the last 18 months, we proactively worked to address the challenges these conditions present to our distribution system through increased vegetation management. In fact, in 2023, our Houston Electric business increased its vegetation management spend by over 30% from the prior year. We continue to execute and invest at a similar, higher level of vegetation management as we recognize the impacts of the challenging growing seasons experienced in the Houston area over the last three years, and the resulting threat they could have on our lines and infrastructure. In addition, Hurricane Beryl's destructive winds, in combination with already weakened trees, highlighted not only the urgency with which we need to execute on our vegetation management plan, but also the scope. As a result, we have doubled our vegetation management resources and are aggressively tackling the riskier line miles with trees nearby. We will trim or remove trees related to an incremental 2,000 miles of our system by December 31st of this year. This represents a nearly 50% increase compared to our planned work for 2024. The vegetation work we have begun is only a part of a more comprehensive plan to improve customer outcomes and directly address the customer concerns and frustrations voiced with respect to critical aspects of our emergency response. This plan will also help us better prepare our response in key areas to future storms or hurricanes. I will walk through the three pillars of our comprehensive action plan to address our customers' concerns. Our first pillar relates to our resiliency investments. By accelerating the adoption of advanced construction standards, retrofitting existing assets on an accelerated basis, and using predictive modeling and AI, as well as other advanced technologies, we will harden our distribution system to help withstand more extreme weather and improve the speed of restoration. This is in addition to proactive steps we took nearly two years ago when we moved to constructing at the new national standard for high wind and extreme ice loading. Second, we will build a best-in-class customer communications program. Since the derecho that impacted Houston in May, our outage tracker has not been available for our customers. The tracker we previously used was hosted on a physical server that was not able to accommodate the demand of millions of users at one time. To keep our communities informed, we provided daily restoration updates, but we understand that for many, this was insufficient. As one component of our customer communication action plan, we are launching a new, more customer-oriented outage tracker later this week. Our new outage tracker will help provide our customers more of the information they need in a timely fashion. It will also be comparable to what our Texas Peer Utility customers experience. The new tracker is cloud-based, which will also allow us to scale to high levels of demand. Third, we will strengthen our partnerships with government and community leaders. Effective emergency preparedness and response requires close coordination with government officials. We will hire a seasoned emergency response leader to help the company rapidly accelerate its planning capabilities and to develop close community partnerships to help ease the burden of storm events on our more vulnerable communities. We believe the work underlying these three pillars will support our efforts to build and operate a grid that meets the demands of one of the most dynamic economies in the United States here in Houston. The initial set of specific actions we are taking is laid out on slide three. We will also be taking additional actions as we continue to learn from our internal reviews and external independent review, as well as through engagement with emergency response experts, our customers, elected officials, and community stakeholders. Our singular and overarching goal is to improve in every area of our emergency preparedness and response. Whether it is before, during, or after any future storm, we will be better prepared to support, communicate with, and serve our customers in these times of emergency. As we begin to execute this initial plan, we will work to consistently provide updates on our progress. The men and women at CenterPoint go to work every day with an unrelenting focus on delivering safe, reliable, and resilient energy to our customers, while also striving to improve their experience. We will continue to make customer-focused capital investments to achieve better outcomes for the nearly 3 million electric customers and over 4 million gas customers across our six-state footprint. And with that, I'll turn it over to Chris."
},
{
"speaker": "Chris Foster",
"content": "Thanks, Jason. Before I get into my updates, I want to echo Jason's gratitude to our customers and our communities. Our team is focused on improving our resilience and emergency response capabilities, and I will speak to our financial plan to support those efforts in my remarks today. Today, I'd like to cover three areas of focus. First, the details of our second quarter financial results and guidance. Second, I'll provide a brief update of the progress we're making on our regulatory calendar. Third, I'll touch on our capital deployment status this quarter and forecasted storm costs. And finally, I'll provide an update on our financing plan. Again, as Jason noted, today we are reaffirming our full year 2024 non-GAAP EPS guidance range of $1.61 to $1.63. Which represents 8% growth at the midpoint from our 2023 actual results of $1.50. Beyond 2024, we are also reaffirming our guidance, where we expect to grow non-GAAP EPS at the mid to high end of the 6% to 8% range annually through 2030, as well as targeting dividend per share growth in line with earnings per share growth. Let's now move to the financial results shown on slide four. On a GAAP EPS basis, we reported $0.36 for the second quarter of 2024. On a non-GAAP basis, we also reported $0.36 for the second quarter of 2024, compared to $0.28 in the second quarter of 2023. Diving into more detail of the earnings drivers for the quarter, growth and rate recovery contributed $0.10, which is primarily driven by the ongoing recovery from various interim mechanisms for which customer rates were updated last year, as well as the interim rates in our Minnesota gas business that went into effect on January 1 of this year. In addition, the Houston area continues to see strong organic growth, extending the long-term trend of 1% to 2% 3average annual customer growth. This sustained growth has been beneficial for our customers and investors alike. O&M was $0.02 favorable for the quarter. This favorable variance was driven primarily by the fact that we incurred more of our expenses in the first quarter and had some of our scheduled activities diverted to attend to restoration efforts related to the major HO storm. Partially offsetting the favorable items from rate recovery in O&M were unfavorable weather and increased interest expense. Weather and usage were $0.01 unfavorable when compared to the comparable quarter of 2023, driven primarily by a milder spring in our Minnesota gas service territory. Interest expense was $0.06 unfavorable, primarily driven by the new debt issuances since the first quarter of last year to fund customer-driven work across our electric and gas territories at a higher relative cost of debt. I now want to turn to an update on our broader regulatory calendar in progress, and I'll cover these sequentially from the dates filed. Starting with Texas Gas, where last month, we received Railroad Commission approval of our now final settlement. As a reminder, our four Texas gas jurisdictions will now be consolidated on a go-forward basis for our ongoing rate adjustments. This new consolidation should benefit many customers through a lower impact on their bills from certain investments, and also a reduced administrative burden for other stakeholders. Moving next to the filed Minnesota gas rate case. And as a reminder, we filed our rate case on November 1st of last year. As discussed on the last call, the interim rates for 2024 were approved in mid-December and went into effect on January 1st. The Minnesota Commission will consider interim rates for 2025 toward the end of this year, depending on how far along we are in the case. Hearings are scheduled to occur in the middle of December of this year. Ahead of those hearings, we intend to engage in settlement discussions with parties involved in the case. And as you may recall, we have settled our previous three rate cases in our Minnesota gas jurisdiction. Now, turning to the Indiana electric rate case. We currently have a non-unanimous settlement pending approval. Hearings on this settlement will begin the first week of September with a new statutory deadline for a final order of February 3rd. We look forward to continuing to work with stakeholders to achieve what we believe to be a reasonable outcome for all parties. I'll now touch on our largest jurisdiction, Houston Electric. Over the last month, we have been engaged with many stakeholders as part of settlement discussions in our pending rate case. Those discussions are ongoing, and we continue to provide regular updates to the ALJ in the case. In addition, as we execute on the actions we've laid out following Hurricane Beryl, we intend to work with stakeholders on how to amend our system resiliency plan with the PUCT. The process is fluid, but at this stage, we have abated the schedule on the underlying system resiliency plan, which all parties have agreed to. This allows us to take the coming months to reflect stakeholder input and additional potential system resiliency concepts that emerge from our after-action review and the review of the PUCT. We currently anticipate filing a revised plan later in Q1 2025. Lastly, I want to briefly mention that next month we will file a notice of intent for our upcoming rate case for our Ohio gas business, which is approximately $1.4 billion in rate base. Next, I'll touch on our capital investments thus far in 2024, as shown on slide 6, including the anticipated impact of storm costs and their associated recovery. In the second quarter of 2024, we invested $800 million of base work for the benefit of our customers and communities. This excludes spending related to storm restoration. We now have a little less than 60% of our original 2024 capital expenditure target of $3.7 billion to be invested over the remainder of the year, excluding storm costs. We remain on track to meet our capital investment target, despite the interruptions of normal capital deployment from the storms we've experienced this year. Maintaining our target as we consider a revised version of the resiliency work is a reflection of the conservatism with which we plan each and every year. Although the cost invoicing is not final, total spending associated with the May storm events and Hurricane Beryl are currently estimated to be approximately $1.6 billion to $1.8 billion. We currently anticipate that we will securitize both the capital and non-capital portion of the $1.5 billion to $1.7 billion distribution costs to limit the impact to our customers on their bills, and will include approximately $100 million of transmission investments within the next T-cost recovery filing. Based on the total current average residential electric bill, we estimate that these costs could result in an increase of a little more than 2%. As a reminder, the mechanism to recover storm costs in the state of Texas is very constructive and cost-effective for customers. Texas TDUs are able to securitize non-T-cost storm-related costs in excess of approximately $100 million under existing statutory authority. As a result, we anticipate filing for securitization in the fourth quarter of this year, with securitization bond proceeds expected to be received towards the end of next year. Finally, I want to touch on our balance sheet and how we're thinking about funding the storm costs I just discussed. As of the end of the second quarter, our calculated FFO-to-debt was 13.3%. Based on our calculation aligning with Moody's methodology as shown on slide 7, the second quarter tends to be our lightest quarter due to the timing of incremental financing relative to interim recovery mechanisms. This quarter also had a temporary cash flow item that we expect to normalize through the next quarter. Taking a step back, as we continue to see the need to fund growth we are experiencing in Texas, we remain focused on the balance sheet. And with respect to our financing plans through the end of the year, we have evolved our approach. Recognizing the storm impacts. As we remain committed to maintaining our current credit metrics in light of these incremental costs, we intend to pull forward $250 million of equity planned for 2025 into this year, which is in addition to the $250 million issued to date. This does not change our long-term equity guidance, rather should only be considered as an acceleration. We will also incorporate higher equity content into our upcoming debt issuances to enhance credit metrics until the anticipated securitization proceeds are received. We would also see this as pulling forward instruments we've been considering in our long-term plans as mentioned in recent quarterly calls. We remain confident in the continuation of our long-term execution. The last thing I want to mention is we are making good progress related to the sale of our Louisiana and Mississippi gas LDCs. We, along with the filings, including filings with the Louisiana and Mississippi public service commissions, and we look forward to working constructively with the commissions to facilitate the approval proceedings. We still anticipate closing the sale late in the first quarter of 2025, and it is anticipated to result in after-cash tax proceeds of approximately $1 billion. As a reminder, a majority of these proceeds will be used to fund our capital investments at Houston Electric for the benefit of customers. And with that, I'll now turn the call back over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Chris. Regardless of the challenges we face, this management team remains firmly committed to delivering for all of our stakeholders, our customers, our communities, our regulators, our legislators, and our investors."
},
{
"speaker": "Jackie Richert",
"content": "Thank you, Jason. With that, operator, we're now ready for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, we will begin taking questions. [Operator Instructions]. Thank you. One moment for the first question. The first question will come from Shar Pourreza with Guggenheim Partners. Your line is open."
},
{
"speaker": "Shar Pourreza",
"content": "Hey, guys. Good morning."
},
{
"speaker": "Jason Wells",
"content": "Morning, Shar."
},
{
"speaker": "Shar Pourreza",
"content": "Morning. Jason, maybe a little bit of a tough question to answer, but I guess, how do you see the commentary that we've all been listening to from customers, legislators, and kind of stakeholders impacting the current settlement negotiations in the Houston Electric rate case?"
},
{
"speaker": "Jason Wells",
"content": "Yeah, thanks for the question, Shar. Clearly, as I've said in a number of different forums, we can and will be better. These are important issues for the greater Houston region, for Texas. Ultimately, though, the answer for getting better is continued investment and resiliency of our system. I think that needs to or will be reflected in the continued negotiations that are occurring from a settlement standpoint. There's, again, clear demand that we need to communicate better, that we need to mitigate the risk of these outages moving forward. And I think, ongoing settlement discussions are all just part of putting the company in a position to continue to be able to make that progress."
},
{
"speaker": "Shar Pourreza",
"content": "Okay. Got it. Then, just lastly, obviously, Hurricane Beryl certainly highlighted more work needs to be done, and you had a level of resiliency spending bucketed as upside to the $44.5 billion CapEx plan. I guess, how do the recent events impact that bucket even directionally? How fast do you plan to ramp up in light of the increased urgency with the current regulatory construct that's out there? Thanks."
},
{
"speaker": "Jason Wells",
"content": "Yeah, I think it's definitely an area of focus. We were investing in resiliency prior to that resiliency legislation. I think we heard loud and clear at the PUCT meeting last week that we need to continue to move forward. We've made commitments to move forward. Ultimately, while we've pulled down the system resiliency plan, and we are working with outside experts, taking feedback, we'll obviously work with parties in the case, we plan to rapidly refile it. I think the short of it means there's probably more support for incremental resiliency investments. I'll give you one example. In the filing, we proposed continued sectionalization of our system, which is an important part of isolating outages, helping minimize the overall number. We proposed a pace of about 20 years in that program. I think that's a program that we need to revisit. I don't think the 20-year pace is no longer a pace that folks expect of us. If anything, I think the bias will be towards accelerating incremental resiliency investment as opposed to delaying it."
},
{
"speaker": "Shar Pourreza",
"content": "Got it. Okay. Appreciate it. I'll pass it to someone else. Thank you, guys."
},
{
"speaker": "Operator",
"content": "One moment for the next question. The next question comes from Steve Fleishman with Wolfe Research. Your line is open."
},
{
"speaker": "Steve Fleishman",
"content": "Yeah. Hi. Good morning."
},
{
"speaker": "Jason Wells",
"content": "Good morning."
},
{
"speaker": "Steve Fleishman",
"content": "Good morning. So, just on the, I guess, first, a question on the financing plan, the comment on the equity content in the upcoming refinancing, should we assume that's more like a junior subordinated, or could that be like a convertible? Any more color on the likely type of financing there?"
},
{
"speaker": "Chris Foster",
"content": "Morning, Steve. It is fair to say that we're certainly looking at different versions of hybrids to pull in more equity content into the plan. And as I mentioned this morning, the other piece is just to pull forward $250 million. Again, to be clear, that doesn't change the overall guide from 2024 to 2030 of the $1.75 billion total. It's just a pull forward of that piece. And as you can imagine, the point there is to just be able to have that in place to comfortably position the balance sheet until we get the anticipated securitization proceeds. Currently thinking those are probably going to be end of year next year."
},
{
"speaker": "Steve Fleishman",
"content": "Okay. And then maybe you could just give us some color on how the rating agencies are reacting to this event and spend in your updated plan. And it's going to be a little while before we know and see the securitization, so just thoughts on kind of their willingness to be patient."
},
{
"speaker": "Chris Foster",
"content": "Sure thing. I think it's fair to say we're having a conversation, Steve, obviously, about both how we're thinking about the plan that Jason has referenced, where we're going to aggressively move forward here in 2024 to do some critical work in the immediate sense. Longer term, we're also talking about some initial thinking on moving forward, ideally in Q1 with a subsequent revised system resiliency plan filing. I think in this case, Texas has had a consistent construct in the state for utilities to securitize costs above the $100 million point. Certainly, that's the case here. And so, sharing certainly that history and consistent history of the state as well in terms of its overall construct. So, fairly fluid conversations, you can imagine, just given how quickly we're moving on a few fronts, but certainly sharing all of our different activities."
},
{
"speaker": "Steve Fleishman",
"content": "Okay. Great. Thank you."
},
{
"speaker": "Chris Foster",
"content": "Thanks, Steve."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jeremy Tonet with JPMorgan Securities. Your line is open."
},
{
"speaker": "Jeremy Tonet",
"content": "Hi. Good morning."
},
{
"speaker": "Jason Wells",
"content": "Good morning, Jeremy."
},
{
"speaker": "Jeremy Tonet",
"content": "I wanted to pick up on the storm commentary. Thank you for the detail today. Just pulling it all together, looking at your post-hurricane action plan in the items you laid out here, how do you feel about, I guess, how Houston Electric can respond to the next storm out there? Do you think you have the pieces in place now to see a better response, even if everything's not in place altogether? Just wondering how you guys think you stand now."
},
{
"speaker": "Jason Wells",
"content": "Yeah, no, thanks for the question. I do feel confident. As I mentioned yesterday in the Senate hearing, it offers no relief to the customers impacted by Beryl. We were moving with pace and urgency after the derecho to move to a fully scalable outage tracker platform that would offer estimated times of restoration consistent with industry-leading practices and had begun the work to overhaul our communications. That's why I feel confident that if a named storm threatens the Texas Gulf Coast region, we'll be in a much better position to communicate before, during, and after that storm. I think giving our customers the information they unfortunately lack during Hurricane Beryl, but it's that work that we've been doing in advance that I think helps on the communication front. Equally, it offers no relief to the customers that experienced this pain during Beryl, but we had been working on bringing a lot of the innovative predictive modeling to target enhanced vegetation management and resiliency investments for work. That's why I'm confident that as we execute on the incremental resiliency commitments that we've made to Governor Abbott and others, it will have a meaningful impact for our communities. The last month has been tough on the City of Houston. We understand the role we play, but that's also why I have confidence looking forward."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Thank you for that. Just to follow up here, you mentioned that 60% of the downfall came from outside of your right-of-ways. What can you do about that going forward? Also, I guess just the assets overall, how did the hardened assets perform during the hurricane? Just want to see what value you think has been delivered with prior hardening here."
},
{
"speaker": "Jason Wells",
"content": "Yeah. Again, it offers no relief to the customers, but we are seeing the value of resiliency investments. We saw very minimal structural damage on our transmission system substations. Strategically, it makes sense to put the first investments in the backbone of the system from a resiliency standpoint. We've begun some of the incremental sectionalization work and hardening of distribution circuits. That work saved over 150,000 outages in the communities that we deployed that. I think moving forward from a resiliency standpoint, it's the acceleration of that work on the distribution grid that will have the most meaningful impact to minimizing outages going forward. The key issue, though, at the end of the day was, candidly, there was little structural damage on the system. It was well less than even 0.5% of our poles failed. But what really caused the outages were, as you pointed out, 60% of the trees impacting our lines were outside of our right-of-way. Candidly, we don't have any authority today to trim and manage those trees. We are doing the work to identify the trees that create those hazards. We are proactively trying to work with property owners to access that property and address those trees, which are a safety issue, obviously, for the residential homeowner, as an example. A tree can just as easily fall into their home as it could into the power line. But we don't have authority today unless granted by the homeowner. So, looking to work with community leaders, our regulators, elected officials to make sure that we can continue to work at pace to address this vegetation that threatens our system moving forward."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Thank you for that."
},
{
"speaker": "Operator",
"content": "And our next question comes from Nicholas Campanella with Barclays. Your line is open."
},
{
"speaker": "Nicholas Campanella",
"content": "Hey, good morning. Thanks for taking my questions this morning. I appreciate all the details."
},
{
"speaker": "Jason Wells",
"content": "Good morning, Nick."
},
{
"speaker": "Nicholas Campanella",
"content": "Morning. Just wanted to follow-up. As we kind of contemplate pulling forward some of this equity from '25 into '24, and then you also talked about doing this equity content financing as well, I know you talked about some kind of one-time issues in the 12-month episode of debt. Where do you think you kind of end at the base year, just based on the current plan today?"
},
{
"speaker": "Chris Foster",
"content": "Sure. Good morning. I think if you saw this report this morning, as you can imagine, some of this is just the differing methodologies. But from this standpoint, in the S&P methodology, there's the assumption that the securitization proceeds do come through, which moves us up to well above the downgrade threshold, up to 12.9%. At Moody's, right, they treated slightly differently, so it takes us from that roughly 14% to 13.3% where we are this morning. I do have to emphasize, though, Nick, keep in mind that last year this was the same situation. This is a bit of the trough that occurs in Q2 before we pick back up. And we've got a one-time item that we believe in Q3 that you'll be able to see come through further improving FFO to debt. Hard for me to be specific about year end, but just you can imagine where we are at this point is it's a transitory impact year of the time period that will pass between now and the securitization proceeds."
},
{
"speaker": "Nicholas Campanella",
"content": "Okay. Thanks for that. And then I guess you spoke about doubling some of the labor efforts around the tree trimming. Can you remind us, because you do have this 1% to 2%, I think it's an O&M reduction forecast in the long-term plan? Does that need to be reassessed? Can you execute on that, even net of these veg management increases? How do we think about that? Does that stuff get deferred? I'll leave it there. Thanks."
},
{
"speaker": "Jason Wells",
"content": "Thanks for the question, Nick. I think we continue to see opportunity to drive efficiency in our O&M practices to help support that overall 1% to 2% reduction in O&M. We continue to highlight, as we have in the past, a classic example of that is the benefit of deploying the next generation of smarter meters on the gas side. So, we see plenty of opportunity to continue to be efficient, which is, I think, obviously in our customers' interest, but also helps free up some opportunity to accelerate in other areas. As I highlighted, we increased proactively our vegetation management over 30% last year in 2023, and we still achieved that 1% to 2% reduction year over year in 2023. We will always make the investment that's needed to drive an improvement in service, but I still feel like we've got a number of opportunities across the full scope of the company's operations to achieve on a consolidated basis that 1% to 2% O&M reduction."
},
{
"speaker": "Nicholas Campanella",
"content": "That's helpful. Thanks so much."
},
{
"speaker": "Operator",
"content": "And our next question comes from Durgesh Chopra with Evercore. Your line is open."
},
{
"speaker": "Durgesh Chopra",
"content": "Hey, team. Good morning. Thank you for giving me time. I think, Chris, you mentioned 2% will increase from the securitization of the distribution spending. I have two questions related to that. First, the confidence level in $1.6 billion to $1.8 billion, I guess where I'm getting at with that is have you basically taken a deep dive of your costs? Are you still incurring costs? And the number could be significantly higher. That's one. And second, what that 2% is over -- you're assuming, I guess, cost recovery over a time frame, over multiple years. Maybe just if you could elaborate on that, please. Thank you."
},
{
"speaker": "Chris Foster",
"content": "Sure thing. Happy to. Good morning, Durgesh. I think there's really two pieces there. I think the first is -- I'll hit the second one first in terms of time frame. At this stage, we would be compiling the costs. The thing to keep in mind is that the existing construct in the state does allow for the entity to combine events that occur, including multiple events over a calendar year, into one securitization. So, again, we would seek to file that and ultimately assume, in this situation, end of year 2025 time frame for recoveries there. As it relates to the overall kind of profile itself, the thing to keep in mind here is that we do already have a good feel of the asset-based costs associated with both the derecho and Hurricane Beryl. The primary driver beyond that is most commonly the labor costs, right? The costs associated with nearly 15,000 individuals that were doing work on our system. And so, we do have a pretty good feel of how those are forecasted at this stage, which informs the disclosure this morning at the high end of $1.8 billion. So, again, it's going to be a somewhat similar profile, just given the crews and the associated contracts are very similar as to what we saw in the situation with the derecho, and we're well over 75% of those costs already in. So, it gives us confidence to inform the profile that you see today."
},
{
"speaker": "Durgesh Chopra",
"content": "Excellent. Thank you. Just one quick clarification, Chris. The 2%, I think you mentioned the 2% impact on customer bills. I guess where I was going with the time frame is that assumes that $1.8 billion is collected over how many years?"
},
{
"speaker": "Chris Foster",
"content": "Sure. Traditionally, in the statutory requirement in Texas, it's 15 years."
},
{
"speaker": "Durgesh Chopra",
"content": "Thank you. I appreciate the time."
},
{
"speaker": "Chris Foster",
"content": "Sure thing."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Arcaro with Morgan Stanley. Your line is open."
},
{
"speaker": "David Arcaro",
"content": "Hey. Good morning. Thanks for taking my question."
},
{
"speaker": "Jason Wells",
"content": "Good morning, David."
},
{
"speaker": "David Arcaro",
"content": "Morning. I'm wondering if you might be able to comment on the legislative outlook from here. I'm curious if there are legislative initiatives that you might pursue or support, just any ideas that may be being explored by lawmakers in the state to help improve resiliency?"
},
{
"speaker": "Jason Wells",
"content": "A couple of the topics that have come up early on are consistent with my previous discussion around vegetation management. I think the question is, does the state of Texas, do we need to do something different to be able to attack these hazard trees that are outside of right-of-ways and do so in a manner that is obviously constructive with property owners? I think that's obviously a place to look. The other thing that's come up is sort of the unique aspect of the market here in Texas, the fact that we have a service relationship with customers but not a commercial relationship. It's, at the end of the day, inexcusable that we don't have customer contact information at each address since we have that service-related responsibility. There may be something around that as well. Clearly, yesterday, there was a lot of feedback on mobile generation. Right now, we want to be constructive with the policy objectives of the state. As I mentioned in the Senate hearing, we have an order by the PUCT that we cannot allow a customer to go more than 12 hours without power in a load shed event. Those assets are necessary to comply with that order, but if policymakers want to change that direction, obviously, we will work to support the policy direction of the state. There's a lot of different things being discussed now, and I think that they will come into greater focus as we approach the end of the year and, obviously, the start of the legislative session next year."
},
{
"speaker": "David Arcaro",
"content": "Okay. That's helpful. Thanks. Maybe, Chris, just wondering if you might be able to clarify, is there a target for when you would expect to get back. At the FFO/Total debt level, you would expect to get back into the target range and get above 14%? For example, at Moody's?"
},
{
"speaker": "Chris Foster",
"content": "Sure, David. I think what you'll see there naturally is that you'll have the adjustment upward from S&P that will take place, and then Moody's does so upon receipt of proceeds. Again, so you'd be looking at roughly Q4 of next year in this timeframe."
},
{
"speaker": "David Arcaro",
"content": "Okay. Understood. Thanks so much."
},
{
"speaker": "Operator",
"content": "And the next question comes from Julien Dumoulin Smith with Jefferies. Your line is open."
},
{
"speaker": "Julien Dumoulin Smith",
"content": "Hey. Good morning, team. Thank you, guys, for the time. I hope you guys are hanging in there. Just maybe on the puts and takes, obviously, you talked about some of the accelerated equity here on '24. Just can we talk a little bit about your thoughts on the positive offsets here to the pressure points, whether it's additional OpEx in the form of these storms, to the extent to which there's any realized interest expense or ultimately just lost sales? How do you think about the good guys and bad guys in the offset there to maintain the outlook here in the very near term?"
},
{
"speaker": "Chris Foster",
"content": "Sure thing, Julien. In the very near term, as you can imagine, there was a usage impact associated with the storm itself. We also had a situation where we were having to adjust work temporarily as it related to the literal storm response and restoration. But ultimately, as we're looking through the remainder of the year, as you saw, we reaffirmed this morning, gives us confidence that we've got both two things going on. One, the ability for the mutual aid and other crews who joined our colleagues to really effectively work to restore customers quickly. But also, as I mentioned, we have been able to retain confidence in achieving the base CapEx plan as well. So net of the different factors, including interest expense, we're confident that we're still able to reaffirm this morning."
},
{
"speaker": "Julien Dumoulin Smith",
"content": "All right, fair enough. And then just coming back to the mobile gen, I mean, that's been getting a certain amount of attention here. And obviously, perhaps they were contemplated for a slightly different circumstance. How do you think about developing a more refined program here to target more of these localized distribution-related outages with vegetation management issues that you've encountered here? And ultimately, how does this work in, because of which you evaluate this or otherwise, into a revised timeline on the resiliency filing here? I know that there's various permutations there as well."
},
{
"speaker": "Jason Wells",
"content": "Yeah, I mean, I strongly believe we have the most comprehensive mobile gen program consistent with what has been asked of us by the state and its policy objectives. The legislation was passed in 2021, and there was a focus on load shed events. Those are sort of larger units tied to substations. And as I mentioned yesterday, there's been 115 instances since that legislation started to be discussed where there were tight system conditions on our cotton. Those systems, those units may be to be utilized. We had also utilized in 2021 one of the medium-sized units for storm restoration and got a significant amount of pushback. And I think the legislature clarified that in 2023. And as soon as we got that clarification in the fall of 2023, we increased the number of small units. And so, I'm proud that we were able to scale to 18 small units out of a total of 30. The other 12 we borrowed from our utility peers to be part of the storm response. And so, as I said yesterday, we manage a number of different risks, whether those are load shed events or storm response. We've got a portfolio of assets to kind of meet those needs. Now, obviously, as I said, if the policy objectives of the state change, we will change with them. But I think today we are maintaining a diversified portfolio for the diversified set of risks that we manage."
},
{
"speaker": "Jackie Richert",
"content": "Operator, I think we're going to have time for one more question."
},
{
"speaker": "Operator",
"content": "Okay. And our last question will come from Anthony Crowdell with Mizuho. Your line is now open."
},
{
"speaker": "Anthony Crowdell",
"content": "Hey, thanks for squeezing me in. I appreciate it. Just two quick ones. I'm not sure if one was answered. If I look on slide 3 and the plan and everything else, if I remember correctly, your system resiliency plan was between $2.2 billion and $2.7 billion. $2.2 billion was the base case. Then, what's on slide 3 be accomplished as a $2.7 billion number, or that would be above the $2.7 billion number?"
},
{
"speaker": "Chris Foster",
"content": "Anthony, morning. I was thinking about it within the $2.7 billion. Keep in mind that we provide that higher end as an articulation of the ability to accelerate some work, and that's really what you're seeing here is a pretty aggressive acceleration here in 2024 to make sure we're doing more work on the system."
},
{
"speaker": "Anthony Crowdell",
"content": "Great. And then a follow-up to an earlier question, you guys identified a lot of the outages occurred due to, I think, trees that are on customer's property. You guys didn't really have any responsibility over it. I mean, does undergrounding become more of a solution in your service territory than maybe years past?"
},
{
"speaker": "Jason Wells",
"content": "Yeah, thanks, Anthony. It's a great question, and I think one where there's certainly going to be a greater push for undergrounding, and it will play probably an even more prominent role in our resiliency efforts going forward. But what I think is important as well as to kind of balance it, about 60% of our customers today receive service through underground lines. It's a pretty significant penetration of undergrounding already in the system. But the point of weakness is those communities are often fed with overhead lines kind of at the feeder level. That's where we saw the tree damage. And so, I think we have to find a balance between undergrounding where it makes sense and where we have overhead lines, making sure that they are hardened and more resilient so that they're not the single point of failure, so to speak, from an outage standpoint. So, it's a little bit of an all of the above, but I would imagine that undergrounding takes an even greater prominence moving forward."
},
{
"speaker": "Anthony Crowdell",
"content": "Great. Thanks for taking my questions."
},
{
"speaker": "Jason Wells",
"content": "Thanks, Anthony."
},
{
"speaker": "Jackie Richert",
"content": "Great. Operator, with that, that will now conclude our Q&A for the day. I appreciate everyone dialing in. I think with that, we'll conclude the call."
},
{
"speaker": "End of Q&A",
"content": ""
},
{
"speaker": "Operator",
"content": "This concludes CenterPoint Energy's second quarter 2024 earnings conference call. Thank you for your participation and have a good day."
}
] |
cnp | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to CenterPoint Energy's First Quarter 2024 Earnings Conference Call with senior management. [ Operator Instructions ] I will now turn the call over to Jackie Richert, Senior Vice President of Corporate Planning, Investor Relations and Trustee. Ms. Richert, you may begin."
},
{
"speaker": "Jackie Richert",
"content": "Good morning, and welcome to CenterPoint Energy's First Quarter 2024 Earnings Conference Call. Jason Wells, our CEO; and Chris Foster, our CFO, will discuss the company's first quarter results."
},
{
"speaker": "",
"content": "Management will discuss certain topics that will contain projections and other forward-looking information and statements that are based on management's beliefs, assumptions and information currently available to management. These forward-looking statements are subject to risks or uncertainties. Actual results could differ materially based upon various factors as noted in our Form 10-Q, other SEC filings and our earnings materials. We undertake no obligation to revise or update publicly any forward-looking statements."
},
{
"speaker": "",
"content": "We will be discussing certain non-GAAP measures on today's call. When providing guidance, we use the non-GAAP EPS measure of diluted adjusted earnings per share on a consolidated basis referred to as non-GAAP EPS. For information on our guidance methodology and a reconciliation of the non-GAAP measures used in providing guidance, please refer to our news release and presentation on our website. We will use our website to announce material information. This call is being recorded. Information on how to access the replay can be found on our website."
},
{
"speaker": "",
"content": "Now I'd like to turn the call over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Jackie, and good morning, everyone. As many of you likely saw from this morning's earnings release, we are off to a strong start in 2024 despite the mild weather and the general trend of higher for longer interest rate environment our sector has experienced. This quarter is yet another illustration of why we believe we have one of the most tangible long-term growth plans in the industry, which we plan to consistently execute and thoughtfully enhance for the benefit of all of our stakeholders."
},
{
"speaker": "",
"content": "On this morning's call, I'd like to address 3 key areas of focus before handing the call over to Chris to discuss our financial results in more detail. First, I'll briefly summarize the strong first quarter financial results I just alluded to. Second, I'll touch on the details of our most recent filing at Houston Electric related to our resiliency investments, including the potential for incremental CapEx. And lastly, I'll provide an update on where we stand with respect to our regulatory calendar including an overview of our pending rate cases and an important update on the settlement of our Texas Gas rate case, where we are hopeful for an eventual constructive outcome for our stakeholders."
},
{
"speaker": "",
"content": "First, turning to our financial results for the first quarter. This morning, we announced non-GAAP EPS of $0.55 for the first quarter, which represents over 1/3 of our full year non-GAAP earnings guidance at the midpoint. As a reminder, our full year 2024 non-GAAP EPS guidance range of $1.61 to $1.63 represents 8% growth at the midpoint from our 2023 actual results of $1.50 per share and reflects our continued focus delivering value for our investors each and every year."
},
{
"speaker": "",
"content": "Beyond 2024, we are reaffirming our guidance where we expect to grow non-GAAP EPS at the mid- to high end of our 6% to 8% range annually through 2030 as well as targeting dividend per share growth, in line with earnings per share growth over that same period of time. Chris will provide additional details regarding our financial results and earnings guidance shortly."
},
{
"speaker": "",
"content": "Now I'll turn to the recent announcement we made regarding Houston Electric's resiliency plan filing. There's been a tremendous amount of collaboration by the public and private sector to align our focus on great resiliency across the state of Texas. I want to applaud the state for its continued support for providing additional tools to help improve resiliency of the electric grid, all of which serves to support the continued economic growth here in Texas."
},
{
"speaker": "",
"content": "This legislation is a recognition of investments needed to strengthen the resiliency of the grid for the increasing risk of disruptive, extreme weather-related or security-related events while at the same time accommodating little growth across Texas. Through these filings, we anticipate achieving a faster pace of investments to support higher levels of resiliency for our customers while also utilizing a recovery mechanism that is expected to enable smoother and more efficient recovery of certain distribution-related costs for the benefit of our customers and our investors."
},
{
"speaker": "",
"content": "Our focus on delivering a more resilient grid that serves approximately 2.8 million metered customers across the Greater Houston area has been underway for some time. The sequence of our work portfolio began with enhancing our electric transmission system and related substation, which comprised the backbone of our electric grid. This work included upgrading our transmission structures to better withstand extreme winds, elevating our substations to mitigate flood risk and converting our older 69 kV transmission lines to a more robust 138 kV standard. We will continue this work on the backbone of our system and when the first 3-year cycle proposed in this filing is complete in 2027, we believe we will have finished the vast majority of work associated with these programs."
},
{
"speaker": "",
"content": "With that series of measures well underway, we're now complementing these program elements by expanding our targeted investments to improve outcomes closer to the customer. Our work articulated in our resiliency filing has 24 individual resiliency measures that are focused on advancing the overall resiliency of our system. The 3-year plan is expected to significantly improve customer outcomes from the most severe system events associated with extreme wind, flood, temperature changes and wildfires."
},
{
"speaker": "",
"content": "Additionally, measures are being undertaken to bolster physical and cybersecurity. Examples of some of the solutions will deploy include composite poles, trip saver devices and intelligent grid switching automation technology. All of these are proven to help the system respond more favorably in extreme conditions, resulting in a reduced number of sustained interruptions that our customers experience."
},
{
"speaker": "",
"content": "In fact, we've steadily deployed similar system automation in recent years, saving our customers over 300 million minutes of interruptions over the last 5 years. With the investments included in our resiliency plan filing, we could more than triple that figure over the next few years."
},
{
"speaker": "",
"content": "In aggregate, our filing includes a range of investments of approximately $2.2 billion to $2.7 billion over the 3-year period of 2025 to 2027. The high end of our filing, if approved, would increase our total capital expenditures from $44.5 billion to $45 billion over our 10-year plan ended in 2030."
},
{
"speaker": "",
"content": "Consistent with how we have historically incorporated incremental investment opportunities in our base plan, the $500 million of additional capital will be formally included in our capital investment plan when we believe we can efficiently execute, finance and recover these investments. We will also align our execution with the feedback and final resolution of the resiliency plan proceeding, which we anticipate will be towards the end of this year."
},
{
"speaker": "",
"content": "While we have factored the majority of this resiliency investment within our updated CapEx and financing plans discussed last quarter, Chris will describe thoughts on efficiently funding the incremental $500 million of capital investment opportunity including pursuing various state and federal incentives. We are excited to work with the commission and other stakeholders to get feedback on the plan we proposed and most importantly, executing this work to create a more resilient electric grid for our customers."
},
{
"speaker": "",
"content": "I now want to turn to an update on broader regulatory calendar. I'll cover these sequentially from the dates file, starting with a Texas Gas rate case, where we have recently announced an all party settlement. Although this settlement is still subject to railroad commission approval, we believe the settlement agreement reached with parties is a constructive outcome for our customers and all other stakeholders."
},
{
"speaker": "",
"content": "In its current form, pending approval, the case will result in an annual revenue requirement increase of approximately $5 million, which results in an average increase of well under 1/10 of 1% for our Houston area residential customers. This very modest customer bill increase is a great illustration of the power of organic growth, coupled with our continued focus on reducing O&M across our businesses. The Texas Gas rate case filing included nearly $500 million of new capital investments and an increase to its authorized cost of capital that I'll briefly touch on in a moment, all while resulting in a very modest increase for our customers."
},
{
"speaker": "",
"content": "Since the last rate case, we have invested a total of $1.4 billion in CapEx to continue to improve system safety and reliability for our customers. These investments have translated to more than 1,800 miles of pipe replacement and more than 300,000 advanced meter upgrades, all helping to modernize our gas network. As I just mentioned, our $5 million settled revenue requirement proposal includes an increase to our authorized capital structure and return on equity."
},
{
"speaker": "",
"content": "The proposed settlement includes an authorized equity ratio of approximately 61% and an authorized return on equity of 9.8% across our entire Texas gas jurisdiction. In comparison, we are currently authorized on average for a 55.5% equity layer and a 9.64% return on equity across the 4 historic divisions, increasing both our authorized equity ratio and our authorized return on equity is vital to the Texas Gas business as well as our other regulated businesses as we continue to compete for capital to make critical investments for our customers."
},
{
"speaker": "",
"content": "In addition to the minimal impact to our customer bills, the settlement combines our 4 historic Texas gas jurisdictions into 1 jurisdiction for future capital recovery mechanisms which will benefit all stakeholders through reduced administrative burden and the ability to spread future investments over a broader growing customer base. We appreciate the effort of various parties involved in the rate case to this point and expect railroad commission consideration of the settlement this summer."
},
{
"speaker": "",
"content": "Moving to the filed Minnesota Gas rate case. As a reminder, we filed our rate case on November 1st of last year, with a requested revenue increase of approximately $85 million and $52 million for 2024 and 2025, respectively. As discussed on the last call, the interim rates for 2024 were approved in mid-December and went into effect on January 1st of this year. The commission will consider interim rates for 2025 toward the end of this year, depending on how far along we are in the case. At this stage, we anticipate hearings to occur in the middle of December this year. Ahead of those hearings, we intend to engage parties to the case in settlement discussions. As you may recall, we have settled our previous 3 rate cases at our Minnesota Gas jurisdiction."
},
{
"speaker": "",
"content": "Now turning to the Indian electric rate case, which we filed in December of last year with a requested revenue requirement of $190 million. As we've discussed previously, much of this revenue requirement increase is associated with our investments in connection with our electric generation transition plan as we move away from coal to more efficient and cost-effective fuel types such as renewables and natural gas. We have slightly delayed the start of the hearings in this case to determine if a settlement is possible with parties. Absent a settlement, we would expect a final decision in this case in the fourth quarter of this year."
},
{
"speaker": "",
"content": "And finally, I'll touch on our largest jurisdiction, Houston Electric. As many of you saw, we have filed our rate case last month with a requested revenue requirement increase of 2.6%, which is approximately $60 million. This revenue requirement increase results in a relatively nominal residential customer charge increase of about $1.25 per month or less than 1%. This revenue requirement increase is premised on the filing seeking an authorized equity ratio of approximately 45% and an authorized return on equity of 10.4%."
},
{
"speaker": "",
"content": "As a reminder, we've been funding the Houston Electric business with a 45% equity ratio, as we believe this is the minimum amount of equity with which this business should be capitalized even though we are currently authorized at 42.5%. The modest revenue requirement request truly exemplifies the strong advantage we have here at CenterPoint, as it's driven by, one, our relentless focus on reducing O&M 1% to 2% per year on average; two, prior securitization charges rolling off the bill in October of this year; and three, the nearly unparalleled growth at Houston Electric and surrounding areas experienced each and every year."
},
{
"speaker": "",
"content": "To put these combined factors into perspective, since our last rate case in 2019, Houston Electric's rate base has nearly doubled, while the average residential charges were nearly the same amount at the beginning of 2024 as they were all the way back in 2014."
},
{
"speaker": "",
"content": "As a management team, we are acutely aware of the advantage we have to serve a growing economy like Houston, but we also understand the tremendous responsibility that a company [indiscernible]. We are tasked with serving and supporting the dynamic growth of Houston's vibrant and diverse population. One recent tangible example of Houston's continued expansion can be seen from the nearly $6 billion in Department of Energy grants awarded a little over a month ago. Nearly 1/3 of these grants were ordered for projects in the Greater Houston area."
},
{
"speaker": "",
"content": "If completed, we believe these projects associated with these grants could contribute well over 500 megawatts alone in new load in the Houston Electric service territory. And this is just one of many examples of the explosive load growth potential in this region. We look forward to working with our stakeholders as we continue to support this incredible growth story here in Houston."
},
{
"speaker": "",
"content": "Before moving on, I want to briefly mention that we have one other rate case that we will be filing in 2024 related to our Ohio gas business. We anticipate filing this rate case in August of this year, and we'll provide more details as we get closer to the filing. We look forward to continuing to work with all of our stakeholders to reach constructive resolutions to all of our rate cases. We believe we are well positioned in all of our filings as we've made prudent investments on behalf of our customers and have made concerted efforts to reduce controllable O&M for the benefit of the communities we serve. Those are all of my updates for now."
},
{
"speaker": "",
"content": "With a strong start here in 2024, we have laid the foundation to once again meet or exceed expectations for the benefit of all of our stakeholders. I'm proud of the early milestones already achieved in 2024 and look forward to being able to provide progress on our cases and how the resiliency plan filing and other opportunities may influence incremental investments in the future."
},
{
"speaker": "",
"content": "I am confident in our path forward and our ability to continue as we reaffirm our commitment to our proven strategy into our non-GAAP EPS guidance target range of 8% in 2024 and at the mid- to high end of our 6% to 8% non-GAAP EPS guidance target range annually from 2025 through 2030. And as we've mentioned in recent quarters, we'll be prepared to update a new 10-year plan through an Analyst Day following the conclusion of our rate cases next year."
},
{
"speaker": "",
"content": "With that, I'll hand it over to Chris for his financial updates."
},
{
"speaker": "Christopher Foster",
"content": "Thanks, Jason. Today, I'd like to cover 3 areas of focus. First, the details of our strong first quarter financial results. Second, I'll touch on our capital deployment progress this quarter and the potential for incremental capital related to Houston Electric system resiliency plan filing. And finally, I'll provide an update on where we stand with respect to our current financing plan and credit metrics."
},
{
"speaker": "",
"content": "Let's start with the financial results shown on Slide 6. As Jason highlighted earlier, the first quarter of 2024 was yet another strong quarter of financial performance here at CenterPoint. On a GAAP EPS basis, we reported $0.55 for the first quarter of 2024. On a non-GAAP basis, we also reported $0.55 for the first quarter of 2024 compared to $0.50 in the first quarter of 2023. With these first quarter results, we have now earned over 1/3 of our full year 2024 non-GAAP earnings guidance at the midpoint."
},
{
"speaker": "",
"content": "Diving into more detail of the earnings drivers for the quarter, growth in rate recovery contributed $0.09, which was primarily driven by the ongoing recovery from various interim mechanisms for which the customer rates were updated last year. In addition to those capital recovery mechanisms, interim rates in our Minnesota gas business went into effect on January 1st of this year. These rates reflect a revenue requirement increase of approximately $69 million, which when combined with our requested 2025 revenue increase, represent an approximately 5% average bill increase over the next 2 years."
},
{
"speaker": "",
"content": "In addition, we continue to see strong organic growth in the Houston area, extending the long-term trend of 1% to 2% average annual customer growth, which continues to benefit both customers and investors. A great illustration of this continued growth can be found in the impressive job creation we've observed in Houston over the last year."
},
{
"speaker": "",
"content": "According to the U.S. Department of Labor, the Houston Metro area added the second most jobs in the entire U.S. from February of last year to February 2024. Weather and usage were $0.02 favorable when compared to the same quarter of 2023. And despite the mild weather, the $0.02 favorable variance was largely driven by more favorable weather when compared to an extremely mild Q1 of 2023, partially offsetting the favorable items from rate recovery and usage were increases in O&M and interest expense."
},
{
"speaker": "",
"content": "O&M was $0.02 unfavorable for the first quarter. This unfavorable variance was driven by additional work pulled forward in the first quarter of this year as well as storm response recovery efforts. However, we remain on track to achieve our target of reducing O&M 1% to 2% per year on average through 2030. Interest expense was $0.04 unfavorable, primarily driven by the new debt issuances since the first quarter of last year at a higher relative cost of debt. However, the impact of this increase was partially offset by the redemption of all outstanding shares of the Series A preferred for $800 million last September which eliminated the approximately $12 million quarterly dividend. I'll discuss our long-term financing plan and balance sheet in greater detail later."
},
{
"speaker": "",
"content": "Next, I'll touch on our capital execution thus far in 2024 and the state of our 10-year capital plan target, which you can see here on Slide 7. In short, we are right on plan. The first quarter of 2024 represented yet another quarter of solid capital investment execution as we invested $800 million for the benefit of our customers and communities. This represents a little over 20% of our 2024 capital expenditure target of $3.7 billion."
},
{
"speaker": "",
"content": "Our approach to incorporating customer-driven capital has resulted in a capital investment plan of $44.5 billion and potentially more, which represents an increase of over 10% since our 2021 Analyst Day. This increased capital plan is expected to drive a nearly 10% rate base CAGR through 2030, which supports strong earnings growth through the remainder of the decade."
},
{
"speaker": "",
"content": "We continue to estimate our growth in customer delivery charges at Houston Electric to be equal to or less than historical inflation rate of 2% through 2030 with this capital investment profile. We have confidence in our ability to achieve this, given the size of Houston Electric's customer base and the underlying tremendous organic growth, securitization charges that are rolling off the bill later this year, and our plan to reduce O&M as I referenced."
},
{
"speaker": "",
"content": "In addition to enhancing the customer experience through our capital investments, we remain focused on affordability, both from an O&M and ongoing targeted capital perspective. A great illustration as to why we are confident that we can continue to prudently invest while keeping customer charges modest can be found by looking at our utility delivery charge increases over the last 10 years. Since 2014, Houston Electric's average monthly delivery charges have stayed essentially flat. That's a truly remarkable outcome for our customers. And as Jason mentioned, our capital has potential for further incremental revisions driven by our resiliency filing in Texas."
},
{
"speaker": "",
"content": "The system resiliency plan filing could drive incremental customer-driven opportunities of up to $500 million at the high end range of our proposed investment. And I want to reiterate that over the past couple of years, we have been increasing our capital investment plan through 2030 as we identify incremental investment opportunities that we believe we can efficiently execute, finance and recover."
},
{
"speaker": "",
"content": "Let's spend a moment on the potential for funding the incremental resiliency investment opportunities of approximately $500 million, which Jason mentioned. We are applying for various federal dollars through multiple avenues and have already applied for $100 million of [ grid ] applications through the Department of Energy Grid Resilience and Innovation Partnership funding opportunity, and that was submitted a little over a week ago. These funds, if approved, would primarily assist in providing a lower cost of borrowing for our resiliency initiatives around distribution circuit rebuilds and substation resiliency innovations."
},
{
"speaker": "",
"content": "In addition, we will also seek other efficient funding opportunities through federal and state matching programs such as the DOE loan guarantee program. CenterPoint has 3 separate loan applications working through the process in various stages for over $2 billion in aggregate. While these are loan dollars, not grant dollars, the relative cost savings versus traditional debt can be substantial, around 100 basis points, representing meaningful savings for customers."
},
{
"speaker": "",
"content": "As Jason alluded to, we are actively pursuing these avenues of funding as we believe these are incredibly valuable initiatives for customers. To the extent that we are not successful, our consistent growth capital investment rule of thumb holds which is funding in line with our consolidated capital structure."
},
{
"speaker": "",
"content": "Finally, to highlight the balance sheet and credit strength. As of the end of the first quarter, our calculated FFO to debt is 14.6%, based on our calculation aligning with Moody's methodology, as shown on Slide 20. On a full year 2024 basis, we still anticipate delivering on the 100 to 150 basis points cushion we continue to emphasize when applying Moody's methodology."
},
{
"speaker": "",
"content": "As you can see on the slide, we've also included S&P's calculation on the slides this quarter and will continue to do so going forward. As the computations illustrate, we've adjusted our calculations for onetime items, mainly driven by Winter Storm Uri. We have had 2 years of onetime items related to the over $1 billion of extraordinary gas costs associated with that storm. We don't believe that this debt nor the eventual receipt of the proceeds and associated taxes were indicative of the fundamental credit health of the company and adjusted accordingly."
},
{
"speaker": "",
"content": "For comparative purposes, you can see on the slide that we put our calculated 14% in the middle of the 18.5% FFO to debt that Moody's derived and the 11.2% calculation that S&P derived. To be clear, we see no need to change our current financing plans we shared with our rating agencies earlier this year to improve the outlook from S&P on our credit metrics."
},
{
"speaker": "",
"content": "In addition, we've made good progress against the modest $250 million at the market or ATM equity program year-to-date. We have completed approximately 75% of our equity sales through today leaving only around an expected $60 million of equity remaining to be issued this year. As a reminder, we continue to have slightly elevated parent debt to total debt as we are continuing to carry over $400 million of debt at the parent to support what we believe is the proper capitalization of the CEHE [indiscernible] operating companies through rate cases. We plan to continue to carry that through the CEHE rate case supporting its approximately 45% equity layer today."
},
{
"speaker": "",
"content": "On the solid footing of a strong first quarter, we continue to reaffirm our non-GAAP EPS target of 8% this year and the mid- to high end of 6% to 8% annually thereafter through 2030. This growth is supported by differentiating factors that we enjoy, including consistent customer organic growth, which has averaged 2% per year over the last 30 years in the Houston area, Texas' pro-business environment which continues to attract new investment, especially in the Gulf Coast region. And lastly, our relentless focus on O&M discipline. We believe these factors will allow us to sustainably grow for years to come."
},
{
"speaker": "",
"content": "The last thing I want to mention is that we are making good progress related to the sale of our Louisiana and Mississippi Gas LDCs. We, along with the buyer, have now made all required regulatory filings including filings with the Louisiana and Mississippi Public Service Commission, and we look forward to working constructively with the commission to facilitate the approval proceedings."
},
{
"speaker": "",
"content": "We still anticipate closing the sale late first quarter 2025 and is anticipated to result in after-tax cash proceeds of approximately $1 billion, which equates to an earnings multiple of nearly 32x 2023 earnings. This will be a terrific outcome for all stakeholders."
},
{
"speaker": "",
"content": "With that, I'll now turn the call back over to Jason."
},
{
"speaker": "Jason Wells",
"content": "Thank you, Chris. I look forward to continuing not only to execute on what I believe to be 1 of the most tangible long-term growth plans in the industry, but also enhancing it for the benefit of all of our stakeholders in both the near and long term."
},
{
"speaker": "Jackie Richert",
"content": "Thank you, Jason. Operator, we're now ready for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And the first question will come from Shahriar Pourreza with Guggenheim Partners."
},
{
"speaker": "Konstantin Lednev",
"content": "It's actually Constantine on for Shahriar. Appreciate the updates on the call today, especially with the resiliency filing, and I see that it was largely embedded in the 4Q update. But as we think about the $500 million upside, just how are you thinking about in terms of accretion versus the 10% rate base growth? And maybe any specific thresholds or incremental -- on the incremental updates on CapEx? And how are you kind of planning to announce any kind of financing optimization there?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Thanks, Constantine. Pretty comprehensive question there. Let me kind of start at the highest level. And I think there's 3 main points to this CapEx update. The first is we've got a great base plan, 10% rate base growth through the end of the decade. And the second point I'd make is we've been spending significantly on resiliency because it's the right thing to do for our customers and case in point. We've increased our CapEx plans over 10% since our 2021 Analyst Day. That was largely [indiscernible] increased resiliency efforts."
},
{
"speaker": "",
"content": "And so this is -- again spend that has been already incorporated in this plan. And then importantly, I do think third, we have a significant amount of opportunities in front of us. Those take the form of continued resiliency investment, particularly on the distribution side, one of the things that I'm probably most excited about is the industrial electrification opportunity that we have here, particularly in the greater Houston area."
},
{
"speaker": "",
"content": "Just as one quick example, there's about 10 gigawatts of hydrogen production in development to come online before 2030. That hydrogen production requires significant increases in electric transmission capacity, substation capacity, also carries with it significant jobs, which will help continue to drive residential loan growth. On the gas side of things, we continue to see significant opportunities for incremental CapEx, particularly around maybe local gas transmission pipeline capacity in the Greater Houston area."
},
{
"speaker": "",
"content": "We're one of the few gas LDCs in the country that don't have localized gas transmission capacity, and I think it can help our customers help mitigate the cost and severe weather events. And so the short of it is we've got a great base plan. We've been spending on resiliency, and we have significant increases in CapEx still in front of us."
},
{
"speaker": "",
"content": "In terms of being accretive to the plan, we wouldn't spend it if it wasn't the right thing to do for customers, if it wasn't the right thing to do for shareholders, for all of our stakeholders. I think we've developed a track record of executing upon that."
},
{
"speaker": "",
"content": "In terms of financing, maybe I'll turn it over to Chris to share some thoughts about funding any incremental CapEx from this point forward."
},
{
"speaker": "Christopher Foster",
"content": "Sure. Happy to hit it, morning, Constantine. I think if you look at the larger incremental potential CapEx that Jason was just referencing, you should think about it as just the prior approach that we've referenced, which is continuing to incorporate that into our capital plan as we can execute it, finance it and recover it and the way in which we would do it would largely be to fund it in line with our enterprise cap structure."
},
{
"speaker": "",
"content": "As you look specifically at the roughly $500 million opportunity we referenced this morning around the resiliency filing, we did reference that we're going to go after some potential both federal and state-based loan and cost matching programs. But to the extent that we're not successful on those, again, the simple way to think about it is we'd be funding in line with the enterprise capital structure."
},
{
"speaker": "Konstantin Lednev",
"content": "I appreciate that. And maybe a quick follow-up on that. You kind of highlighted the path on credit metrics and how are you thinking about options of refinancing needs on both floating rate exposure and kind of near-term maturities? And is there any optimization opportunities there with convertibles, hybrids, any of these kind of federal loan programs to supplement?"
},
{
"speaker": "Christopher Foster",
"content": "Sure. Happy to touch on it. And I have to say, we're pleased with where we are today, reported 14.6% in terms of FFO to debt based on the Moody's calc and consistently are seeing as we go forward, a good trajectory, both on the Moody's and S&P calculation."
},
{
"speaker": "",
"content": "As we think about the different financing alternatives, it is certainly the case that we are already pursuing some DOE loan program dollars to the tune of just over $2 billion already. So those have already been filed. Really, that's just a cheaper alternative for better financing costs for customers. As we look at the financing plan throughout the year, certainly, we've got a few maturities here that are coming up. We've hedged against a portion of the current offering that's probably closer here in front of us at the parent level."
},
{
"speaker": "",
"content": "And then as you look at hybrid alternatives, I think you referenced there, that's certainly something that we're evaluating, you should assume. We kind of like the profile there, but we are looking really at a couple of alternatives, both for some tax alternatives this year and some hybrid opportunities if they make sense. And it's just my way of saying, Constantine, that we're always going to be pursuing the most efficient financing we can as we go forward."
},
{
"speaker": "Konstantin Lednev",
"content": "Okay. So everything is on the table. And just a quick one on Jason's comments around demand growth that you mentioned and cost shift has kind of become more of a prominent issue with the inflection and load that we are seeing. Do you see any issues in Texas or even Indiana, where you would need to adjust kind of cost allocation? And would those be addressed in the current rate case process or any kind of separate proceedings?"
},
{
"speaker": "Jason Wells",
"content": "Constantine, I think it's a great question. Probably less kind of an issue directly in the service territories that we serve largely because the growth that we're seeing, both the potential for it up in Southwest Indiana as well as here in the Greater Houston area really driven by industrial load growth that comes with significant jobs."
},
{
"speaker": "",
"content": "Much of the discussion over the last couple of quarters has been around data centers, AI growth, that's some of the toughest electric load growth to serve, right? Low margin doesn't necessarily come with the jobs and so it does put to your point, sort of pressure more largely on cost allocation. I think here, again, we're -- I think it's a clear differentiator for CenterPoint. We serve load that is not only growing from a residential standpoint and an industrial standpoint, but it keeps that cost allocation issue sort of less -- less impactful than maybe some of the peers that have data center growth really driving their electric sales."
},
{
"speaker": "Operator",
"content": "The next question will come from James Thalacker with BMO Capital Markets."
},
{
"speaker": "James Thalacker",
"content": "I just wanted to follow up on Constantine's question on the system resiliency filing. The plan is $2.2 billion to $2.7 billion, which I think is roughly almost double to $1.3 billion we've been standing over the last couple of years. But if I heard you correctly, the $500 million of incremental capital is kind of in line with the higher end of the filing. So if we kind of run this forward, if the PUCT ultimately decides to approve a spending that's, say, near the bottom this or even below the range, could you talk a little bit about where you see other investment opportunities and how would this change your financing plan, if at all?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Maybe a couple of quick points on that, Jim. So the 2.2%, the low end of the range is consistent with $44.5 billion, the upper end of the resiliency filing that incremental $500 million would put us to $45 billion overall through 2030. Look, I think that there is pretty strong alignment across the state here in Texas around investments to keep the great resilience and can help the economic growth that we're experiencing in Texas."
},
{
"speaker": "",
"content": "I also think what's important part of this filing, and what it may be different than some of the historical resiliency spend is -- as part of the filing, we have to prove the benefits of the incremental resiliency mitigation measures exceed the cost. So part of this filing really demonstrates that on a net basis is still in the customer's best interest for us to make these investments. And so I feel like there's going to be a strong support for our filing and the other filings of the transmission and distribution utilities."
},
{
"speaker": "",
"content": "That being said, to your point, if there is concern around the proposed mitigation measures that we have in our filing, as a quick reminder, this is about 15% of our total CapEx plan. And as I alluded to in my answer to Constantine, I think we have plenty of incremental CapEx opportunities outside of this whether they be on the gas side of the business, I talked about local transmission pipeline there, potential to accelerate our next-generation smart meter deployment and then on the electric side, I just -- I cannot reiterate enough the opportunity with this exponential load growth driven by industrial electrification and electrification of commercial fleets. So I think that there are an abundant set of opportunities of incremental CapEx."
},
{
"speaker": "",
"content": "And I don't know, Chris, if you want to continue to reinforce thoughts on the financing plan."
},
{
"speaker": "Christopher Foster",
"content": "And sure, just to build on that, again, as we look at the base plan at the low end of the resiliency filing, that would just support the $44.5 billion with the ongoing very modest ATM program that we've got through 2030. And again, as we look beyond that for some of these incremental opportunities, it really would be funny in line with the existing cap structure."
},
{
"speaker": "Operator",
"content": "The next question will come from Steven Fleishman with Wolfe Research."
},
{
"speaker": "Steven Fleishman",
"content": "Just on the Indiana update that you mentioned on the settlement or get delay in the hearing. Just maybe a little more color on how long it's delayed and just likelihood of an agreement?"
},
{
"speaker": "Jason Wells",
"content": "Steve, thanks for the question. We pushed the start of the hearing by day as we continue to explore the potential here for settlement. It's hard to handicap kind of expectations. I think we're working hard with stakeholders to find what we believe would be a constructive path forward."
},
{
"speaker": "",
"content": "As a quick reminder in this case, a lot of the CapEx that's included in the Indiana electric filing has been in front of the IURC and our stakeholders in previous forums, whether that's the cost of the coal transition or the transmission and distribution investments that we are making to improve reliability and resiliency in that area. And so a lot of the issues of the case have kind of been seen by stakeholders in a number of different forms. And so we continue to try to work constructively towards the settlement, and we'll update you as we have more information."
},
{
"speaker": "Steven Fleishman",
"content": "Great. And then just on the kind of S&P negative outlook, I just want to clarify. Just -- is your -- I mean, I think these things usually take like a year or so to go through. But just are you -- your intention is just these metrics will get better just as the Uri impact goes away and that should be sufficient -- to meet the targets there? Is that how to think about it?"
},
{
"speaker": "Christopher Foster",
"content": "Steve, that's accurate. Really, what S&P was looking at was the past, right? As they evaluated and arrived at that outcome. Our general assumption, it is that roughly year-long period. And as we look at the plan going forward, as we look over the next few years, you'll see naturally that Uri impact roll off and we'll see ourselves really as we see just in 2024, looking at the year, you're going to see us at Moody's, continuing to target that 100 to 150 basis points cushion, that won't change. And additionally, you're going to see us grow into a greater cushion at S&P as we walk into the subsequent year. So comfortable with the base financial plan and what it informed for the years ahead."
},
{
"speaker": "Jason Wells",
"content": "I think -- Steve, if I could add to that. Obviously, as Chris said, we're comfortable. But I think it's important just to highlight the core difference in methodology here because it is transitory in nature. The way that issue I'd add is we've received securitization proceeds from [indiscernible] significant cash inflow. We have to pay taxes on that, cash outflow. S&P's methodology excludes that significant inflow but includes the associated cash outflow, right? That's sort of a transitory effect. And as Chris said, as we look forward, we feel comfortable about the trajectory that we're on. And so just a very sort of idiosycratic impact from their calculation."
},
{
"speaker": "Steven Fleishman",
"content": "Okay. And then last question, just on Texas, and I know you kind of answered this, and the hydrogen hub sounds exciting. That just feels like that just takes time, but there's just so many other dynamic economic things, whether it's data centers or other industrial. Just could you just give maybe a little more flavor on CenterPoint's ability to get to opportunity set related to the growth in Texas?"
},
{
"speaker": "Christopher Foster",
"content": "Yes. Thanks, Steve. What I would say is, I don't think you can find a more dynamic setting anywhere in the country, particularly on electric sales growth and you can't hear. Residential load growth continues to be best-in-class, right? We continue to see the industrial load growth that I mentioned, transportation, electric load growth. And I think that's really reflective in our sales numbers for the first quarter. On a quarter-over-quarter basis, when we adjust for weather, sales are up 8% over the first quarter last year, driven by strong residential, commercial and large industrial growth. There's electrification at one of our nation's largest ports here in Houston. We continue to see incremental growth in the petrochem complex will becoming one of the dominant areas in the country for life sciences."
},
{
"speaker": "",
"content": "And so what I would say is basically the growth that you see in any one sector, including data centers around the country, we see it in all the sectors here in the Greater Houston area. And so I see it showing up in the numbers this quarter, and I see it driving continued growth at least through the remainder of the decade, if not well beyond."
},
{
"speaker": "Operator",
"content": "The next question comes from Nick Campanella with Barclays."
},
{
"speaker": "Nicholas Campanella",
"content": "A lot of things have been answered. But I guess, just on your comments about kind of pursuing state and federal incentives for this plan, it sounds like some of this is grant, but some of it's also DOE loans. But -- can you just kind of talk -- I think it's very helpful from a financing benefit and from a customer affordability benefit. But how do we kind of think about the contribution from EPS if you were to kind of pursue state programs rather than kind of traditional financing?"
},
{
"speaker": "Christopher Foster",
"content": "I think about it, is just to be clear, very small, right? We're really talking about component here, where we're looking at the federal program from the loan standpoint, as you mentioned, as well as the specificity that we provided around the GRIP program that's there, which has already been filed. We've also got some Texas Department of Energy -- excuse me, emergency management funds that we've also asked for on the state level. Those would be in the form of grants, again, just a situation where we can get better outcomes in total for customers."
},
{
"speaker": "",
"content": "I don't know, Jason, if you want to give kind of color on high level how it informs the EPS guide?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Thanks, Chris. What we've consistently said, Nick, is that we'll come back after these rate cases next year and provide a new 10-year plan well into the mid-2030s to reflect in our continued confidence on long-term growth. What I want to highlight, though, are there's been a handful of things that we've been able to accomplish since we rolled out that guidance, the long-term EPS guidance, which is again, 8% growth here in 2024 and then the mid- to high end of the 6% to 8% range through 2030."
},
{
"speaker": "",
"content": "And what I would say is we certainly have more tailwinds than we have headwinds. From a tailwind standpoint, we had some success in the legislative session helping reduce some regulatory lag in key jurisdictions. As I mentioned previously, we've increased CapEx since we've issued that guidance by more than 10%. The third thing that I'd point to is last quarter when we announced the sale of Louisiana, Mississippi and the recycling of that capital that's moving what is nearly $800 million of rate base and $1 billion of CapEx into jurisdictions that earn a higher return."
},
{
"speaker": "",
"content": "I'd be remiss to say that obviously, interest rates are a little higher, and we've announced a modest equity program. But -- but suffice it to say, the tailwinds here exceed the headwinds. And as we get to the other side of these rate cases, we'll be in a better position to give a kind of a long-term comprehensive update to the earnings guidance for the company."
},
{
"speaker": "Nicholas Campanella",
"content": "That's great. And I guess just kind of a follow-up on high grading the plan here. You mentioned in your prepared remarks, the higher for longer interest rate environment. And expectations, I think, across the market have certainly changed from January to today on the trajectory of rates. Can you just kind of remind us on -- not necessarily what you're assuming, if you don't want to comment, but just how the plan is kind of provisioned into the back half of this year and then going forward, if we do kind of continue to be higher for longer here?"
},
{
"speaker": "Christopher Foster",
"content": "Sure thing, Nick. I'll just say, as we are building the plan heading into 2023. I don't know that any of us really could have appropriately predicted the impact there, but I think you saw the company execute well and overcome that pressure. As we look into 2024 walking into the year, we definitely plan conservatively there. And it's hard for me to be too specific, but just know that if you look across our plant, I hope that you've seen we're consistently bringing forward conservatism so that there are no surprises in the end."
},
{
"speaker": "",
"content": "I think it's the same thing on our capital programs, right? As we folded in CapEx over time, we're making sure we're doing so conservatively as we see the opportunity to execute it, to finance it and recover it. So it really holds on the same side in terms of higher for longer. We walked into this year, assuming this was going to be the case."
},
{
"speaker": "Operator",
"content": "The next question comes from Jeremy Tonet with JP Morgan Securities."
},
{
"speaker": "Jeremy Tonet",
"content": "Just wondering, going back to the SRP here, if you could frame overall wildfire mitigation needs relative to the $140 million in the SRP filing. And looking more broadly, how might SRP capital competition evolve over time from this first application? And what does the SRP investment runway look like at this point?"
},
{
"speaker": "Jason Wells",
"content": "Yes. Thanks for the comprehensive question. Look, from a wildfire standpoint, as you highlighted, $140 million is in a significant driver of the overall $2.2 billion to $2.7 billion plan. I think it's important to understand why 60% of our system is currently underground. Jeremy, as I know you know, we have high relative humidity here. So all things being equal, we have significantly lower cloud buyer risk than our peers. That being said, obviously, we haven't sat on our hands. We've been addressing this risk with changes in operations, shutting of automatic or closers, enhanced inspections during periods of higher wildfire rigs. But this plan basically addresses about 1% of overhead miles that are in higher fire risk areas. And so this is probably under the current set of conditions sufficient to mitigate our wildfire risk."
},
{
"speaker": "",
"content": "Now obviously, we're going to continue to look at weather patterns, trap patterns to see how that evolves over time. But I don't really see the wildfire litigation being a significant long-term driver of CapEx, where I do see further opportunity beyond this plan is really on the distribution side. As I said in my prepared remarks, we have been really focused on hardening the backbone of our system, the electric transmission and the substation flood control efforts."
},
{
"speaker": "",
"content": "We will largely be through those programs by the end of this first cycle. And so the real opportunities, as I mentioned, is on the distribution side going forward and really creating a more resilient, reliable overhead electric system for our customers."
},
{
"speaker": "",
"content": "So more to come on that front. We're happy to make this first filing, and I see the opportunity for continued CapEx growth as we make subsequent filings in the future."
},
{
"speaker": "Jeremy Tonet",
"content": "Got it. Makes sense. If there's one thing we know, it's that Houston is humid, I'll leave it there."
},
{
"speaker": "Jackie Richert",
"content": "Operator, I think we have time for one more question, please."
},
{
"speaker": "Operator",
"content": "And the last question will come from Durgesh Chopra with Evercore."
},
{
"speaker": "Durgesh Chopra",
"content": "I appreciate it. I'll ask 2 very quick questions, and I'll ask them together. Just first, can you help us sort of pan out a time line for the resiliency plan approval, what to look for there? And then second, Jason, in your comments, you mentioned regulatory lag as a tailwind opportunity. Can you just quickly remind us what your earned regulated ROEs are as of the end of the first quarter?"
},
{
"speaker": "Christopher Foster",
"content": "Yes. Thanks, Durgesh, for the questions. On the first side, the time line for approval of the resiliency plan, I think the legislation call it for about a 6-month approval period. What I will say is this is first of its kind legislation. So we'll have to kind of get in the middle but I'm sure there will be a number of parties sort of intervening, but I would look towards the tail end of this year, calendar year, to get a final decision on the resiliency plan that we file."
},
{
"speaker": "",
"content": "On the question on regulatory lag, we've historically seen particularly here in the Texas business, about 150 basis points on average regulatory lag. And what I would say is we sort of meaningfully reduce that amount but it's an odd time to really be calculating kind of what regulatory lag is at the end of the first quarter just because we're in the middle of our rate case filing. And as a result, we don't have access to the full complement of capital recovery mechanisms that we will have sort of on the other side of this rate case. And so just know that we've taken steps to begin to reduce that historical regulatory lag, and I think we'll be in place that gives sort of a more normalized view of that on the other side of the rate case."
},
{
"speaker": "Jackie Richert",
"content": "Okay. Operator, with that, that concludes our call for the quarter. Thanks, everyone, for joining."
},
{
"speaker": "Operator",
"content": "This concludes CenterPoint Energy First Quarter 2024 Earnings Conference Call. Thank you for your participation. Have a great day."
}
] |
cof | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Capital One Q4 2024 Earnings Call. Please be advised that today's conference is being recorded. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead."
},
{
"speaker": "Jeff Norris",
"content": "Thanks, Josh, and welcome, everyone. And just as a reminder, as always, we are webcasting live over the Internet and to access the call on the Internet, please log on to Capital One's website, capitalone.com and follow the links from there. In addition to the press release and financials, we've included a presentation summarizing our fourth-quarter 2024 results. With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew are going to walk you through this presentation. To access a copy of the presentation and press release, please go to Capital One's website, click on Investors and click on financials and then click on quarterly earnings release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. And for more information on these factors, please see the section titled forward looking Information in the earnings release presentation and the Risk Factors section in our Annual and Quarterly reports that are accessible at Capital One's website filed with the SEC. Now, I'll turn the call over to Mr. Young. Andrew?"
},
{
"speaker": "Andrew Young",
"content": "Thanks, Jeff, and good afternoon, everyone. I will start on slide three of tonight's presentation. In the fourth quarter, Capital One earned $1.1 billion or $2.67 per diluted common share. For the full year, Capital One earned $4.8 billion or $11.59 per share. Included in the results for the fourth quarter were adjusting items related to discover integration costs and a legal reserve build. Net of these adjusting items, fourth-quarter earnings per share were $3.09. Full-year adjusted earnings per share were $13.96. We also had one notable item in the quarter, which was $100 million of accelerated philanthropy contributions. Pre-provision earnings of $4.1 billion in the fourth quarter were down 13% from the third quarter, driven by higher non-interest expense. The linked quarter increase in non-interest expense was driven by increases in both operating expense and marketing spend. Revenue in the linked quarter increased 2%, driven by higher non-interest income. Provision for credit losses was $2.6 billion in the quarter, up about $160 million relative to the prior quarter. The quarterly increase in provision was driven by higher net charge-offs, partially offset by a larger allowance release. Turning to slide four, I will cover the allowance in greater detail. We released $245 million in allowance this quarter, and our allowance balance now stands at $16.3 billion. The decrease in this quarter's allowance was driven by releases in our Commercial Banking and Commercial segments. Our total portfolio coverage ratio decreased 20 basis points to 4.96%. I'll cover the drivers of the changes in allowance and coverage ratio by segment on slide five. The allowance balance in our domestic card business was flat. The coverage ratio declined 33 basis points, primarily driven by seasonal balances as well as favorable near-term credit trends. In our Consumer Banking segment, we released $131 million in allowance, resulting in a 22 basis point decrease to the coverage ratio. Vehicle values were stable in the quarter, resulting in an improvement -- improved recoveries outlook, which drove the release. And finally, our Commercial Banking allowance decreased by $130 million, resulting in a 15 basis point decrease to the coverage ratio. The release was primarily driven by the reduction in criticized loans and to a lesser extent by charge-offs in the quarter. Turning to page six, I'll now discuss liquidity. Total liquidity reserves in the quarter decreased by about $8 billion to approximately $124 billion. Our cash position ended the quarter at approximately $43 billion, down about $6 billion from the prior quarter. The decline in cash was largely driven by seasonally higher card loans and funding maturities, which were partially offset by continued strong growth in our Consumer Banking business deposits. Our preliminary average liquidity coverage ratio during the fourth quarter was 155%. Turning to page seven, I'll cover our net interest margin. Our fourth quarter net interest margin was 7.03%, 8 basis points lower than last quarter and 30 basis points higher than the year-ago quarter. The linked quarter decrease in NIM was primarily driven by lower asset yields, which were only partially offset by lower deposit and wholesale funding costs. Turning to slide eight, I will end by discussing our capital position. Our common equity Tier-1 capital ratio ended the quarter at 13.5%, 10 basis points lower than the prior quarter. Net income in the quarter was more than offset by the impact of loan growth, dividends and $150 million of share repurchases. As a reminder, the announcement of the acquisition of Discover constituted a material business change. Therefore, we continue to be subject to the Federal Reserve's pre-approval of our capital actions until the merger approval process has concluded. With that, I will turn the call over to Rich. Rich?"
},
{
"speaker": "Richard Fairbank",
"content": "Thanks, Andrew, and good evening, everyone. Slide 10 shows fourth quarter results in our Credit Card business. Credit Card segment results are largely a function of our domestic card results and trends, which are shown on slide 11. In the fourth quarter, our Domestic Card business delivered another quarter of steady top-line growth, strong margins, and stable credit. Year-over-year purchase volume growth for the quarter was 7%. Ending loan balances increased $8 billion or about 5% year-over-year. Average loans increased about 6% and fourth-quarter revenue was up 9% from the fourth quarter of 2023, driven by the growth in purchase volume and loans. Revenue margin for the quarter increased 55 basis points from the prior year quarter to 18.6%, largely driven by the impact of the end of the Walmart revenue sharing agreement. The charge-off rate for the quarter was 6.06%. The impact of the end of the Walmart loss-sharing agreement increased the fourth-quarter charge-off rate by roughly 40 basis points. Excluding this impact, the charge-off rate for the quarter would have been 5.66%, up 31 basis points year-over-year. And after 20 consecutive months of second derivative improvement, the 30-plus delinquency rate crossed into actual year-over-year improvement. The 30-plus delinquency rate at the end of December was 4.53%, down 8 basis points from the prior year. As a reminder, the end of the Walmart loss-sharing agreement did not have a meaningful impact on delinquency rate. On a sequential-quarter basis, the charge-off rate was up 45 basis points. The 30-plus delinquency rate was flat compared to the linked quarter. Domestic Card non-interest expense was up 13% compared to the fourth quarter of 2023. Operating expense and marketing both increased year-over-year. Total company marketing expense in the quarter was $1.4 billion, up 10% year-over-year. Our choices in Domestic Card are the biggest driver of total company marketing. We continue to see compelling growth opportunities in our Domestic Card business. Our marketing continues to deliver strong new account growth across the Domestic Card business. Compared to the fourth quarter of 2023, Domestic Card marketing in the quarter included higher media spend and increased investment in premium benefits and differentiated customer experiences like our travel portal, airport lounges, and Capital One Shopping. Slide 12 shows fourth-quarter results in our Consumer Banking business. Auto originations were up 53% from the prior-year quarter. A portion of this growth can be attributed to overall market growth, while the remainder is the result of our strong position to pursue resilient growth in the current marketplace. As a reminder, our choices to tighten credit and pull back in anticipation of credit score inflation and declining vehicle values were still in effect in the fourth quarter of 2023, resulting in relatively low originations. These choices also drove out really basically they drove strong and stable credit performance that positioned us to lean into current marketplace opportunities and return to originations growth in 2024. With four consecutive quarters of origination growth in 2024, Consumer Banking loan balances returned to growth in the fourth quarter. Ending loans increased $2.7 billion or about 4% year-over-year and average loans were up 1%. On a linked-quarter basis, ending loans were up 2% and average loans were up 1%. Compared to the year-ago quarter, ending consumer deposits grew about 7% and average consumer deposits were up about 8%. Consumer Banking revenue for the quarter was up about 1% year-over-year. Growth in loans and deposits was partially offset by a higher year-over-year average deposit interest rate. Non-interest expense was up about 10% compared to the fourth quarter of 2023, driven largely by the unique fourth-quarter items Andrew discussed, as well as increased auto originations and continued technology investments. The auto charge-off rate for the quarter was 2.32%, up 13 basis points year-over-year. The 30-plus delinquency rate was 5.95%, down 39 basis points year-over-year, largely as a result of our choice to tighten credit and pull back in 2022, auto charge-offs have been strong and stable on a seasonally adjusted basis. Slide 13 shows fourth-quarter results for our Commercial Banking business. Compared to the linked quarter, ending loan balances were essentially flat. Average loans were down about 1%. Both ending and average deposits were up about 4% from the linked quarter. Fourth-quarter revenue was up 7% from the linked quarter and non-interest expense was up by about 5%. The Commercial Banking annualized net charge-off rate for the fourth quarter increased 4 basis points from the sequential quarter to 0.26%. The commercial criticized performing loan rate was 6.35%, down 131 basis points compared to the linked quarter. The criticized non-performing loan rate decreased 16 basis points to 1.39%. In closing, we continued to post strong and steady results in the fourth quarter. We delivered another quarter of top-line growth in Domestic Card loans, purchase volume and revenue. In the Auto business, we posted growth in originations for the fourth consecutive quarter and the return to year-over-year growth in loan balances and consumer credit trends remained stable. Our full-year operating efficiency ratio net of adjustments was 42.35%, consistent with our guidance of the low 42s, even after incurring $100 million in accelerated philanthropy contributions. And turning to the Discover acquisition. The shareholder votes are scheduled for February 18th, and we continue to work closely with the Federal Reserve, the OCC and the Department of Justice as our applications continue to work their way through the regulatory approval process. We remain well-positioned to complete the acquisition early in 2025, subject to regulatory and shareholder approval. Pulling way up, the acquisition of Discover is a singular opportunity. It will create a consumer banking and global payments platform with unique capabilities, modern technology, powerful brands, and a franchise of more than 100 million customers. It delivers compelling financial results and offers the potential to enhance competition and create significant value for merchants and customers. And now we'll be happy to answer your questions. Jeff?"
},
{
"speaker": "Jeff Norris",
"content": "Thank you, Rich. We will now start the Q&A session. Remember, as a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. And if you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Josh, please start the Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] And our first question comes from Ryan Nash with Goldman Sachs. You may proceed."
},
{
"speaker": "Ryan Nash",
"content": "Hey, good afternoon, everyone."
},
{
"speaker": "Richard Fairbank",
"content": "Hey, Ryan."
},
{
"speaker": "Andrew Young",
"content": "Hey, Ryan."
},
{
"speaker": "Ryan Nash",
"content": "So Rich, delinquencies have been in line or better for nine straight months losses, and you talked about delinquencies now being down on a year-over-year basis and losses have sort of followed suit, but at a little bit of a slower pace. And you've outlined a lot of the reasons, deferred charge-offs, the press recoveries. But when you think about credit from here, just broadly, what are you seeing from the consumer and how are you thinking about loss performance as well as any other factors that could be impacting losses? And do you think we're on a downward trajectory from here? Thank you. And I have a follow-up."
},
{
"speaker": "Richard Fairbank",
"content": "All right. Thank you, Ryan. So let me start by just talking about the health of the consumer and then maybe I'll turn and talk about the credit performance at Capital One. So the US consumer continues to be a source of strength in the overall economy. The labor market remains strong and we saw signs of softening in the first-half of 2024, but in the second-half of the year, the unemployment rate has been stable and job creation data has shown renewed strength. Incomes are growing steadily in real terms as inflation settles out a bit. Consumer debt servicing burdens are stable near pre-pandemic levels. Consumers have higher bank account balances than before the pandemic. Now, of course, the circumstances of individual consumers and households are highly variable and so talking in averages doesn't always fully cover what's going on. We do see some pockets, as I've been saying for some time now -- we do see some pockets of pressure related to the cumulative effects of inflation and elevated interest rates among consumers whose incomes have not kept up with inflation or who have high debt servicing burdens. And of course, there's still some inflation pressure and longer-term interest rates strikingly have increased since the Fed started lowering rates in September. So we do see a bit of a disconnect between the average consumer and the folks closer to the margin. And you can see that, for example, in payment rates in our Card business. On the one hand, card payment rates remain on average meaningfully above pre-pandemic levels. And this is true overall and within each of our major customer segments. On the other hand, the proportion of customers making just the minimum payment is also running somewhat above pre-pandemic levels, which is consistent with our card delinquencies running above pre-pandemic levels. Now, I should add that we're seeing this minimum payment effect across the credit spectrum. I'm not making a point here about the low end of the market or even about subprime. In fact, if anything, the lower end appears to be doing relatively better at the moment. So just pulling up, I believe we're almost certainly still seeing some pandemic-related effects like delayed charge-offs from the period of unprecedented stimulus and forbearance in 2020 and 2021 and 2022, this effect is impossible to isolate, but we can infer it from our own credit trends and industry credit trends over the past several years. But sort of pulling up on the consumer. I think consumers are in good shape compared to most historical benchmarks. There are -- as we've been saying for some time, there are pockets of pressure that have to work their way through before levels can get down -- credit loss levels can get down to sort of pre-pandemic levels. But I think the consumer story is very consistent with what I've been saying for a number of quarters and it is very solid. So let me turn to Capital One Credit. Over the course of 2024, our card delinquencies have moved in line with normal seasonality with losses following about a quarter behind. Now as a reminder, earlier this year, we flagged that changes in the level and timing of tax refunds due to tax law changes were probably changing seasonal credit patterns in our Card business. We derived new seasonality benchmarks for card delinquencies based on post-pandemic performance. And those benchmarks have less amplitude in both directions than in the past. So we've now had a full year to look at what we were hypothesizing as the new seasonality benchmark and as we now look at the whole year, this experience is very confirmatory and we very much sort of believe that we've got the benchmark right. And when we first saw delinquencies settling out, it is clear that for -- really for the whole year now, we've been calling stabilization. We've not been declaring a peak or declaring that credit would improve from here, but we can now look at the whole year and see a really nice stabilization. In the fourth quarter, and again, you saw this in the monthly -- the month we just reported. We saw our delinquencies improve on a seasonally adjusted basis in the quarter for the first time since normalization began. And they ended the year slightly lower on a year-over-year basis. So that's certainly an encouraging sign. Looking ahead, we're not giving guidance on future credit, but over time, there are a number of forces that play out. Our recoveries inventory will continue to rebuild and that should be a gradual tailwind to our losses over time, all else equal. Still, high interest rates will probably remain a source of pressure for some consumers, especially those with higher debt servicing burdens. And there still is, we believe, the phenomenon of delayed charge-offs and of course, this effect is hard to measure and certainly hard to forecast. But over time, it should play through, but how long it plays out, that's just something that is just a matter of speculation. I think we will eventually get back to the place where traditional labor market indicators are the main drivers of change in Consumer Credit. But that will still take some time. And finally, as we move into the new year, we'll keep an eye on the level and timing of tax refunds since we know these can materially affect seasonal movements in card credit."
},
{
"speaker": "Ryan Nash",
"content": "Got it. Thanks for the color. If I can throw in one high-level follow-up. So Rich, efficiency improvement has been a hallmark of Capital One for the last seven or eight years, ex a small period during COVID. You recently talked about investments you wanted to make in the network once the deal hopefully closes at some point in the first quarter? I guess the question is, do you expect to continue to be on an efficiency journey, fully recognizing that the cost saves obviously make it easier, but just curious how you're thinking about efficiency for the consolidated company over the medium term, fully recognizing that there's going to be a lot of noise in the results?"
},
{
"speaker": "Richard Fairbank",
"content": "So we look-forward to the completion of our deal and actually really getting inside the financials and the performance and all the details of the business. The businesses at this rather remarkable company Discover. But as we've talked about, when we look still from the outside, we see just a great opportunity there. And of course, we have said there are three areas that are going to need in continued investment when we think about virtually anything that all the strategic upside of this Discover deal, it's sort of all roads lead through three areas, kind of obvious areas of continued investment. And the first, of course, is compliance and risk management. And Discover has really been leaning into that and we, of course, are doing everything we can to prepare to continue to lean into that and we'll do whatever it takes on that front. Obviously, that's an investment. The second is we -- is network acceptance. We've talked about how struck we are and how struck we were to find out and confirm just how good the acceptance is in the United States for Discover. You can see, in fact, they've been putting some ads on TV sort of touting that and it's a very good story. And internationally, they've been investing there and focusing on where their customers travel and they've made a lot of progress there. When we look at our customer base at Capital One and where we would love to be over time in terms of being in a position to add more-and-more volume onto the Discover network, we think an incredibly important objective is to increase the depth and breadth of acceptance internationally, sloping the work, of course, working backwards where -- from where our customers and Discovers travel. So that -- that's going to be a multiyear thing that -- that's a very important strategic imperative, I think, for us. And then the third one will be building the network brand. We plan to keep the name Discover for the network. We think it's a great brand. And we're really happy with the underlying reality of where acceptance is. We know there are challenges in terms of consumer perception relative to those realities and we know also we need to, in fact, build the international reality and then the brand perception that follows that. So those are the three strategic -- the kind of obvious and strategic investment areas that we've been identifying really since the start of the deal. And back to your question about what do we think -- how do you think -- how do we think that fits in relative to efficiency ratio? We, of course, on the Capital One side have had a long -- decade-long journey of continuing to improve operating efficiency ratio and it's striking that improvement has come even as we have continued to really ramp up investment in technology. Now the way that paradox works is the technology is -- we're also investing more in technology and at the same time, getting all the benefits on the efficiency side, both in terms of growth and in terms of costs that come from such an investment in technology. So the engine that drives operating efficiency ratio strategically will continue at Capital One and it should continue it with the combined institution as well. Now then you ask, will the big three investment areas that we talk about, what will that do to operating? I think the -- we always at Capital One have strategic imperatives that we're investing in. I think the overall picture of how Capital One's tech journey helps pay -- one of the important ways investors get paid is through operating efficiency improvement. I think that story to me stays strategically intact even as we have new investment areas because we'll also have new areas to capture synergy and growth opportunities and things that really wouldn't have been possible for either of our companies alone. So thanks for the question. Operating efficiency is a really important way that we create value for investors. And in the long run, we continue to really see increased opportunities there."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you."
},
{
"speaker": "Ryan Nash",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Terry Ma with Barclays. You may proceed."
},
{
"speaker": "Terry Ma",
"content": "Hi, thank you. Good evening. I wanted to follow-up on Credit first. It seems the trend that we've seen for the second derivative suggests there's room for that to continue to go lower. Is there some sort of framework to think about how much lower DQs can go -- can trend going forward? And is there anything in the near term that can cause the second derivative to inflect higher again? And I have a follow-up."
},
{
"speaker": "Richard Fairbank",
"content": "So Terry, yes, so thank you for the question. Obviously, well, since the founding of the company, we've always had our microscopes out looking at delinquencies because they're the single best predictor of credit of all the metrics. There are many metrics we watch, but that certainly is at the top of the list. And it is, I think, a really important -- it's certainly a gratifying milestone to where finally the second derivative cross the horizontal axis effectively and we'd certainly note that milestone. The first thing I would say about as we all get our microscopes out to look at trends on a monthly basis is to just talk about seasonality itself. And we don't publish a seasonality curve per se because there's no precise benchmark with which to do it, but we certainly like to guide our investors about how we think about that. Seasonality for Capital One has tended to have more amplitude up and down over the course of the year than most other card players. And one might ask, why is that? We believe that the biggest driver of seasonality, while there are several, the biggest driver of seasonality is tax refunds. And since we have a larger subprime book than most other players who really don't do subprime, those customers do tend to have higher seasonality in their credit performance than folks higher upmarket. So I think that's why Capital One has a greater seasonality effect. And for these customers in particular, tax refunds certainly in terms of the monthly flow of cash can end up creating something very nice that comes seasonally and some of that makes its way into payments. Now the changes in the tax withholding rules a few years ago led to fewer tax refunds and lower average refund payments. And the IRS was also paying certain refunds later than before. So that created a lot of noise, as I've been saying on recent calls. You'd think it would be easy to reestablish a seasonality curve, but while credit was normalizing so dramatically, it was sometimes swamping the seasonality effect. But we created sort of this detrended seasonal curve from 2023 to the best we could and that turned out to really be right on for 2024. If I were to pull up and kind of summarize what we saw in 2024. 2024 settled out with fewer refunds paid than before the pandemic and about 25% lower total refund volume in real terms. Delinquencies moved with our new post-pandemic seasonality benchmarks, which have similar timing, but if I were to summarize what this new curve versus the one we've had for many years, it appears to have about 35% to 40% less amplitude in both directions than in the past. By the way, just a note for a second on, auto, all of this also happens in auto seasonality, but in an even faster and more concentrated way. We tend to see auto delinquencies at their seasonal low in Q1 and losses in Q2. And this year that seasonal improvement was delayed a bit. So that's the backdrop for now talking about the credit performance that we see. If you start, Terry, with the sort of foundation that the consumer is in very good shape. The economy is in quite good shape overall, you know one would certainly feel there's sort of a gravitational pull toward even better credit in the business that is helped by the math associated with recoveries that our recoveries rate has been very constant, but the recovery inventory that we have had to collect on, it got very small in -- during the pandemic and that has been replenishing and so there's sort of a good guy gradually coming as recoveries fully restore. And then that really gets us to whatever effects there are of inflation, whatever effects there are on the consumers on the tails that are not in as good shape as sort of the averages that we all look at. And that's -- and what we see there is probably the way actually that the delayed charge-offs are actually playing out. They're probably playing out exactly through these consumers on the tail that are not -- they're still struggling at the margin. So the credit metrics are looking great. We have more solid benchmarks, Terry. The consumer is in a great place. But I think the sort of bigger picture phenomenon of delayed charge-offs that still has intuitively to play out and sort of these effects going on at the tail puts us in a position not to be declaring that things are headed down from here, but it's certainly positive indicators that we see at the margin."
},
{
"speaker": "Terry Ma",
"content": "Got it. That's helpful. Maybe just to talk about the auto business. You called out the loan book return to growth this quarter. Should we expect you to lean into that and see loan growth accelerate? And maybe can you just talk about the overall profitability of the loans you're booking today versus what you've seen historically? Thank you."
},
{
"speaker": "Richard Fairbank",
"content": "So we feel very good about the auto business. You know, the credit performance is really striking and in fact, let's just savor something that is I think an outlier relative to the industry. But our auto delinquencies have remained consistently below pre-pandemic levels and they've been lower on a year-over-year basis for the past two quarters. And so the auto business is -- when you -- there are many similar things about our card business and the auto business, but if you were to compare the two, the degree with which we sort of intervened in the business and trimmed credit around the edges, it might have been even more dramatic than the term around the edges, what we did in the auto business over the last over the last few years when we were worried about margin pressures in the business as prices were not being sort of past -- inflation pressures were not being passed through. So there were margin pressures, there were declining vehicle values and there was inflation of credit scores. So all of that led us to pull backend each of those have sort of -- have been resolving themselves. You asked about margins, the margins are sort of much more sort of normal in the business right now. The grade inflation on credit scores is resolving itself as credit normalizes. Vehicle values we'll have to continue to keep an eye on those. But pulling way up on the shoulders of a lot of the changes that we have made and the technology that we have massively invested in this business in underwriting and in originations and in our auto navigator platform, all of those put us in a position to feel bullish about leaning into auto. And I think we -- all the trends that we see on margins, credit and competition, we feel good about and that lines up to a story of leaning in on the auto business."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Rick Shane with J.P. Morgan. You may proceed."
},
{
"speaker": "Rick Shane",
"content": "Thanks for taking my question. Hey, Rich, you did a great job laying out the factors that have caused the historical relationship between labor and credit to weaken. And one of the factors you mentioned was the impact of rates. And that makes sense credit cards are one of the two largest classes of floating rate consumer debt. As we think about reversion to historical norms, should we expect charge-off rates to be structurally higher as long as interest rates are structurally higher or is it possible to get back to historic loss rates in a high interest rate environment?"
},
{
"speaker": "Richard Fairbank",
"content": "It's a great question. It's interesting how all of us -- some of us were around doing similar things back when in -- well, Capital One, we hadn't even come up with the idea for Capital One back when inflation was really raging the last time around. So I think we would be speculating there. But I think, Rick, if we pull up and think about interest rates and their impact, we think about how higher rates as a thing affect consumer credit. So debt servicing burdens for consumers, of course, can get affected the higher rates as they work their way through consumer products gradually, but not immediately sort of make their way into higher debt burdens. So you have mortgages that tend to have fixed rates, auto loans have fixed rates. So you have time delays before interest rates make their way to more pressure on consumers, but still that effect obviously can continue. Most credit cards have variable APRs. So rising interest rates have tended to lead to somewhat higher minimum payments for consumers overall. But if we if we pull up, I think that if wages -- if things stabilize and wages tend to keep up with inflation, I would think on the Credit Card side, there's -- it is plausible that charge-off rates could be very consistent with what they've been in a lower ambient rate environment. I think it gets very challenging when they're suddenly in motion up, but if they stabilize, I'm just speculating here at a moderate level that's higher than they were for the last couple of decades. I think as wages sort of stabilize to make real incomes move the way they should, I would think that credit numbers could be very consistent with historical patterns. I think the biggest driver of why they're not right now, if I were to speculate, probably number one on my list is really the just unprecedented number of years of which charge-offs with all the government stimulus and the forbearance that so many consumers got a lifeline that those for whom that lifeline was a little more temporary in its benefit, some of those issues are still resolving themselves in terms of current charge-offs. It's always an interesting thing to just take a look at the area under the curve in credit losses for -- if we look back over the last number of years and look at where credit losses would typically have been versus where they were and you look at the area under the curve and ask yourself, well, what if all of that were delayed charge-offs? You still have a majority of that area under the curve that would still have to play out in terms of delayed charge-offs. Now we don't believe that anything close to all of the area under the curve would need to come on the other side. But I think if you know a one-sentence sound bite to me of why in such a benign environment, credit losses in businesses like credit cards are running higher than pre-pandemic. It is the delayed charge-off effect. And time should be our friend there that should resolve itself overtime. And there are a lot of positive factors behind that are putting sort of good gravitational pull in the right direction in this industry."
},
{
"speaker": "Richard Shane",
"content": "Thank you very much, Rich."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from John Pancari with Evercore ISI. You may proceed."
},
{
"speaker": "John Pancari",
"content": "Good evening. Just on the efficiency side, just a follow-up to Ryan's line of questioning. I know you've guided to an operating efficiency ratio in the low 42% range for 2024. Does this 42% range remain the case as you look at 2025 or do you see a change to the upside or the downside off of this level? Thanks."
},
{
"speaker": "Richard Fairbank",
"content": "So, we I think the operating efficiency ratio has really been -- hopefully our investors share our excitement that this 700 basis point improvement that has happened since we began our tech transformation in 2013 has certainly been a very good guy. There are multiple things behind that, but the biggest driver is the technology transformation. And even as we invest a lot, there are also ways to create savings, savings through reduced vendor costs, the really high cost of a lot of legacy technology, the benefits on the cloud and really the ability to then on the other side of the technology transform -- transformation sort of rebuild the company and how it operates on a foundation of modern technology. And so that's a journey that continues and so we see benefits there. I do want to say though also, you have -- we've had a lot of beneficial increase in the ratio in the last couple of years. And I wouldn't want people to just draw -- take the curve and say, wow, that thing almost looks like it's accelerating down. And you no, we don't give guidance in the short term. There are a lot of things that very important investments we're making in the business. But what I like to do is really just point out that when we stand back over a longer time frame and look at the journey of Capital One, this has been a journey for which the efficiency was never the objective function. It was one of the many benefits of a tech transformation, but it's very gratifying to see that continue. But I think the extrapolation from any one year to the next is not something that we would recommend. And so -- but it's a great long-term story."
},
{
"speaker": "John Pancari",
"content": "Got it. Okay. Thanks, Rich. And then one -- a quick second one. I assume this will be a pretty quick answer, but would be helpful if there's any -- have you changed -- made any changes to your expected deal metrics tied to the Discover deal, either the 15% or greater of EPS accretion in [‘27] (ph) or the expense efficiencies or the timing of adding the $175 billion in purchase volume to the network? Thanks."
},
{
"speaker": "Richard Fairbank",
"content": "Hey, John. Yes, what I'll say is it's two independent public companies. We still are operating separately at this point, and there are a number of variables that have moved and will continue to move between now and legal day one. And so I'm not going to specifically comment on how any one of those variables or metrics are changing since the deal model. What I will say is we considered a wide range of outcomes across each of the line items and we continue to be comfortable with the estimates that we included in the deal model. We feel very good both strategically and financially about the deal today as we did nearly a year ago when we announced it. And so as we get to legal day one and put the marks on the balance sheet, we'll provide updates on the relevant metrics at that point."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Mihir Bhatia with Bank of America. You may proceed."
},
{
"speaker": "Mihir Bhatia",
"content": "Good afternoon and thank you for taking my questions. I wanted to start first by just talking about NIM a little bit. You called out the Walmart impact this quarter. Any other call-outs for the quarter? It just feels banks have been quite disciplined about lowering saving accounts interest rates as the Fed has reduced rates? Do you think that continues or are you starting to see some demand for deposits or deposit competition ramping as we start contemplating loan growth here into 2025? I guess just related to that, if you could just talk about some of the puts and takes on NIM in 2025 that'd be great? Thank you."
},
{
"speaker": "Andrew Young",
"content": "Sure, Mihir. Well, let me start with just reminding everyone that the one thing for sure we know is that in the first quarter, we have two fewer days. And so that will drive a 15 basis point roughly decrease in NIM. But if I kind of pull up and think beyond day count and look at a longer term -- the longer term, a lot of the same forces that I've been describing for the last number of quarters as potential headwinds and tailwinds still exist today. So if you think about the headwinds, first of all, we're very modestly asset-sensitive. And so you'd see a small decrease in NIM if rates continue to decrease and you saw a little bit of that effect here in this quarter. And the other one, you bring up deposit beta, of course, in our rate risk modeling, we make assumptions around deposit betas. So to the extent that betas are lower or slower on the way down, we would be a little bit more asset-sensitive in that scenario. So those could be headwinds. But on the tailwind side, the steepening yield curve relative to forwards would be a good guy if that persists. But then probably the single biggest factor and we've seen this play out over the last number of quarters is the card growth and card becoming a bigger percentage of our balance sheet, all else equal is a pretty meaningful tailwind to NIM. So those are really the forces at play that I would highlight for you."
},
{
"speaker": "Mihir Bhatia",
"content": "Got it. Thank you. And then maybe just turning quickly to capital return. You've been doing $150 million in buybacks last few quarters. Your CET1 is up to 13.5%. We understand with the deal, you have to get approval right for any capital actions. But the question is -- two-part question there is, A, is that approval keeping you a little conservative right now? And two, once the deal is approved, should we assume you'd be pretty aggressive in getting that down or would it probably fair to assume it stays elevated for a little bit even post deal as you get through the integration?"
},
{
"speaker": "Andrew Young",
"content": "Yes. I'll wrap my answer to both of those questions into one for you, Mihir. First of all, just go without saying, but I will say it too, which is we clearly recognize that over the longer term capital return is a key component of shareholder value creation. And you've seen in prior periods, we've executed substantial share repurchases. But in the near term, our pending deal is certainly influencing our approach to capital in a few ways. As you said, we're still under regulatory pre-approval rules for each of our capital actions. And then second, we will need to run our own bottoms-up analysis as a combined company to just assess our view of the combined capital need and we continue to be two separate companies and therefore, don't have the ability to do that analysis until after close. And then third, we will need the Fed's approval to go back to operating under the SEB framework. So if I pull up from there, and put all of those together, I think it's likely we're going to stay at a slower repurchase pace until we resolve these factors, but after that, we'll have more flexibility."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Bill Carcache with Wolfe Research Securities. You may proceed."
},
{
"speaker": "Bill Carcache",
"content": "Thank you. Good evening, Rich and Andrew. It was good to hear all the references to the Capital One Arena around the inauguration. I wanted to ask about your ability to better compete against the big banks in debit, assuming the Discover transaction closes as you expect? We know debit rewards for Visa, Mastercard issuers essentially went away after the force reduction in interchange under Dodd-Frank, but would reintroducing debit rewards be something that you'd consider given the greater flexibility that owning the Discover Network will afford you?"
},
{
"speaker": "Richard Fairbank",
"content": "Hey, Bill. So obviously, a really key part of the deal is our excitement about getting the network and being able to add such a key dimension in vertically integrating our business. And we talk so much about credit cards all the time, the debit business is a really important one. And on little cat feet, Capital One has really been investing in our national banking business. So -- and by the way, having our own network will be valuable there and we'll be able to enjoy the vertically integrated economics of owning a network and the scale that comes of course from pulling Discover and a bunch of Capital One's volume together. Now, I just want to pull back and just talk a little bit about Capital One's Consumer Banking strategy, and therefore and debit is of course, right in the transaction business right at the heart of that. If you pull way up and think about consumer banking way back to when banks began, you had banks with branches on every corner. And then in the last 15 or 20 years, there have been the evolution of direct banks and they have been savings only, offering higher rates and they have no physical distribution whatsoever. And we, of course, also through our acquisitions, have acquired several banks with branches on every corner. And we also acquired the nation's largest direct bank, and I announced at the time of that acquisition, this is a great financial trade, but it is also a strategic game-changer for Capital One. That was back like 12 years ago. So since then, we have been very steadily, systematically, relentlessly and patiently if I could put so many adjectives on -- adverbs on that, pursuing a business model that actually doesn't really exist right now because we have those two endpoints. But what we're really trying to do is build, in a sense the Bank of the future. And we believe that Bank of the Future is not just a direct bank, it's also not a bank with a branch on every corner, it is a bank with thin physical distribution. For us, we've got branches, but then also in major metropolitan areas, we have put in cafes that are really basically less about coffee, but really more about being sort of a hybrid of a branch and a showroom for Capital One and a place people can go and understand Capital One is there to help them and get a sense for really what this company is about and how it may be able to help them live their life more effectively. So as we've been -- so this strategy has been about, if we work backwards from what we believe is the bank of the future. From a distribution point of view, that's thin physical distribution and highlighted by these Cafe showrooms it also -- a very central part of that is digital capabilities that enable something that's a very, very difficult thing to do, which is to take just about everything that can be done in a branch and make it available digitally. Now there are some things like safe deposit boxes we haven't figured out how to create a digital safe deposit box for your valuables. And there are a few things that just you can't get there on a digital basis. But what's -- but as we've looked at this, we said just pretty much virtually all the activities that people go to branches for, we want to be able to deliver to them through our thin physical distribution plus massive full-service digital capability. And that's what we've been building over these years. Additionally, it requires -- in order to generate business, we need great products and we've been the only major bank out there with no fees, no minimums, and even a recent move of no overdraft fees, and those better deals come from having built the -- in a sense superior economics that come from this sort of physical distribution light model. Now then you asked the question, so what will be our debit card strategy? We haven't completed the deal. We haven't fully gone in on the other side of exactly seeing, how things are working on the Discover side. But we are very pleased with the results that we're having with our current strategy, including our current debit card strategy. And we are investing heavily to continue to grow that business. You look at the significant increase in marketing over the years. One of the drivers of this is that Capital One is building a National bank organically and without a lot of physical distribution and to get there, it takes a lot of marketing. So I think the best way to think about it is Discover gives a shot in the arm and a boost to a strategy we've been pursuing for more than a decade and the best way to think about it, I think is picture just more of the same from Capital One with a little bit of an accelerator."
},
{
"speaker": "Bill Carcache",
"content": "I appreciate all the details, Rich. Thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Moshe Orenbuch with TD Cowen. You may proceed."
},
{
"speaker": "Moshe Orenbuch",
"content": "Great. Thanks. Rich, you talked about better growth in Auto and Card, you talked about the high-end cards. Talk about the non-prime businesses in both card and auto, given the improved credit, how you're thinking about growth in those businesses in the coming quarters?"
},
{
"speaker": "Richard Fairbank",
"content": "Moshe, the word that I would use at the lower -- and the sort of lower end of the business, obviously, there are parts of the market below where we play. But if we sort of loosely call it at the lower end of the non-prime or subprime part of the marketplace, the word that I would use to describe it is stability and stability of -- let's look at the key aspects of that. On the consumer credit side, actually, the first part of our business to normalize really to settle out with respect to credit was the lower end of the market. That's been very stable. The -- our originations in that segment and really pretty much across our business, the originations are coming in on top of each other for years. So that has a stability there as well. Competitively, it's a very competitive part -- it's a very competitive part of the business that has many in addition to regular card players, many non-traditional players as well. So the competitive intensity is high, but we watch it very carefully. And so with the stability of performance and the strength of the consumer, we in both the card and the auto side of the business continue to lean in a very similar way that we have -- well, for card, it's just been very consistent for years. With auto, we kind of pulled back quite a bit in that part of the business and we're leaning in as we often have done historically. So we're leaning into both of them and we're really pleased with the stability and strength of the metrics that underlie those businesses."
},
{
"speaker": "Moshe Orenbuch",
"content": "Got it. Thanks. And maybe just as a follow up, when you think about reserve levels, given that you are seeing or likely to see some improvement in credit losses kind of on a core basis or like-for-like. And it sounds like the growth is probably -- a growth that you have on the balance sheet is probably going to come in your lower loss categories, not the higher ones, thoughts about the reserve level as we move forward?"
},
{
"speaker": "Andrew Young",
"content": "Sure, Moshe. So what's going to happen in future quarters starts with what happened this quarter. So I just want to reiterate a couple of the drivers of this quarter as a jumping-off point. As I said in the prepared remarks, your coverage was down 33 basis points by two things. The bigger effect being that we typically have seasonally higher balance -- balances in the fourth quarter that require very low levels of coverage and that denominator effect from those balances put downward pressure on coverage. The other effect was that the allowance we needed for what I'll call non-seasonal growth was offset by favorable observed credit performance. And so we added $0 of allowance balance to the numerator, but the non-seasonal growth impacted the denominator. And so in the first quarter, I just wanted to provide that backdrop to say the seasonal balances will run off and so there will be a corresponding upward pressure on coverage, all else equal from that effect. But beyond that, it's really going to come down to growth and our loss forecast and loss forecast specifically for the coverage. And to the extent that loss forecast improves, changes in coverage could be modest in the near term as we just reflect the uncertainty of our projections and the allowance. But eventually, the improved loss forecast is going to flow through the allowance and continue to bring the coverage ratio down as uncertainties become more certain. And so while the direction of travel would be down, the pace and timing is going to depend on a variety of factors, one of which will include the mix of businesses, as you say, but when it's denominated to the whole portfolio, the relative growth of different forecasted loss portions of the of the book aren't going to have material impact to coverage just given that the new originations as a percentage of the overall book in any given quarter is relatively small. And then the only thing I also want to remind you of is, I know our investors look at history as a potential guide for levels of coverage. And I just want to remind you that we called out the roughly 50 basis points of impact to coverage from the termination of the loss-sharing agreement with Walmart. So that created a step function change in coverage relative to our prior history as well."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Don Fandetti with Wells Fargo. You may proceed."
},
{
"speaker": "Don Fandetti",
"content": "Yes, Rich, your Credit Card purchase volume growth on a like account basis has picked up. I'm just trying to get a sense if this is a Q4 blip or are you thinking that the consumer is actually more confident here after the election? And are you seeing that same improvement in consumer and small business as well?"
},
{
"speaker": "Richard Fairbank",
"content": "Well, we have -- if we think about our purchase volume, our growth in overall purchase volume continues to be driven by growth in our branded card customer base and the branded card includes both our consumer and our small business. The growth that you see and that we've seen for several years now is certainly a thing powering. It has been a strength in originations and some strength in originations at the higher end of the market. But the other way to think about your question is at a customer level, what you know, on a per customer basis, what's been happening to spend growth. And even as our spend metrics were growing over overall, the spend growth per customer in our consumer business have been largely -- they had been largely flat through 2023 and really the first-half of 2024. And then they started to pick up midway through last year and they grew further in Q4. And I don't have in front of me the small business card numbers. They're embedded in the numbers that I gave you. So the fact that we have seen spend per customer finally pick up here is striking, whether it will continue and exactly what's driving it is hard to say, but I did want to point out that positive trajectory as the year finished off."
},
{
"speaker": "Don Fandetti",
"content": "Got it. And Andrew, you touched on this, but your '24 vintage, can you talk a little bit about how you're feeling -- how you're seeing that shape up in terms of credit performance? I've seen some industry data that shows delinquencies are still pretty high for '24?"
},
{
"speaker": "Andrew Young",
"content": "Yes, Don, why don't I take that. So recent originations in our card business, we continue to see stability in the performance of our originations. It's really striking here. We've been calling this out consistently over the past few years. Vintage over vintage, we're seeing mostly stable risk levels over time. And also striking is our overall front book of new origination vintages continues to perform in line with pre-pandemic vintages. Now when you compare with pre-pandemic vintages, you can't look at 2019 because 2019 very quickly got sort of corrupted by the pandemic. So we're looking at 2017 and 2018 when we make these comparisons. But from a Capital One point of view, I think this is this stability in origination performance and quarter-over-quarter and the consistency with pre-pandemic is the result of our intervention to deal with inflated credit scores and the high level of industry supplies that were flooding, particularly the subprime marketplace back there. So we trimmed around the edges and continued to very closely watch the origination vintages. And that has led to a sustained stability on the part of Capital One and some of our most recent vintages. Now again, we're still looking -- you've got to look like, six months in the rearview mirror to see much, but we continue to see some very positive results there. We also have looked at industry data that shows some gapping out in vintages over the last couple of years. So I think the industry effect is not probably consistent with what we have described. And if I were to explain why because I think they're very capable companies doing this. I think the -- I'm not sure that most of the industry adjusted for inflated credit scores. And we intervened on our models with a belief that the university was suddenly giving out As that should be Bs basically and so we intervened and then kept validating along the way. But for a while, we didn't have validation. We just intervened because we believed it was the right thing to do. So I think what we had -- what has been seen if you look at just overall industry originations is, as you say, some gapping out and I think that would be the biggest driver."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Sanjay Sakhrani with KBW. You may proceed."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thank you. I guess, Rich, just one more on the deal. Given the timeline that you've outlined earlier this year, is it fair to assume like everything is going pretty smoothly in terms of the regulatory approval process and there hasn't been any surprises? I'm also wondering sort of where you guys are in terms of the integration efforts and how much work has been done there?"
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Yes, so no, the approval process continues to move forward. We've made substantial process in the recent months. We remain actively engaged with the Fed and the OCC about our merger applications and it is the Fed and the OCC who ultimately decide on our merger application. Late last year, we received approval from the Delaware State Bank Commissioner, which we needed because Discover is a State Chartered Bank. We of course, had the big public hearing in July and that went very well, we feel. Earlier this month, of course, we finalized a joint proxy statement with the SEC setting up the February 18 shareholder vote. So that was good progress finally there. We are also engaged with the Justice Department as they play a key role in advising the Fed and the OCC on the competitive aspects of the deal. And we continue to believe that this transaction is both pro-competitive and pro-consumer, bringing our best-in-class products and services to a broader set of consumers and small businesses, and really enhancing opportunities and benefits for merchants as well. So pulling way up, it's certainly the deal process is a long labor, but we remain well-positioned to get approval of the deal early this year. And we are really proud of the work everyone is doing here and we look forward to getting this over the goal line."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Okay. Just to follow-up on a question Ryan asked some time ago on sort of when you put the companies together and the efficiencies, and sort of the investments that need to be made. I guess when you put the two companies together, the efficiency ratio actually goes down and obviously, there's a lot of synergies both on revenues and expenses. Do you think those are sufficient enough to sort of accomplish? I'm just trying the question again. Do you think those are sufficient enough to make all of the investments that you sort of outlined? Or do you think that there's others that you might have to make as you peel the onion a little bit when you have the company?"
},
{
"speaker": "Richard Fairbank",
"content": "So, I don't think we're in a position to -- and it's not just because we want to be coy about it. We -- we're not in a different place than we were at the time we announced the deal. And we should point out that we are working really hard preparing for integration, but we are still separate companies and Discover is working incredibly hard and working on their compliance and I know they're doing preparations for integration as well and we certainly are. We're not getting an inside view of their numbers, their performance, their business model. So we're mostly sort of where we were at the outset. But if we pull up to your point, so Discover operated -- operates with a significantly lower efficient -- operating efficiency ratio than Capital One. That's certainly a good thing for the combined company. I think it is also the case that the -- I think Discover has had a heritage of probably less investment in certain areas than Capital One. And in a few cases, they're sort of making up for lost time there. But I think having not seen on the other side, we assume that there are some areas that we will -- and we've assumed this from the beginning, we're going to need to step-up the investments and obviously on the risk management side, there's a lot of investment to be done, whether it is how -- what ultimately needs to be done compares with what they're investing and all of that remains to be seen. We obviously had assumptions in our deal model about leaning in on that. But what we get is -- so there's going to be a lot of effects that are all pretty significant that just go in different directions. A company with an amazing efficiency ratio, a company that's probably underinvested in a number of areas that's relative to Capital One and we would shore up some of those investments. We also get a lot of synergy that comes from bringing overlapping businesses together. That's a very a strong effect. And then these three -- the investment areas, the three that we're pointing out, we are talking about investing in those at a level that's a lot different than what Discover has done traditionally. Obviously, the risk management one, we've all talked about that and they're leaning in hard now. On international acceptance, they certainly -- again I'm amazed with their not that great scale, what they've done, but we would expect to invest at a higher level than they have there and in terms of the network brand relative to -- I wanted to make a comment about the network brand and some of this other investment. It is -- we have sloped -- we have taken our card business and sloped the business that we think most naturally and easily can go to the Discover network and it involves folks that aren't big international travelers, for example. So we've sloped the work. There is -- we think it's very straightforward to move this business front book and back book business to Discover. And some of these investments that I'm talking about leaning into are particularly important for the longer-term opportunity of being able to move more business than what we put into our deal model. And again, in doing that, we would -- we sloped -- we took our whole customer base and imagine sort of sloping it in terms of what part of the business fits most naturally within the context of the capabilities and the brand of Discover's network. And then as we want to move more we're going to need the bar to be raised relative to acceptance in brand and that's why I think you know these other investments were talking about will be multi-year they'll be overtime and there'll be things that help the deal payoff even more so in the longer term."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "And our final question comes from John Hecht with Jefferies. You may proceed."
},
{
"speaker": "John Hecht",
"content": "Good afternoon, guys, and thanks for fitting me in here. First question, just thinking about the mix of the overall consumer book. I mean, you've got some new cards like the Venture One and Quicksilver, and some of those are attracted to different demographic groups. And then you've got the subprime mix and then you've got auto. Where do we see just given kind of in-bound customer mix? Where do we see that going this year as a standalone business? And then, Rich, do you have any comments of what the total portfolio might look like assuming the combination with Discover?"
},
{
"speaker": "Richard Fairbank",
"content": "Yes, so thank you, John. So we -- so let's -- let me take Discover just in a minute. So if you pull way up on Capital One for a long, long time, Capital One has been a sort of a full spectrum player. We have had -- for several decades, we have had a subprime business that is tailor-made for the information-based strategy we have because it's all about surviving and winning on the credit side of the business, but also in that business, we've also very, very much focused relative to others who play in the space to degree of exceptionally good deals. It's not just about sort of surviving on the credit side, but really giving great deals, helping people use credit wisely. And in fact, really, I think the deals that we're offering are very, very simple and profoundly better than a lot of the deals that are available in the marketplace. And so that business has -- is a very stable part of what we do at Capital One and we continue to lean into that. The -- probably the most dramatic thing that's been happening in the last decade in Capital One's card business is, as you referenced, the quest toward the top of the market and that is a journey that as far out as we can see, we will continue to lean into that because there is so much opportunity at the top of the market. And obviously, it takes a lot of investment, but the key indicator to us that when we stratify the segments of our business by spend levels, the part that's growing the fastest consistently year after year at Capital One is the heaviest spenders. And there's just so much upside north of where we are, we will continue to invest in that. Now if you stand back, just think about our Card business, while our subprime business has been going along and we keep leaning into that, there has been a gradual mix shift upmarket for the company. And even within each segment, within the sort of the subprime book, the sort of the prime book, and certainly the top of the market, there has been a gradual mix change with a spender first philosophy that permeates our business. So that's -- and some of that you can see in just some of the structural changes in the payment rates at Capital One. So I believe that what you see and what you have seen for numbers -- a number of -- for many years is a good prognosticator of probably how the future of legacy Capital One would likely go. Meaning, continued leaning in across the spectrum, but differentially an awful lot of investment toward the top of the market and the most growth opportunity there. Now we -- now let me turn to Discover. Discover, interestingly, has taken a very different approach than Capital One. While we have taken a very broad approach playing in all parts of the market, Discover has had a very focused strategy on the prime part of the business and they've done a very, very good job there and we certainly always admired them from the outside. So we will be bringing into our company a significant increase in that portion of the market, which probably differentially got a little less emphasis if anything. It's not like we weren't playing there, but if anything, we had a greater emphasis probably north and south of that part of the business. But so from a mix point of view, we certainly -- we will be bringing in a business that's very homogeneous relative to the very heterogeneous business that we have. And then on the other side of all of that, I think that we will -- if I were to summarize our strategy, it will be to continue. Everything we were doing is Capital One because we're getting a lot of traction in that, and then making very sure that we don't crush the butterfly of this beautiful business model that Discover has in the prime part of the market, but that we go in there and while, yes, integrating things like technology and some of the risk management processes and a lot of things, do everything that we can to make sure that we don't directly or even unwittingly sort of crush the really nice butterfly of what they do. And in that way, we hope to bring in a growth business that Discover has and add it to the very complementary growth businesses that Capital One has and collectively continue to try to get the best of both worlds, bringing along the way some -- better efficiencies and really bringing top technology to all aspects of the business."
},
{
"speaker": "John Hecht",
"content": "Great. Very much appreciate it. Thanks."
},
{
"speaker": "Jeff Norris",
"content": "Well, thank you everyone for joining us on the conference call today and thank you for your continuing interest in Capital One. Have a great night, everybody."
},
{
"speaker": "Richard Fairbank",
"content": "Thanks, everybody."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
cof | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing-by. Welcome to the Capital One Q3 2024 Earnings Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead."
},
{
"speaker": "Jeff Norris",
"content": "Thanks very much, Josh, and welcome, everyone. We're webcasting live over the Internet as usual. And to access the call on the Internet, please log on to Capital One's website at capitalone.com and follow the links from there. In addition to the press release and financials, we've included a presentation summarizing our third quarter 2024 results. With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew will walk you through this presentation. To access a copy of the presentation and the press release, please go to Capital One's website, click on investors, then click on Financials and then click on quarterly earnings release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. And for more information on these factors, please see the section titled forward-looking Information in the earnings release presentation and the Risk Factors section of our annual and quarterly reports accessible at Capital One's website and filed with the SEC. Now, I'll turn the call over to Mr. Young. Andrew?"
},
{
"speaker": "Andrew Young",
"content": "Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight's presentation. In the third quarter, Capital One earned $1.8 billion or $4.41 per diluted common share. Included in the results for the quarter were adjusting items related to Discover integration costs and a small downward revision to our FDIC special assessment estimate. Net of these adjusting items, third quarter earnings per share were $4.51. Pre-provision earnings in the third quarter increased 3% from the second quarter to $4.7 billion. Revenue in the linked quarter increased 5%, driven by higher net interest income. Non-interest expense increased 7%, driven by increases in both operating expense and marketing spend. Provision for credit losses was $2.5 billion in the quarter, down $1.4 billion relative to the prior quarter. The quarterly decrease was primarily driven by the absence of the second quarter's one-time allowance build for the termination of the Walmart partnership, a decline in the coverage ratio in card and a $40 million decrease in net charge-offs. Turning to Slide 4. I will cover the allowance in greater detail. We released $134 million in allowance this quarter, and our allowance balance now stands at $16.5 billion. Our total portfolio coverage ratio decreased 7 basis points to 5.16%. The decrease in this quarter's allowance and coverage ratio was largely driven by allowance releases in our Card and Consumer Banking segments. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. In our Domestic Card business, we released $66 million of allowance, which decreased coverage by 18 basis points to 8.36%. Our credit outlook has improved slightly as our confidence in the stability of underlying credit trends has grown, driving a modest release in allowance. In our Consumer Banking segment, we released $50 million in allowance, resulting in a 10-basis point decrease to our coverage ratio. The release was driven by strong credit performance and increasing recoveries in our auto business. And finally, our commercial banking allowance decreased by $14 million, resulting in the coverage ratio remaining essentially flat at 1.76%. Turning to Page 6. I'll now discuss liquidity. Total liquidity reserves in the quarter increased about $9 billion to approximately $132 billion. Our cash position ended the quarter at approximately $49 billion, up about $4 billion from the prior quarter, driven primarily by continued strong deposit growth. Our preliminary average liquidity coverage ratio during the third quarter was 163%, up from 155% in the second quarter. Turning to Page 7. I'll cover our net interest margin. Our third quarter net interest margin was 7.11%, 41 basis points higher than last quarter and 42 basis points higher than the year ago quarter. The sequential increase in NIM was largely the result of three factors. First, we had higher card and auto yields. As a reminder, the card yield benefited from a full quarter impact of the termination of the revenue-sharing agreement with Walmart. The removal of revenue sharing increased the total company NIM by 12 basis points quarter-over-quarter and 22 basis points relative to the year ago quarter. Second, there was one additional day in the third quarter. And finally, we had a higher mix of card loans on the balance sheet. Turning to Slide 8. I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 13.6%, 40 basis points higher than the prior quarter. Higher net income in the quarter was partially offset by the impact of dividends, loan growth and $150 million of share repurchases. As a reminder, the announcement of the acquisition of Discover constituted a material business change. Therefore, we continue to be subject to the Federal Reserve's pre-approval of our capital actions until the merger approval process has concluded. With that, I will turn the call over to Rich. Rich?"
},
{
"speaker": "Richard Fairbank",
"content": "Thank you, Andrew, and good evening, everyone. Slide 10 shows third quarter results in our Credit Card business. Credit Card segment results are largely a function of our Domestic Card results and trends, which are shown on Slide 11. In the third quarter, our Domestic Card business delivered another quarter of top-line growth, strong margins and stable credit. Year-over-year purchase volume growth for the quarter was 5%. Ending loan balances increased $9.1 billion or about 6% year-over-year. Average loans increased about 7% and third quarter revenue was up 10%, driven by the growth in purchase volume and loans. Revenue margin for the quarter increased 43 basis points year-over-year to 18.7%. The full quarter effect of the end of the Walmart revenue sharing agreement drove a 51-basis point year-over-year increase. Excluding this impact, the revenue margin would have been about 18.2%. The charge-off rate for the quarter was 5.61%. The full quarter impact of the end of the Walmart loss-sharing agreement increased the quarterly charge-off rate by 38 basis points. Excluding this impact, the charge-off rate for the quarter would have been 5.23%, up 83 basis points year-over-year. The 30+ delinquency rate at quarter end was 4.53%, up 22 basis points from the prior year. As a reminder, the end of the Walmart loss-sharing agreement did not have a meaningful impact on the delinquency rate. The pace of year-over-year increases in both the charge-off rate and the delinquency rate have been steadily declining for several quarters and continued to shrink in the third quarter. On a sequential quarter basis, the charge-off rate, excluding the Walmart impact was down 63 basis points and the 30+ delinquency rate was up 39 basis points. Both sequential quarter trends are consistent with seasonal expectations. Domestic Card non-interest expense was up 12% compared to the third quarter of 2023, primarily driven by higher marketing expense. Total company marketing expense in the quarter was $1.1 billion, up 15% year-over-year. Our choices in Domestic Card are the biggest driver of total company marketing. We continue to see compelling growth opportunities in our Domestic Card business. Our marketing continues to deliver strong new account growth across the Domestic Card business. Compared to the third quarter of 2023, Domestic Card marketing in the quarter included increased marketing to grow originations at the top of the market, higher media spend and increased investment in differentiated customer experiences like our travel portal, airport lounges and Capital One Shopping. Slide 12 shows third quarter results in our Consumer Banking business. Auto originations were up 23% year-over-year in the third quarter. Our stable credit performance, which is the result of choices we've made over the past couple of years, puts us in a strong position to lean into current origination opportunities in the marketplace. Consumer Banking ending loans were essentially flat year-over-year and average loans were down 1%. On a linked quarter basis, ending loans and average loans were both up 1%. Compared to the year ago quarter, both ending and average consumer deposits were up about 6%. Consumer Banking revenue for the quarter was down about 3% year-over-year, largely driven by higher deposit costs compared to the prior year quarter. Non-interest expense was up about 5% compared to the third quarter of 2023, driven largely by continued technology investments and increased auto originations. The auto charge-off rate for the quarter was 2.05%, up 28 basis points year-over-year. The 30+ delinquency rate was 5.61%, down 3 basis points year-over-year, largely as the result of our choice to tighten credit and pull back in 2022, auto charge-offs have been strong and stable. Slide 13 shows third quarter results for our Commercial Banking business. Compared to the linked quarter, ending loan balances decreased about 2%. Average loans were down about 1%. The modest declines are largely the result of choices we made in 2023 to tighten credit. Ending deposits were up about 5% from the linked quarter. Average deposits were down about 1%. We continue to manage down selected less attractive commercial deposit balances. Third quarter revenue was up 1% from the linked quarter and non-interest expense was up by about 2%. The Commercial Banking annualized net charge-off rate for the third quarter increased 7 basis points from the sequential quarter to 0.22%. The Commercial Banking criticized performing loan rate was 7.66%, down 96 basis points compared to the linked quarter. The criticized non-performing loan rate increased 9 basis points to 1.55%. In closing, we continued to post strong results in the third quarter. We delivered another quarter of top-line growth in domestic card loans, purchase volume and revenue. In the auto business, we saw year-over-year growth in originations for the third consecutive quarter and consumer credit trends remained stable. Our year-to-date operating efficiency ratio, net of adjustments through September was 41.7%. We had guided to 2024 annual operating efficiency ratio, net of adjustments to be modestly down compared to the 43.5% we posted in 2023. Our view included the positive impact from the end of the revenue sharing related to the Walmart partnership and assumed the CFPB late fee rule would take effect in October. Looking forward, we now expect the full year 2024 annual operating efficiency ratio net of adjustments to be in the low 42s. We expect a sequential quarter increase in operating expense in the fourth quarter, that will be roughly in line with historical patterns as we continue to invest in our technology transformation. And we are no longer assuming that the CFPB late fee rule will be implemented in 2024, given ongoing uncertainty around industry litigation. Our view of 2024 marketing has not changed. We continue to lean into marketing to grow and to further strengthen our franchise. In the Domestic Card business, we continue to get traction in originations across our products and channels. In Consumer Banking, we're leaning into marketing to grow our digital first national banking franchise. We continue to expect total company marketing in the second half of 2024 to be meaningfully higher than in the first half, similar to the pattern we saw last year and that includes the much higher marketing levels that we typically see in the fourth quarter. And turning to the Discover acquisition, we're working closely with the regulators as our applications continue to work their way through the regulatory approval process. Separately, Discover mentioned in their press release and on their earnings call last week that they continue to work in parallel with the SEC to resolve comments regarding their accounting approach for their card mis-classification matter. As soon as that process wraps up, we expect to mail out a joint proxy and a schedule -- and to schedule a shareholder vote most likely early next year. We remain well positioned to get shareholder and regulatory approvals and we expect to be in a position to complete the acquisition early in 2025 subject to regulatory and shareholder approval. Pulling way up, the acquisition of Discover is a singular opportunity. It will create a consumer banking and global payments platform with unique capabilities, modern technology, powerful brands and a franchise of more than 100 million customers. It delivers compelling financial results and offers the potential to enhance competition and create significant value for merchants and customers. And now we'll be happy to answer your questions. Jeff?"
},
{
"speaker": "Jeff Norris",
"content": "Thank you, Rich. We will now start the Q&A session. Remember, as a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any further questions after the Q&A session, the Investor Relations team will be available after the call. Josh, please start the Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from Ryan Nash with Goldman Sachs. You may proceed."
},
{
"speaker": "Ryan Nash",
"content": "Hi, good afternoon, everyone."
},
{
"speaker": "Richard Fairbank",
"content": "Hi, Ryan."
},
{
"speaker": "Andrew Young",
"content": "Hi, Ryan."
},
{
"speaker": "Ryan Nash",
"content": "So Rich, maybe to just start on credit. You obviously have lot -- you can see lots of different parts of the consumer market, high end consumer, subprime, prime, private label, different parts of auto. And you guys seem to be bucking the trend with really solid credit results, so I think some others aren't. So maybe can you just talk about what you're seeing across consumer and some of these different cohorts? And maybe what do you think it means for where losses could be headed in some of your main asset classes? Thanks. I have a follow-up."
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Thank you, Ryan. So let me just pull up and just talk first about the health of the consumer. I think the U.S. consumer remains a source of relative strength in the overall economy. You know, think about this. The labor market remains strong. You know we saw -- we saw signs of softening in the first half of 2024 and the unemployment rate picked up a bit, but the most recent data points on unemployment and job creation have actually shown renewed strength. Incomes are growing in real terms and last month, we saw a significant upward revision of the savings rate. Consumer debt servicing burdens are stable relative to pre-pandemic levels and consumers have higher average bank account balances than before the pandemic. Now we see some pockets of pressure related to sort of the cumulative effects of inflation and elevated interest rates. And we are almost certainly still seeing a thing that we've been calling out for years, even really before it happened saying we think it inevitably will happen and but we won't fully be able to measure that. We won't be able to measure that along the way, but that is delayed charge-offs from the pandemic period. We should remember that millions of consumers who would have charged off under normal circumstances in 2020, 2021 and 2022 avoided defaulting, thanks to unprecedented stimulus and forbearance. And these consumers were on the edge, and they got a lifeline. But for some of them, their underlying vulnerability remains. So I believe that what we're seeing today is some catching up from that period of historically low charge-offs. So I'd say consumers on the whole are in good shape compared to most historical benchmarks, but I do think there's some pockets of pressure that will persist until we fully work through this cycle essentially of inflation and elevated interest rates and of course for an un-measurable period of time, the -- there will be, I think this delayed charge-off effect from the pandemic. So that's a comment, Ryan, sort of on the consumer generally. You said you had another question. Of course, I can get into Capital One's individual credit as well. But why don't I hear where you want to take this?"
},
{
"speaker": "Ryan Nash",
"content": "Yes. And it would be helpful if you can comment on Capital One specifically, but maybe I'll throw another question for Andrew and you guys can handle both of them. So Andrew, obviously, there was a big beat on the net interest margin and the Fed has begun easing. I'm just curious if you could maybe just talk about the drivers and expectations from the margin -- for the margin from here. And just given you've historically operated in this kind of 6.8% or 6.9% range. But given the balance sheet -- the changing balance sheet dynamics, do you think we've sort of broken out of that range? Thanks."
},
{
"speaker": "Andrew Young",
"content": "Yes, Ryan. Look, as I think about the NIM in the near term, I enumerated the driving forces of what led to the increase this quarter. But in the near term outside of seasonal effects, we have one modest likely headwind, which as you can see in our disclosures, is that we're asset sensitive and so that will put a bit of pressure on NIM in the immediate term, but we also have one potential tailwind, I'll call it, and that is the pace of card growth relative to the rest of the balance sheet. And you've seen the tailwind to NIM all else equal over the last few quarters. Longer term, I think there's a few headwinds and tailwinds. The tailwind being again card even beyond the next few quarters, we've seen strong growth, particularly relative to the rest of our balance sheet. And I've highlighted in the past that our current levels of cash are likely above where we think they will eventually settle out. And if we were to see a steepening of the yield curve, that's also a good guide to us, all else equal. On the headwind side, I think there's a question of where betas go from here and there's a possibility that they could be slower or lower depending on a host of factors. We could maintain cash levels for some period of time at least, especially in light of the strong deposit growth we're seeing. And then always there's a little bit of a wildcard of the path of credit, right? And so if for some reason it stays elevated, the potential revenue suppression could be a headwind. But overall, I would say taking all of those factors into account, you've kind of seen the stability over the last few quarters prior to this one and the step-up here in the third quarter. And so I'll let you kind of weigh all of the headwinds and tailwinds that I just laid out for you."
},
{
"speaker": "Ryan Nash",
"content": "Thank you."
},
{
"speaker": "Richard Fairbank",
"content": "So, Ryan, let me just -- I talk generally about the consumer. Let me talk a little bit about Capital One, specifically what we see, and this is of course, partly because of what I just said about the consumer and some Capital One specific things as well. So in the Card business, we -- you know our delinquencies and charge-offs are consistent with normal seasonality now, and it's clear that our card credit has settled out. It's also clear that it settled out above pre-pandemic levels. And sort of there's three main reasons for this. First, we still have relatively lower recoveries compared to before the pandemic as a result of historically low charge-offs in the rearview mirror and therefore in our charge-off inventory. So our recovery rate per dollar of charge-offs has been stable, if anything, in fact a bit better than before the pandemic, but just the inventory remains below pre-pandemic levels. But it's rising, it's heading toward returning to the pre-pandemic levels. So this effect will diminish over the next few quarters, we would expect. Secondly, that we believe the cumulative effects of inflation and higher interest rates are creating affordability pressures for some consumers, particularly those whose incomes have not kept pace with inflation or have higher debt servicing burden. So we think that's a factor. And you know, to your point, I'm actually not making a point about the low end of the market, whether measured by income or credit score. Generally speaking, we've seen stronger relative income growth at the lower end of the distribution since 2020. And you know, customers with the highest debt servicing burdens tend to skew more prime than subprime. So -- and then, of course, the other factor, you know that we would point at as to why charge-offs are settling out above the pre-pandemic levels is the delayed charge-off effect that we think is still playing through. But just back -- if I could just throw in an industry point just for a second, I should have mentioned this probably earlier because this isn't really a Capital One effect. But I think that what we see in industry data is that post pandemic origination vintages are running at higher risk level than pre-pandemic vintages, probably because of inflated credit scores during the pandemic. And that's an industry point, not a Capital One point because and then here, Ryan, is when you mentioned that you're seeing Capital One credit, in some cases move differently from some of the industry trends. At Capital One, we anticipated these effects, related to some of the unusual things going on during the pandemic and particularly the -- what we might say is the great inflation of credit scores. So we tightened our underwriting back in 2020 and '21, when credit was the best we've ever seen. And as credit normalized, we continued to make adjustments where we saw pockets of rising risk, what I was saying along the way where we kept trimming around the edges. The result for Capital One has been relatively stable performance on our recent originations now for a long time, which are really running at similar levels of risk to pre-pandemic vintages. But I do think there is some underlying worsening in the marketplace that may be showing up elsewhere that some of our choices were able to offset. So pulling way up our credit results, we feel are strong and stable, driven by the choices that we've made through the pandemic and the post-pandemic period. And we feel very good about where we are and it's an important reason that we are leaning in, as you can see in terms of our originations in the business. I can talk about auto at some point, but maybe I'll wait for another question on that."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Sanjay Sakhrani with KBW. You may proceed."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thank you. Good evening. Just following up on credit, sorry. Just Rich, you had mentioned, maybe it was last quarter or the quarter before that we should start to see the credit, the delinquency improvements do better than seasonality. And I guess stabilized as you know, it's moving along with seasonality. Is some of that related to the stuff you were just talking about or do you still expect the improvement to be better than seasonality at some point?"
},
{
"speaker": "Richard Fairbank",
"content": "Well, at some point, of course, you know, it can be a long time. But no, let me just say that I don't recall saying that we expected credit to be better than seasonality. I think what we have been saying over the last number of months is for a long time, we said credit is normalizing. We are on the absolute lookout for the very early signs of credit normalizing, which it should, where exactly it will normalize, who knows till we actually get there. And so way back to more than a year ago, starting interestingly in the lower end of the market, we were pointing out that we see the signs of credit stabilizing, of course, we all went down that ski slope of second derivative and that continues to, you know to be a strong effect. But these are all things, Sanjay, that are going on related to credit stabilizing. And we have not declared that we think, credit is in fact headed down from here. At some point, we can in another question, go through the potential, you know, case for that. I want to say one other thing though, you mentioned seasonality and I put a marker down last quarter about a potential seasonality, a change in seasonality patterns. And I'd like to just kind of seize the moment and comment on this because I think all of you that are watching the credit patterns on a monthly basis, it's really important that we talk about the seasonality benchmark to which to compare that. So let's talk for a moment about how seasonality works. Our portfolio in fact, tends to have more pronounced seasonal patterns than the industry average. The second quarter tends to be the seasonal low point for delinquencies and the fourth quarter tends to be the seasonal high point. Card losses lag relative to delinquencies, the losses tend to be seasonally lowest in the third quarter and highest in the first quarter. Now, we have always thought and still do that tax refunds are a significant driver of these seasonal trends. And tax refunds drive a large seasonal improvement in delinquent payments in the February-March time period, which flows through to lower delinquencies in April, May and then to lower charge-offs in the August-September timeframe. Tax refunds also drive a seasonal uptick in our recoveries. Now a few years ago, the tax withholding rules changed leading to fewer tax refunds and lower average refund payments. And the IRS was paying certain refunds later than before because of fraud-related issues that they had seen. Now, so we were watching all this, but there was so much noise in the payment data due to the pandemic that we were unsure to what extent credit seasonality patterns had changed. So in the first half of this year, as credit metrics settled out, we flagged that the combined effect of lower and later tax refunds as the more it settles out, the more we can sort of see these underlying patterns that we flag that this combined effect was likely affecting our near-term credit performance by delaying and muting the usual seasonal improvement that we see in the second quarter. But we didn't want to go to the highest mountaintop and declare that because we wanted to make sure we weren't explaining away credit numbers that in fact looked worse than seasonally what you would expect. We also at the time, you know, believed that we would see more muted seasonal increases in delinquencies in the third quarter on the other side of that effect. And we've now had several quarters to look at this and that experience has been confirmatory. And now that you know, we're in a sense, credit is coming in better than the old seasonal patterns. So we've seen both the worst side and the better side. I think we can pull up and really sort of declare this effect really seems to be happening. 2024 settled out with fewer refunds paid than before the pandemic and about 25% lower total refund volume in real terms. So what we're basically seeing and pulling way up is that seasonality, which has we believe is driven predominantly by tax refunds, as tax refunds become less of an effect, not surprisingly, in fact, we're seeing seasonality that has less amplitude to it. So that's, I think, the seasonality that we observe now and when we've done sort of a -- an adjusted look at last year, we definitely think that we see the new trend. By the way on the auto side, all of this happens in auto seasonality but in an even faster and more concentrated way. So I think I just wanted to share that with you. But I think what we've really been declaring here, Sanjay, is that it's -- there's just such a confirmation that, that credit is really settling out here."
},
{
"speaker": "Sanjay Sakhrani",
"content": "I mean my follow-up question would be the question you were looking for later. What's the path to normalization? And I guess for credit as well as the reserve rate, we're well above the levels we were in 2019, maybe you and Andrew can tag team on that one. Thank you."
},
{
"speaker": "Richard Fairbank",
"content": "So why don't I start, Andrew. So the -- we're really, really pleased with how card credit has settled out after, quite a period of normalization. So looking ahead, while we're not giving guidance on future credit, I just want to point out a number of forces that play out. So the one force, of course is this thing that we believe so strongly is there, but we can't measure it is the phenomenon of delayed charge-offs. If you kind of look at the area under the curve of all the charge-offs that sort of didn't happen, now we don't believe all of that area will play out over time. But if you look at the area below the curve and compare it to the area in a sense above the curve now, one can see that conceptually there could be still quite a bit of, in a sense delayed inventory that could happen. I just want to flag that effect. I think it's going to moderate at some point, but I think that effect will be with us from -- for some time. Another factor is the recoveries inventory that continues to rebuild and that should be a gradual tailwind to our losses over time, all else being equal. And then the moderating of inflation, I think, is a good guy for card credit, but still high interest rates are probably a source of pressure at the tails for some consumers, especially those with higher debt servicing burdens. And of course, the economy will be a factor too, but those are just some of the forces I think are going to be at work as credit plays out here, Sanjay."
},
{
"speaker": "Andrew Young",
"content": "And then with respect to allowance, Sanjay, obviously, we'll be allowing for growth. So that's the starting point on a dollar basis. I suspect you are more focused on coverage. So let me talk in coverage terms. First, and just very tactically, as a reminder near term, in the fourth quarter, we typically have seasonally higher balances, and those balances just have lower coverage because of the high levels of expected payments. So all else equal, and I stress that point, but that would put downward pressure on coverage in the fourth quarter. But I -- in hearing your question, I think you're looking for a longer-term view. So first, the coverage over time is going to primarily be driven by our loss forecast and our confidence in those estimates. And so Rich just kind of shared, the things that we'll be looking for and what will ultimately be driving those forecasts. But how the allowance then plays out relative to that, I think it's important to note that even if we find ourselves in future quarters where our projected losses are lower than the projected losses in the current quarter's forecast, we might see only modest declines in coverage as we incorporate uncertainties related to those projections. But eventually the -- that lower loss forecast if and when it comes through theoretically flow through the allowance and bring the coverage ratio down as those uncertainties become more certain. And so the direction of travel in that scenario would be down. The pace and timing would obviously depend on a variety of factors. Because you mentioned though CECL Day 1, I guess I'll end, Sanjay, just as a reminder, one other call out using CECL Day 1 as a rough proxy for a through-the-cycle coverage assumption, it's important to note that embedded in CECL Day 1 was a law-sharing agreement with Walmart. And so with the termination of that agreement, the roughly 50-basis point impact to allowance coverage that we recognized last quarter, I just want to make sure that as you're thinking about CECL Day 1 excluding the Walmart effect that 6.5% roughly percent is actually more like 7%. Hopefully, that gives you though a sense of the direction of travel."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Terry Ma with Barclays. You may proceed."
},
{
"speaker": "Terry Ma",
"content": "Oh, thank you. Good evening. I wanted to touch on the auto business and ask kind of what you're seeing in a competitive environment and how you're thinking about growth going forward. You called out originations have been positive the last three quarters and it looks like loan growth is going to turn positive. I know you're still mindful of used-car prices. So should we expect more measured growth in auto going forward?"
},
{
"speaker": "Richard Fairbank",
"content": "So yes, thank you, Terry. You know, our auto originations, as you say, they've been -- they've been growing now, I guess it's the last three quarters. And as we stated in our prior calls, in 2022 and in early 2023, we had anticipated risk and pullback on our originations. And even as the vehicle values have been declining, the credit performance on both our front book and our back book remains very strong. So additionally, just talking about some industry factors. Some of the headwinds that the industry has been facing with high interest rates and high vehicle prices are now easing as the interest rates have started to come down and vehicle values are down from their peak, although both of these remain higher than pre-pandemic levels. So interest margins are on our -- also very important, interest margins on our front book have increased and credit has stabilized and we're seeing opportunities to grow in a resilient way. So our strategy is to lean into areas that we like and that is supported by our very sophisticated underwriting and technology infrastructure, our data-driven decisioning as well as deep relationships with our dealer network. So looking ahead, we feel good about our auto business, and we feel we are well positioned to grow in a disciplined way targeting particularly what we think is the very resilient business."
},
{
"speaker": "Terry Ma",
"content": "Great. Thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Bill Carcache with Wolfe Research Securities. You may proceed. Bill, your line is now open."
},
{
"speaker": "Bill Carcache",
"content": "Thank you. Good evening, Rich and Andrew. Following up on your NIM commentary, Andrew, if credit continues to trend in line or potentially better than normal seasonality from here, is it reasonable to expect revenue suppression would begin to serve as more of a NIM tailwind that would arguably overwhelm some of the NIM headwinds that you described in your earlier response?"
},
{
"speaker": "Andrew Young",
"content": "Outside of seasonality, Bill, which is an important qualifier to that, but yes, to the extent that credit is coming down in an absolute sense, suppression is highly correlated with loss rates. So over a period of time, that's what we would expect to see."
},
{
"speaker": "Bill Carcache",
"content": "Thanks. And then also another follow-up for you, Andrew, on your reserve commentary. In prior quarters, qualitative overlays, it seems -- and please correct me if I'm wrong, it seems like it had the effect of preventing you from releasing reserves. Is it fair to conclude that this quarter's reserve release suggests you expect consumer credit conditions to continue to gradually improve from here to the point where, you know, that would support peak losses likely being -- or sorry, peak reserve rates likely being behind us at this point?"
},
{
"speaker": "Andrew Young",
"content": "It's hard to think about the qualitative factors in isolation, Bill, because we look at the totality of the forecast and the economic backdrop. And that's just one albeit important but component of thinking about the allowance overall. So really the release this quarter was driven by the stability of underlying credit trends and just our confidence in those trends. So that's really the driver that led to this quarter's release."
},
{
"speaker": "Bill Carcache",
"content": "Thank you for taking my questions."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Don Fandetti with Wells Fargo. You may proceed."
},
{
"speaker": "Don Fandetti",
"content": "Hi, Rich, on the Discover merger, do you still feel like owning a network helps your position with regulatory approval? I mean, I guess the DOJ suit against Visa does validate that. I'm just trying to get a sense on whether or not you feel like your arguments are resonating with regulators and you have confidence in the deal closing?"
},
{
"speaker": "Richard Fairbank",
"content": "So I think it's, you know, this is an unusual deal in the sense that usually there is, a player in a certain industry doing an acquisition of another player in that industry and certain -- certainly part of the consideration is looking at those aspects, but the very unusual part here is two things. First of all, one is such an important part of this acquisition is buying a network, something that we don't have. So we're not even in that part of the business. But then secondly, of course, it is, you know, an acquisition buying a position in an industry that is, getting a tremendous amount of scrutiny for how concentrated it is. And the network that we are acquiring, for example, on the credit card side has gone from 6% down to 4% share in recent years. And so certainly, we are making a strong case that to a regulator that obviously has shown they care a lot about competition in that marketplace that we certainly believe that this is a very pro-competitive in that sense. Of course, we also believe very much that on the credit card side, the deal is pro-competitive as well."
},
{
"speaker": "Don Fandetti",
"content": "Thank you."
},
{
"speaker": "Richard Fairbank",
"content": "Yes. And yes. Yes, go ahead."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from John Heck with Jefferies. You may proceed."
},
{
"speaker": "John Heck",
"content": "Good afternoon, guys. Thanks very much for taking my questions. Most of them have been asked and answered. I'm wondering if you guys can maybe give us some color on spend trends, the built business volumes. We've heard that there's -- that the consumer is being a little bit more cautious and careful or responsible with their spending as opposed to reacting to some sort of weakness or concerns about the economy. And I'm wondering what your opinion is on that and how that affects your business?"
},
{
"speaker": "Richard Fairbank",
"content": "So, John, thank you. The -- consumer spending has had a little bit of a wild ride over the past few years. So just to reflect for a second on this, at the start of the pandemic spend per customer plummeted, then it surged as consumers resumed their spending and it has since been settling out. Since the beginning of 2023, our spend per customer has remained largely flat overall, although it has begun to tick up in recent months. So the spend growth that you see for Capital One is really being driven by the growth in new accounts and the spending on those accounts. And then we see just a little bit of a tick up in the last few months. Just to -- while I know some people have kind of wondered if you double click into the spend patterns, you know, discretionary and non-discretionary spend have really -- the growth rates of them have been very stable lately. And in fact, the mix has been stable across incomes and FICOs and is in line with pre-pandemic levels. So we think things really have settled out in the -- in the card business with respect to spend. And when we -- it's really striking when we look at banking overall and pretty much the only industry that's really growing is the credit card industry and it's been a tough way to make a living in most of the banking product areas and that of course, I think, the credit card continues to be part of a very -- a very important and multi-decade macro trend with respect to the movement out of cash and checks and really into the incredibly convenient spending mechanisms of a credit card. So I think there's sort of a macro tailwind that continues to help the industry. And then I think for a lot of us companies, certainly a few of us companies like Capital One, our strategies are very focused. It's what I call a spend first strategy so that a lot of what we do, the choices we make on the marketing side, on the credit side and really the business we want to be has a spend first lean to it and that that's another benefit to our metrics. Thank you, John."
},
{
"speaker": "John Heck",
"content": "Thank you. Appreciate the color."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Mihir Bhatia with Bank of America. You may proceed."
},
{
"speaker": "Mihir Bhatia",
"content": "Good afternoon. Thank you for taking my question. And actually, just following up kind of similar lines as John's question about spending. Maybe just drilling down specifically on the venture ex-portfolio. And I was wondering if you could just talk a little bit more about it. It's been in the market for a couple of years now. Just how much has it grown, how material is it to the overall card business? What are you seeing in terms of performance in that portfolio that's encouraging you to invest more in it. But just any additional details would be great. Thank you."
},
{
"speaker": "Ime Archibong",
"content": "All right. Thank you, Ime here. So we launched our Venture X card in late 2021, and we're very pleased with the market response and the customer engagement so far. This launch is, of course, a continuation in our journey that's been many years in the making to win at the top of the market and that journey started years ago with the declaration. And then we have continued to just sort of every year stretch a little higher and lean in to the momentum and the brand strength that we were getting in our market position to be able to keep growing. So Venture X was a very important milestone in that journey. And also, very important in that journey to win at the top of the market was the launch of our Capital One travel portal and the opening of Capital One lounges as well as enhancements to our customers' overall experience more broadly. So and I'm sure you saw that actually in the third quarter of last year, we then launched the Venture X business card and we're also pleased with the market response and customer engagement so far as well. So I guess the way -- while we don't give out the specific numbers on this, we continue to be very pleased with our quest to win at the top of the market and both of these Venture X products are getting a lot of traction so far. And as you can see, we're leaning in quite a bit. But again, what I want to say is, I think one of the mistakes that card companies sometimes make is to think about a quest to win at the top of the market related to we're going to launch a particular product with these features. I really want to stress that winning at the top of the market requires a sustained comprehensive effort to create experiences, access to things that are unique and sort of something to tell your friends about, lounges, digital experience, rewards, of course, and then a very important component of this is building the brand credibility to have -- be viewed as a premium player in that part of the marketplace. So all of that is what we're investing in. You've, of course, seen quite an increase in our marketing and a fair amount of that is in service of our continued quest at the top of the market. But I would leave this one observation with you as well is that while you see the overall purchase volume growth rate for Capital One, and when we -- when we break that data up by spend segment, basically the higher the spend segment, meaning the higher we reach up in the marketplace, the faster our growth rate is, which is a confirmation of the traction we're getting, but also not only in overall volume, but the traction that we're getting reaching farther up."
},
{
"speaker": "Jeff Norris",
"content": "Next question please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Chase Haynes with Evercore ISI. You may proceed."
},
{
"speaker": "John Pancari",
"content": "Hi, it's John Pancari at Evercore ISI. I wanted to just ask on capital CET1 ratio at 13.6%. I wanted to get your updated thoughts here on how you think about buyback in that context. I know you had indicated that the Discover transaction could impact the pace of buybacks ultimately, but you still bought back about $150 million in the third quarter. So I wanted to get your updated thoughts there. Thanks."
},
{
"speaker": "Andrew Young",
"content": "Yes, John, look, there's a few forces at play that impact how we think about capital management. The first, of course, being the uncertainty around the end game rule. The re-proposal provided some high-level indications, but the devils in the details there, not to mention the uncertainty on implementation timing. And second, although it's been moderating, of course, there still continues to be a degree of macroeconomic uncertainty. But last and perhaps most importantly, we have the pending Discover acquisition. And so post close, we will need to run both our internal assessment of the needs of the combined company, but we'll also go through the Fed's CCAR process to come up with our view and the Fed's view of the combined capital need -- the combined company entity's capital need. So those are the reasons why we are operating at current levels and believe it's prudent to do so. And we've been at this $150 million a pace for a number of quarters. And once we are back under an SEB regime, we'll, of course have flexibility to return capital as we see appropriate and you saw in late 2021 and early '22 when we had excess capital, we were returning that at something like $2.5 billion a quarter in repurchases. So if we were to find ourselves in a similar position, we understand that returning excess capital is an important part of creating shareholder value and we have the ability to do so quickly, but I go back to the forces at play of why we're operating where we are right now."
},
{
"speaker": "John Pancari",
"content": "Got it. Thank you, Andrew. If I could just ask one more on the loan yield increase, up about 58 basis points this quarter, how much of that increase was the impact from Walmart for the full quarter? And was there any impact on the APR from any increase to the APR in response to the proposed CFPB late fee rule? Thanks."
},
{
"speaker": "Andrew Young",
"content": "And John, I just want to make sure I understand your question of the yields quarter-over-quarter, are you saying or like year-over-year yield on card, year-over-year yield in card is flat when you take into account the effect of Walmart. Quarter-over-quarter, it's really just the seasonality effect. There's the partial quarter of Walmart, but yield is really the seasonal effects and partial quarter of Walmart when you're comparing third quarter to the second quarter."
},
{
"speaker": "John Pancari",
"content": "Okay."
},
{
"speaker": "Andrew Young",
"content": "And then..."
},
{
"speaker": "John Pancari",
"content": "Okay, thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question comes from the line of Jeff Adelson with Morgan Stanley. You may proceed."
},
{
"speaker": "Jeff Adelson",
"content": "Hi, good evening. Thanks for taking my question. Just one for me to follow up on John's question there. Just on the late fee rule, I fully appreciate that things remain in flux at this point. But could you give us an update in your latest thinking and how you're potentially preparing for that with any offsets or mitigating actions? Have any of those actions been taken yet? And I get that you talked about taking a more mindful approach here. Just wanted to make sure that this is still the same approach you're taking or if there's anything else we should be thinking about in our models here? Thank you."
},
{
"speaker": "Andrew Young",
"content": "Thank you, Jeff. So at this point, we're waiting for industry litigation to play out to see if and when the late fee rule goes into effect. And we're not going to predict when that will happen. As we've said before, if the rule is implemented in its current form, it will have a significant impact on our revenue. But we also believe that the rule will have an impact on the marketplace, including competition, pricing, customer behavior, volumes, credit. The reality is that we have spent decades painstakingly building a customer first franchise with the fewest fees in the industry and extremely simple products. We believe that we've been rewarded for these choices with better growth, better attrition and better credit selection. Ultimately, we will work backwards from what preserves our customer franchise, our customer loyalty and credit resilience if the rule does go into effect. Relative to anything that we've done so-far, we -- really the only thing we've done is we did defer a few investments in anticipation of this rule being implemented. If the ruling never happens, we will likely go ahead and make these investments over time. Thank you, Jeff."
},
{
"speaker": "Jeff Norris",
"content": "Well, that concludes our Q&A session for the evening. Thank you for joining us on this conference call today and for your continuing interest in Capital One. Everybody, have a great night."
},
{
"speaker": "Richard Fairbank",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] |
cof | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Capital One Q2 2024 Earnings Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead."
},
{
"speaker": "Jeff Norris",
"content": "Thanks very much, Josh, and welcome everyone to Capital One's second quarter 2024 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One's website at capitalone.com and follow the links from there. In addition to the press release and the financials, we've included a presentation summarizing our second quarter 2024 results. With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew will walk you through the presentation. To access a copy of the presentation and press release, please go to Capital One's website, click on Investors, and click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion in the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events, or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. And for more information on these factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC. And with that done, I'll turn the call over to Mr. Young. Andrew?"
},
{
"speaker": "Andrew Young",
"content": "Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight's presentation. In the second quarter, Capital One earned $597 million or $1.38 per diluted common share. Included in the results for the quarter were adjusting items related to the Walmart partnership termination, Discover integration costs, and an accrual for our updated estimate of the FDIC's special assessment. Net of these adjusting items, second quarter earnings per share were $3.14. Relative to the prior quarter, period end loans held for investment increased 1%, while average loans were flat. Ending deposits were flat versus last quarter, while average deposits increased 1%. Our percentage of FDIC insured deposits increased 1 percentage point to 83% of total deposits. Pre-provision earnings in the second quarter increased 7% from the first quarter. Revenue in the linked quarter increased 1%, driven by higher net and non-interest income, while non-interest expense decreased 4%, driven by a decline in operating expense. Our provision for credit losses was $3.9 billion in the quarter. The $1.2 billion increase in provision relative to the prior quarter was almost entirely driven by higher allowance. Included in the second quarter was an $826 million allowance built from the elimination of the loss sharing provisions that occurred within the termination of the Walmart partnership. The remaining quarter-over-quarter provision increase was driven by a $353 million higher net reserve build and a $28 million increase in net charge-offs. Turning to Slide 4, I will cover the allowance in greater detail. We built $1.3 billion in allowance this quarter. The allowance balance now stands at $16.6 billion. Our total portfolio coverage ratio increased 35 basis points to 5.23%. The increase in this quarter's allowance and coverage ratio was largely driven by a build in our card segment. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. In our domestic card business, the allowance coverage ratio increased by 69 basis points to 8.54%. The substantial majority of the increase in coverage was driven by the impact of the termination of the Walmart loss sharing agreement. In our Consumer Banking segment, the allowance decreased by $23 million, resulting in a 5 basis point decrease to the coverage ratio. And finally, our commercial banking allowance increased by $6 million. Coverage ratio remained essentially flat at 1.74%. Turning to Page 6, I'll now discuss liquidity. Total liquidity reserves in the quarter decreased about $5 billion to approximately $123 billion. Our cash position ended the quarter at approximately $45 billion, down about $6 billion from the prior quarter. The decrease was driven by wholesale funding maturities, loan growth, and declines in our commercial deposits, partially offset by deposit growth in our retail banking business. You can see our preliminary average liquidity coverage ratio during the second quarter was 155%, down from 164% in the first quarter. Turning to Page 7, I'll cover our net interest margin. Our second quarter net interest margin was 6.7%, 1 basis point higher than last quarter and 22 basis points higher than the year ago quarter. The relatively flat quarter-over-quarter NIM was the result of largely offsetting factors. NIM in the quarter benefited from the termination of the revenue sharing agreement with Walmart as well as modestly higher yields in the auto business. These two factors were roughly offset by the seasonal effects on yield in the card portfolio and a slight increase in the rate paid on retail deposits. Turning to Slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 13.2%, 10 basis points higher than the prior quarter. Net income in the quarter was largely offset by the impact of dividends and $150 million of share repurchases. During the quarter, the Federal Reserve released the results of their stress test. Our preliminary stress capital buffer requirement is 5.5%, resulting in a CET1 requirement of 10%. However, as we disclosed in our last 10-Q, the announcement of the acquisition of Discover constituted a material business change. As a result, we are subject to the Federal Reserve's pre-approval of our capital actions until the merger approval process has concluded. With that, I will turn the call over to Rich. Rich?"
},
{
"speaker": "Richard Fairbank",
"content": "Thanks, Andrew, and good evening, everyone. Slide 10 shows second quarter results in our credit card business. Credit card segment results are largely a function of our domestic card results and trends, which are shown on Slide 11. In the second quarter, our domestic card business delivered another quarter of strong results as we continued to invest in flagship products and exceptional customer experiences to grow our franchise. Year-over-year purchase volume growth for the quarter was 5%. Ending loan balances increased $11.1 billion or about 8% year-over-year. Average loans also increased about 8% and second quarter revenue was up 9%, driven by the growth in purchase volume and loans. Revenue margin for the quarter remained strong at 17.9%. The revenue margin includes a positive impact of about 18 basis points resulting from the partial quarter effect of the end of the Walmart revenue sharing agreement. The charge-off rate for the quarter was 6.05%. The partial quarter impact of the end of the Walmart loss sharing agreement increased the quarterly charge-off rate by 19 basis points. Excluding this impact, the charge-off rate for the quarter would have been 5.86%, up 148 basis points year-over-year. The 30 plus delinquency rate at quarter end was 4.14%, up 40 basis points from the prior year. As a reminder, the end of the Walmart loss sharing agreement did not have a meaningful impact on delinquency rates. The pace of year-over-year increases in both the charge-off rate and the delinquency rate have been steadily declining for several quarters and continued to shrink in the second quarter. On a sequential quarter basis, the charge-off rate excluding the Walmart impact was down 8 basis points and the 30 plus delinquency rate was down 34 basis points. Domestic card non-interest expense was up 5% compared to the second quarter of 2023, primarily driven by higher marketing expense. Total company marketing expense in the quarter was $1.1 billion, up 20% year-over-year. Our choices in domestic card are the biggest driver of total company marketing. We continue to see compelling growth opportunities in our domestic card business. Our marketing continues to deliver strong new account growth across the domestic card business. Compared to the second quarter of 2023, domestic card marketing in the quarter included increased marketing to grow originations at the top of the marketplace, higher media spend, and increased investment in differentiated customer experiences, like our travel portal, airport lounges, and Capital One Shopping. Slide 12 shows second quarter results for our Consumer Banking business. After returning to positive growth last quarter, auto originations were up 18% year-over-year in the second quarter. Consumer banking ending loans were down $1.6 billion or 2% year-over-year and average loans were down 3%. On a linked quarter basis, ending loans were up 1% and average loans were flat. Compared to the year ago quarter, ending consumer deposits were up about 7% and average deposits were up 5%. Consumer banking revenue for the quarter was down about 9% year-over-year, largely driven by higher deposit costs and lower average loans compared to the prior year quarter. Non-interest expense was up about 2% compared to the second quarter of 2023, driven by an increase in marketing to support our national digital bank. The auto charge-off rate for the quarter was 1.81%, up 41 basis points year-over-year. The 30 plus delinquency rate was 5.67%, up 29 basis points year-over-year, largely as a result of our choice to tighten credit and pull back in 2022, auto charge-offs have been strong and stable. Slide 13 shows second quarter results for our commercial banking business compared to the linked quarter, ending loan balances decreased about 1%. Average loans were also down about 1%. The modest declines are largely the result of choices we made in 2023 to tighten credit. Ending deposits were down about 6% from the linked quarter. Average deposits were down about 3%. The declines are largely driven by our continued choices to manage down selected less attractive commercial deposit balances. Second quarter revenue was essentially flat from the linked quarter and non-interest expense was lower by about 6%. The Commercial Banking annualized net charge-off rate for the second quarter increased 2 basis points from the sequential quarter to 0.15%. The commercial banking criticized performing loan rate was 8.62%, up 23 basis points compared to the linked quarter. The criticized non-performing loan rate increased 18 basis points to 1.46%. In closing, we continued to deliver strong results in the second quarter. We delivered another quarter of top line growth in domestic card loans, purchase volume, and revenue and a second consecutive quarter of year-over-year growth in auto originations. Consumer credit trends continued to show stability and our operating efficiency ratio improved. We had guided to 2024 annual operating efficiency ratio, net of adjustment to be flat to modestly down compared to 2023, assuming the CFPB late fee rule takes effect in October. And we're on a very consistent path with what we expected when we gave that guidance. If the implementation of the rule is delayed, that would be a tailwind to 2024 annual operating efficiency ratio. One thing that has changed is the Walmart relationship. Our partnership ended in the second quarter, which will increase charge-off rates, but have a positive impact on operating efficiency ratio. Including the Walmart impact, we expect full year 2024 operating efficiency ratio, net of adjustments to be modestly down compared to 2023. We continue to lean into marketing to grow and to further strengthen our franchise. In the domestic card business, we continue to get traction in originations across our products and channels and our origination opportunities are enhanced by our technology transformation, which enables us to leverage machine learning at scale to identify the most attractive growth opportunities and customize our marketing offers. We are also getting traction in building our franchise at the top of the market with heavy spenders. It is not lost on us that competitive intensity and marketing levels are increasing at the very top of the market and we know we have important investments to make. We continue to be pleased to see our investments pay-off in customer and spend growth and returns. And we're building and enduring franchise with annuity like revenue streams, very low losses, and very low attrition. In consumer banking, our modern technology and leading digital capabilities are powering our digital first national banking strategy, and we're leaning even harder into marketing to grow our national checking franchise, which has had industry leading pricing with no fees and industry leading customer satisfaction. Pulling up, marketing is a key driver of current and future growth and value creation across the company and we're leaning hard into our marketing investments. We expect total company marketing in the second half of 2024 to be meaningfully higher than the first half, similar to the pattern we saw last year. We are all-in and working hard to complete the Discover acquisition. Our applications for regulatory approval are in process and we're fully mobilized to plan and deliver a successful integration. We continue to expect that we'll be in a position to complete the acquisition late this year or early next year, subject to regulatory and shareholder approval. The combination of Capital One and Discover creates game changing strategic opportunities. The Discover payments network positions Capital One as a more diversified, vertically integrated global payments platform, and adding Capital One's debit spending and a growing portion of our credit card purchase volume to the Discover network will add significant scale, increasing the network's value to merchants, small businesses, and consumers and driving enhanced network growth. In credit cards and consumer banking, we're bringing together proven franchises with complementary strategies and a shared focus on the customer. And we will be able to leverage and scale the benefits of our 11 year technology transformation across every business and the network. Pulling way up, the acquisition of Discover is a singular opportunity. It will create a consumer banking and global payments platform with unique capabilities, modern technology, powerful brands, and a franchise of more than 100 million customers. It delivers compelling financial results and offers the potential to create significant value for merchants and customers. And now we'll be happy to answer your questions. Jeff?"
},
{
"speaker": "Jeff Norris",
"content": "Thanks, Rich. We'll now start the Q&A session. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Josh, please start the Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question comes from Sanjay Sakhrani with KBW. You may proceed."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thanks. Rich, Andrew, just looking at the credit metrics, as Rich mentioned, it seems like the trends are pretty favorable. I mean, in most segments things are improving, if not stable. And then the U.S. card, there is an improving trend in that second derivative. I'm just curious how we should think about reserve rate going forward because I think even excluding the Walmart impact, the reserve rate went higher."
},
{
"speaker": "Andrew Young",
"content": "Sure, Sanjay. Well, let me start by covering this quarter's allowance and then I'll talk about the future. So in the quarter, as you said, first, we had the effect of Walmart, the $826 million build that we spelled out as an adjusting item. We also reserved for the growth we saw in the quarter. Beyond that coverage in card, as you referenced, grew, I think it was just over 10 basis points, which is a little over 1% of the allowance balance. And so, as part of that process each quarter, not only are we rolling forward our baseline forecast, but we're also looking at a range of macroeconomic and consumer behavior uncertainties, including things like the changing seasonal customer behavior we talked about last quarter. And so as a result, in this quarter, we increased the qualitative factors to reflect those uncertainties and that's what drove the modest increase in coverage this quarter. As I look ahead and talking conceptually here, but in a period where projected loss rates in future quarters are projected to stabilize and ultimately decline and might indicate a decline in the coverage ratio, I would say, you could very well see a coverage ratio that remains flat for some period of time as we incorporate the uncertainty of those future projections into the allowance. And in a period where forecasted losses are rising, we're quick to incorporate those higher forecasted losses and also potentially add qualitative factors for uncertainty like you saw early in the pandemic, but I would say it is unlikely to be symmetric on the way down. And so eventually, the projected stabilizing and ultimately lower losses will flow through the allowance, particularly as the uncertainties around that forecast become more certain. But at this point, I'm not going to be in the business of forecasting when that's actually going to take place for us."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Got it. And then, Rich, maybe you could just talk about the consumer and sort of the uncertainties there. Is there any discernible like change that you've seen since the last quarter in terms of the state of the consumer? We've obviously seen the spending trends sort of slow somewhat across the industry. But anything else to sort of point out?"
},
{
"speaker": "Richard Fairbank",
"content": "Sanjay, I think what we see is something that's very stable. The U.S. consumer remains a source of strength in the overall economy. Of course, the labor market remains strikingly resilient. Rising incomes have kept consumer debt servicing burdens relatively low by historical standards despite high interest rates. When we look at our customers, we see that on average, they have higher bank balances than before the pandemic and this is true across income levels. On the other hand, inflation shrank real incomes for almost two years and we've only recently seen real wage growth turn positive again. And in this high interest rate environment, the cost of new borrowing has gone up in every major asset class, mortgages, auto loans, and credit cards. So we'll obviously keep an eye on that. And I think at the margin, these effects are almost certainly stretching some consumers financially. But on the whole, I think I'd say consumers are in reasonably good shape relative to most historical benchmarks. And as our credit numbers came in five months [Technical Difficulty] I'm sorry. Can you hear me? Can you still hear me? You can hear me, okay? I just had some cross message coming in on my phone. But with respect to credit, we were very pleased with the credit performance in the quarter. We had talked a bit about the seasonality, maybe people want to ask question about that, but we saw basically pulling up, we see things settling out nicely in the card business and there things are very strong in the auto business."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Mihir Bhatia with Bank of America. You may proceed."
},
{
"speaker": "Mihir Bhatia",
"content": "Hi. Thanks for taking my question. Maybe just turning to NIM for a second. With the Fed or at least expectations for rate cuts coming into view, can you just comment on the current backdrop for deposit competition? How do you -- and how do you expect deposit betas to trend during the early stages of the Fed rate cutting cycle?"
},
{
"speaker": "Richard Fairbank",
"content": "Sure, Mihir. Like, what we've seen at least within our walls and you saw it as evidence of it this quarter in a quarter where seasonally you typically see a decline in deposit balances. Looking at H8 (ph) data, we saw a few -- I think it was $4 billion of growth. We've been quite pleased over the course of the last couple of years with all of the investments we've made over many years in building a deposit franchise and are certainly benefiting from that. And so with respect to the beta going forward, first, looking at what we saw in the upcycle here in the total cumulative beta that we've seen in this cycle this quarter, I think cumulatively it was 62% and so assuming that the Fed's next move is to bring rates down. It's hard to precisely predict what's going to happen to deposit costs and therefore betas, and in particular, the pace of those declines because market dynamics, competitive pricing actions, other actions related to companies looking to potentially preserve NIM, that's going to drive betas in the future cycle. But I think you get a pretty good sense for our pricing and mix based on what you saw in the upcycle and within that backdrop that I just described, that's going to influence what happens to our beta on the way down."
},
{
"speaker": "Mihir Bhatia",
"content": "Got it. That's helpful. Thank you. And then just switching back to the health of the customer overall. As you look across your portfolio, we've heard a little bit of talk about pull -- people pulling back, particularly on discretionary spend and lower income cohorts, etc. Is that a dynamic you are also seeing when you look at your customer base? And then relatedly, Rich mentioned how pleased he is with the progress you're making on the higher income side, if you will, on the big -- on the transactor in that high end transactor balance side. I was just wondering, how does that change your portfolio as you think about it like over the next few years, like as you grow that book further?"
},
{
"speaker": "Richard Fairbank",
"content": "Yes. Well, thank you so much. Just with respect to spending, we see pretty proportional movements in discretionary versus non-discretionary spending, nothing really striking there when we look at the portfolio spending metrics. The spend per customer is really pretty flat. When you see spend growth at a company like Capital One, the purchase volume growth is really being driven by the new accounts. So things are really pretty stable, flat and stable, healthy, but pretty flat on a per-customer basis. With respect to the question about the gradual transition of our portfolio to a higher end customer, let me just pull up and talk about that. We have for decades been a company that sort of serves the mass market really from the top of the credit spectrum through to even down to some subprime customers. And we have continued very consistently with this strategy, probably the most striking thing though that's happened over the last 10 or 14 years, I guess, 14 years ago is when we launched the Venture Card. We have systematically leaned into going after the top of the market, not leaving the other behind, but really as an additive strategy. And we have continued through our marketing and through the products that we're offering to just keep moving higher and higher in terms of the target customers and the traction that we're getting. And by the way, we continue even as we're growing purchase volume overall, where we see the highest growth rates in purchase volume are as we go higher in the market. So we're very happy about that. And when we think about the portfolio effects that happened there, this is one thing that we see is that payment rates have along that journey gone up quite a bit at Capital One. And when we look to see our payment rates coming back to where they were pre-pandemic, they sort of -- they probably just aren't going to return all the way because that would be a reflection of the portfolio shift. We just in general have had the kind of mix shift that you'd expect with higher payment rates and a -- just higher levels of spend, higher spend rates in the business and that's been very successful. So -- but from an outstanding's point of view, it doesn't -- the top of the market business doesn't have that much impact on outstandings because these folks generally pay in full. So when you see the outstandings movements of Capital One, it's pretty consistently driven by the mass market part of our business. It's just that inside some of the portfolio, metrics are moving because of the mix shift toward more spenders."
},
{
"speaker": "Mihir Bhatia",
"content": "Thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Rick Shane with J.P. Morgan. You may proceed."
},
{
"speaker": "Richard Shane",
"content": "Thanks for taking my question this afternoon. Look, given the breadth of your reach across the consumer income levels. Can you talk a little bit about sort of any patterns that you're seeing? We've heard, for example, some slowdown in spending for lower-income consumers. I'm curious, particularly you had made a comment earlier in the quarter about an increase in minimum payment rates. I'm curious if you're seeing anything in terms of payment behavior that we should consider by income level."
},
{
"speaker": "Richard Fairbank",
"content": "Yeah. Okay. So let's just pull up for a minute on just talking about how the subprime consumer is holding up. So, way back in the global financial crisis, we observed that credit metrics in subprime moved earlier in both directions. Subprime, also worsened less on a percentage basis than prime, but of course, it -- in absolute delta, it still moved more. In the pandemic, subprime credit moved more and more quickly than prime. It normalized more quickly and appears to be stable and appeared basically to stabilize sooner as well. And that's in the context of lower income consumers seeing disproportionate benefits of government aid and forbearance on financial products and then the unwinding of that over time. And so subprime is, of course, not synonymous with lower income, although they're correlated and we saw these effects across credit both in talking about the credit spectrum and also the income gradients. So on the other hand, just a couple of other effects just on the credit side that have happened over the recent years. Subprime consumers have been subject to more industry credit supply, including fintech competition during and after the pandemic. So that's been something we've always kept a close eye on and worried about whether that was going to disproportionately impact the credit performance of subprime for customers. I don't really -- I mean, given the overall pretty strong performance in subprime, I think we haven't seen that effect too much. And another thing to point out is that income growth has been consistently higher for lower income consumers over the past several years and this is the opposite of what we saw during and after the global financial crisis. But while no two cycles alike -- are alike, I think again we're seeing that subprime consumers and lower income consumers again they're not the same thing, but they tend to move earlier, but not necessarily more than the overall market. Now when you -- let's talk a little bit about payment rates. So throughout the course of the pandemic, payment rates increased not only for us but across the industry. And more recently payment rates have drifted down from pandemic highs as the effects of stimulus have waned. And the payment rates generally we have seen this effect, so the effect that we've seen of payment rates going down relative to where they were, one to two years ago relative to their peak basically. In every part of our business, they have come down, but are still above where they were pre-pandemic. And again, I think part of that is the mix effect that we talked about in the prior question. There is a mix effect not only across our whole portfolio but even within the segments of our portfolio, we just had more emphasis on the spender side versus the revolver side internally. And so I think you see some of that showing up in the metrics. One other thing I want to say is that talk about your question about minimum payments. So we have simultaneously -- we're sort of seeing an effect where payment rates while they're going down, continue to be well above pre-pandemic levels, even as minimum -- the percentage of customers paying minimum payments. This by the way is not a subprime effect. This is a portfolio effect I'm talking about. The percent of customers paying minimum payments is also somewhat above pre-pandemic levels. Now, it seems a little odd to have both of those effects happening at the same time. But I think in many ways this is a very natural way that normalization is happening. And you've heard us talk for a long time now about what we call the delayed charge-off effect in consumer credit that so many customers got stimulus and forbearance that I think a lot of people who otherwise would have charged off were able to avoid that charge-off. Many, hopefully, we're able to permanently avoid that, but for some, we have believed it was more of a deferral of an inevitability and this phenomenon of delayed charge-offs, which can't be separately measured, we believe is a driving factor behind why credit has been settling out higher than pre-pandemic. Because I think there's just a delayed charge-off effect for some of these customers who otherwise would have charged off earlier. And that then would be consistent with a very healthy consumer payment rates generally even being higher than pre-pandemic, but there is a tail of consumers paying a higher percentage on minimum payments, and some of them going through a charge-off that might have otherwise happened a few years earlier."
},
{
"speaker": "Richard Shane",
"content": "Thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ryan Nash with Goldman Sachs. You may proceed."
},
{
"speaker": "Ryan Nash",
"content": "Hey, good afternoon, Rich. So maybe to ask about marketing. So I think you’re -- the guide that you provided said around $2.6 billion roughly of marketing spend in the second half. And you talked a little bit about the competitive intensity in the top of the market is increasing. Can you maybe just talk about how much of the increase in marketing is being driven by the -- investing more to acquire more customers versus competition pushing up the cost to acquire? And then just given what you just talked about around low end consumers, are you pulling back and else anywhere to cover the increased cost of acquiring?"
},
{
"speaker": "Richard Fairbank",
"content": "Ryan, our -- yeah, our comments about the competitive intensity, let me just elaborate a little bit more about that. The card business is very competitively intense across the spectrum, it's been consistently intense. Competition has -- competition in things like rewards have certainly heated up over the last couple of years. And the thing that I was pointing out is just something that again is not something that is like the realization of the last month or so. It's a phenomenon we've seen from some -- for some time but it is striking which is at the very top of the market. We are seeing for the -- especially a couple of competitors that we have that most intensely play at the very top of the market, you can just absolutely see they are stepping up, investing more in lounges, in experiences, in dining, investing in companies, marketing levels, it's -- I'm sure all the investors can see it. We can all see it and they talk about it. And it's not lost on us that these are strong competitors and we certainly, have -- we already have had very important investment plans in these areas and we note that others are investing heavily too. So, but with respect to the -- let me just now kind of pull up now and just talk about the marketing sort of where we are from a marketing point of view. We continue to see great opportunities and really across our businesses, we remain very excited about the success of our origination activities, especially in our card products and channels and of course, what's happening in the bank. The two big areas that are driven by marketing spend. This continues to be powered by our technology transformation. And just to savor a little bit because we often point at that, why does the technology transformation help here? It gives us the ability to leverage more and more data and machine-learning models to identify the most attractive growth opportunities. And it allows us to increasingly tailor our solutions to -- down to the individual customer level to ensure that we're meeting them right where we are. So kind of the first point I would say and the key reason we're leaning into the marketing is, we are getting a lot of traction and that our tech transformation is certainly helping to power more opportunities. Secondly, we continue to expand on our success in building a franchise at the top of the market and with heavy spenders in this quest, while for years we've been talking about going after the top of the market every year as we get more traction, we reach just a little bit higher. These customers are very attractive. In addition to the obvious spend growth, they generate strong revenue, very low losses, low attrition, and the business helps elevate our brand really across the company. Now it's also something that we've known all along is that it's expensive and requires quite a bit of investment to build a business at the top of the market. In the form of upfront costs and also in the form of a sustained commitment to customer benefits and experiences and building a brand. So, yeah, you have early spend bonuses that are important cost of doing business that shows up in the marketing line item. Brand makes a huge difference and brand of course requires a long-term commitment to build. And as we continue to move up the market, we are moving increasingly into areas where consumers are looking for exclusive services and experiences that aren't available in the general marketplaces such as -- place such as airport lounges and access to select properties and iconic experiences. So we've seen at the top of the market our two biggest competitors really lean in here. And we -- when we certainly are leaning in as well, Ryan, I wouldn't -- there are some times I've seen over the years that marketing levels just rise and so you just got to market more and more and more just to hold your own. And I don't feel that we're in an environment like this. I feel that the -- certainly competitive intensity is increasing. But when we're talking about in general in the card business where competitive intensity is increasing a bit, and specifically with respect to these investments at the top of the market. These are just important things that we have to build to win at the top of the market, but we are very pleased with the traction we're getting, the economics of our heavy spender business. And so this is -- we just -- it's just not lost on us, a couple of our other competitors are very focused on the same thing. So we continue to lean into growth here, both in terms of upfront customer acquisition and our ongoing investment in brand and exclusive experiences and benefits. Now, let me now turn to the third part of our marketing story, which is our investment in building our national bank. So this has been a journey that we've been on for many, many years. When we bought ING Direct way back in 2012, we said this is going to be not only a great financial acquisition, but it's going to be a transformational strategic acquisition. Because now as a player with a significant branch network and a national direct bank, we have the building blocks to build a unique national bank. And that's what we're building, a digital first national bank. We've got smaller physical branch network. So we lean more on our cafe network, which is in cafes in 21 of the top 25 MSAs. Lean very heavily into our digital experiences and really importantly without a branch on every corner across the United States. The role for Capital One that marketing and brand play in building this national banking business is absolutely a central role. So we are very pleased with the growth that we're getting, the traction, the performance of this business and the opportunity just gets bigger when we think about in the context of the combined entity now joining force with Discover. So these are the compelling opportunities behind our marketing growth and we continue to feel really good about the success and the opportunities in front of us. And that's why we are leaning in very much into the marketing and specifically with respect to the rest of the year, why we pointed to. And of course, virtually every year at Capital One, the second half of the year has quite a bit more marketing than the first half. We pointed to the pattern kind of like what we saw last year in terms of proportional increases in marketing. Thanks, Ryan."
},
{
"speaker": "Ryan Nash",
"content": "Thanks for the color."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Bill Carcache with Wolfe Research Securities. You may proceed."
},
{
"speaker": "Bill Carcache",
"content": "Thank you. Good evening, Rich and Andrew. Following up on your credit commentary, there had been an expectation among many investors that we would see peak charge-offs somewhere around the second half of this year, given the delinquency trends that you're seeing. Is that a reasonable expectation? And if so, it seems like your credit outlook has derisked somewhat given an improving loss trajectory, but higher reserve rate driven by qualitative factors. Is that a fair thought process? I'll just ask my follow-up as part of this. You mentioned, Andrew, that your capital return is subject to Fed approval, given the pending acquisition. How should we think about the pace of incremental buybacks as we look ahead through rest of the year? Thanks."
},
{
"speaker": "Richard Fairbank",
"content": "Yeah. Bill, yeah, let me make a couple of comments on credit. Let me seize a moment in the spirit of Henry Kissinger who says, I hope you have questions for my answers. I -- let me just ask myself a question, so I can answer it because it's going to -- it's set the table for answering your question. Which you may remember last quarter, we pointed at tax refund patterns and said that there may be a new seasonality pattern emerging and it would be too early to call that but it was making it a little bit -- things were not following as closely on a month-by-month basis to some pre-pandemic delinquency patterns that our hypothesis was three months ago that we're seeing a tax refund effect. So let me just talk about that for a second and then Bill, I'll pull up and talk about just sort of what does this mean for sort of how I feel about where we are with respect to credit. So, the -- let's just talk for a second about how seasonality works. We've always seen seasonal credit patterns in our card business and our portfolio trend, they have in generally been more -- they've had more pronounced seasonal patterns than the industry average. I think that's because we have a higher subprime component and those customers are even more linked I think to the seasonal patterns associated with tax refunds, that would be our hypothesis there. Now the second quarter tends to be the seasonal low point for delinquencies and Q4 tends to be the seasonal high point for delinquencies. Card losses lag relative to delinquencies, the losses tend to be seasonally lowest in the third quarter and highest in the first quarter. Now, we believe that tax refunds, again are a significant driver of these seasonal trends. And tax refunds drive a large seasonal improvement in delinquent payments in the February, March time period, which then flows through to lower delinquencies in April and May and then to lower charge-offs. And tax refunds also drive a seasonal uptick in our recoveries. So the tax code actually new tax withholding rules went into effect way back in 2020. They were passed in 2019, went into effect in 2020, but the pandemic and the normalization since then have kind of swamped seasonality. So we haven't really got -- been able to get a really good read at it -- of it. So we've tended to benchmark to the seasonality of pre-pandemic like 2018 and 2019. But we've now had several more months to look at this pattern and we're seeing a pattern. Well, let me back up. What we've done is what we call de-trending of our credit metrics. So we in hindsight, take the trends out of them to the best we can, so we can see what the net seasonality effects are. And on a detrended basis, last year showed a seasonality with less amplitude on the high side and the low side than had previously been seen pre-pandemic. We assumed that was probably again a manifestation of the new behaviors going in with the new tax refunds. As we now have seen this tax season play out, the seasonality, the payment patterns have been very close to our de-trended 2023 line, so that we believe that we are seeing and it's very plausible, we are seeing a new seasonality. I just want to share that with investors. So later tax refunds and later and lower sort of -- lower the seasonal improvement in delinquencies. But we think the seasonal increase in delinquencies that we see in the back half of the year, likely will also be less pronounced going forward than it has been in the past. All of this by the way happens in auto seasonality but in an even faster, more concentrated way. So we -- what we see, we felt it was a little bit noisy. Last quarter when we were talking to you, we were finding each quarter things were coming in a little bit. I mean, the second derivative was still doing great things. But relative to our sort of close in expectations based on seasonality, things were a little bit off. With the revised seasonality, what we see is things very nicely settling out in card credit. And we feel very good about the last couple of months that came in relative to that new seasonality curve. So I think settling out is the real word from here. Given that from -- but to your question about peak, we're not really going to -- we're not giving really forward guidance about declarations at peak. But from a seasonal point of view, things should head down from here in Q3, and then sort of pop up around October. October is often a month, we tend to get just a little bit of an October surprise, so we'll keep an eye on that. But the other thing I just want to say about credit is our recoveries inventory is starting to rebuild and that should be a gradual tailwind to our losses over time, all else being equal. And then other than the economy, I think the other real factor that's going to drive credit performance for us and other issuers in the next couple of years will be, what is the size of this delayed charge-off effect from the pandemic. Thank you."
},
{
"speaker": "Andrew Young",
"content": "Okay. And then, Bill, well, with respect to the derisk comment, Rich just provide a lot of color on our view of losses. I would just say, given the accounting rules, we forecast losses under a variety of scenarios and use qualitative factors for uncertainties around that. And I would say, therefore, like we are appropriately reserved for all of that. With respect to your question around repurchases, I'll just note, our agreement with Discover doesn't prohibit us from buying shares. The only restriction is that we'll need to be out of the market during the S-4 proxy vote period. However, we are not operating under the SCB. As I said in my prepared remarks and we laid out in the last Q, the announcement of the intention to acquire Discover did constitute a material business change. And therefore, like we did in this recent quarter, in the second quarter, we're subject to Fed pre-approval of our capital actions until the merger approval process has concluded. And so that's what's going to dictate the pace at which we repurchase until that process has concluded."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Don Fandetti with Wells Fargo. You may proceed."
},
{
"speaker": "Don Fandetti",
"content": "Yes. Rich, can you talk a bit about how you're seeing loan growth in auto? And also as banks potentially come back in, are you seeing or worried about spread or yield compression on new originations?"
},
{
"speaker": "Richard Fairbank",
"content": "So, hey, Don, it's an interesting thing. We always seem to zag while others -- zig while others zag in the auto business. As we discussed in the last quarter, we have an optimistic outlook on the auto business. We're seeing a lot of success in the auto business and our investments in infrastructure are also reaping a lot of benefits for us. So just on the numbers, our originations grew 21% versus last year in Q1 and the trend continues in Q2 with 18% growth on the year-over-year quarter. And the loss performance has normalized and it's stable. We -- very importantly, we made -- intervened and made an adjustment for what we felt was credit score inflation that was happening during the pandemic. And so we pulled back in '22 and '23 by just in a sense, worsening the otherwise scores one would see under a belief that they were artificially inflated. And that enabled our vintages all through this period of time, '22, '23, and all through the normalization to perform very well. We like the economics of the loans were originated and we're very satisfied with the performance of the overall portfolio. So when we think about the headwinds in the business, interest rates remain high. And of course, that along with high vehicle values continues to pressure affordability. And auto, used car prices, which are still high relative to historical standards, they are probably in a position to gradually be coming down. So we'll have to keep an eye on that. For a long time, we were concerned about the margins in the business because competitors had not passed through higher interest rates into the cost of the auto loans. We pulled back quite a bit, Don, as you remember during that period of time. We have seen those margins basically return to where they were. So I think that's a pretty good sign there. So all things considered, with a watchful eye on used car values, we are seeing enhanced opportunities in the auto business with margins that have a good resilience to them and quite a bit improved relative to the period where we were raising the alarm bells a bit about what was happening to the effective resilience in that business. Thank you."
},
{
"speaker": "Don Fandetti",
"content": "Thanks."
},
{
"speaker": "Richard Fairbank",
"content": "Thank you."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "And our final question this evening comes from the line of Moshe Orenbuch with TD Cowen. You may proceed."
},
{
"speaker": "Moshe Orenbuch",
"content": "Great. Thanks. When you talked about the increase in the reserve rate, not the dollars or the reserve, not the Walmart piece, but the reserve rate itself. Andrew, you didn't mention like mix of receivables. Is it -- has there been any shift towards mass market or subprime from super prime within the card business?"
},
{
"speaker": "Andrew Young",
"content": "Not in any material way that would have a significant impact on the allowance, Moshe."
},
{
"speaker": "Moshe Orenbuch",
"content": "Got it. Okay. And just as a follow-up, Rich, given what's happened with Walmart and the pending Discover acquisition, could you talk a little about your thoughts on the partner or private label business kind of in the current environment? Like what are your thoughts now in terms of your existing contracts and the tendency to want to get new ones or any thoughts on that in this environment?"
},
{
"speaker": "Richard Fairbank",
"content": "So, thank you. I think the -- well, the Walmart partnership is a very unique one, that I think there is not a lot to extrapolate to other partners on that. I think we've ended up in a situation there where we -- the loss share was a very good thing. So we're going to be carrying around loss rates that are something on the order of 40 basis points higher on our portfolio for that. So we'll have to just make sure we all see that, but we've got the full economics on the business increasingly that portfolio -- the portfolio we inherited is now very seasoned and the rest of it is the portfolio we ourselves originated. So we know it well. And I think that we feel very good about that. So the partnership business is a very partner-by-partner business. I think where people get into trouble is feeling they've got to drive to a certain scale. We all know scale matters in the credit card business and scale matters in the partnership business. But here's the thing, we have certainly learned over time how unique or how individual different partnerships are. And we've seen great ones, we've seen not so great ones. Here is Moshe, what we -- if I pull up on the patterns of what we most look for. It's first of all a healthy franchise, a company that is itself healthy and that's certainly a good sign. Now the credit card business does have a pretty good default structure whereby if a partner runs into trouble and can't continue, we inherit the portfolio, which now Walmart of course is a very strong company, but we're -- here's an example of inheriting a portfolio, where I think things are going to continue very successfully there. But the other thing that we really look for is what is the reason that the partner is driving this either co-brand or private-label business. Is it to -- is the -- on one end of a continuum is it’s the sheer quest for profits? And on the other end of the continuum, it is having the card partnership at the -- as a centerpiece in driving a franchise. And the behaviors that a partner has, the incentives that get baked into programs, they tend to be very driven by where on that continuum one is. We've walked away from a lot of opportunities over the years where things were just too focused on the card partnership as sort of the means to drive profit for the partner at more so than a way to really build a franchise. But those are some of the patterns, there are always exceptions to every rules -- for every rule. But -- so we're still very much a believer in the card partnership business, but the key is, we're going to be selective and never knowing that it's an auction based business, that's the other thing. One has to really be willing to walk away when the price is right. So with that, those are my thoughts, Moshe."
},
{
"speaker": "Jeff Norris",
"content": "Thank you, Rich, and thanks everyone for joining us on the conference call today. Thank you for your continuing interest in Capital One. Have a great evening."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
cof | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Capital One Q1 2024 Earnings Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead."
},
{
"speaker": "Jeff Norris",
"content": "Thanks very much, Josh, and welcome to everyone. We are webcasting live over the internet this evening. To access the call on the internet, please log on to Capital One's website at capitalone.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our first quarter 2024 results."
},
{
"speaker": "",
"content": "With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew are going to walk you through this presentation."
},
{
"speaker": "",
"content": "To access a copy of the presentation and press release, please go to Capital One's website and click on Investors and click on Financials and then click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials, and Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise."
},
{
"speaker": "",
"content": "Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section called Forward-looking information in the earnings release presentation and the Risk Factors section of our annual and quarterly reports accessible at Capital One's website and filed with the SEC."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Rich -- to Andrew, Mr. Young?"
},
{
"speaker": "Andrew Young",
"content": "Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight's presentation. In the first quarter, Capital One earned $1.3 billion or $3.13 per diluted common share. Included in the results for the quarter was a $42 million additional accrual for our updated estimate of the FDIC special assessment."
},
{
"speaker": "",
"content": "Net of this adjusting item, first quarter earnings per share were $3.21. Relative to the prior quarter, period-end loans held for investment decreased 2% and period-end deposits increased 1%. Both average loans and average deposits were flat. Our percentage of FDIC insured deposits remained at 82% of total deposits. Pre-provision earnings in the first quarter increased 13% from the fourth quarter or 6% adjusting for the impacts of FDIC special assessments in both quarters."
},
{
"speaker": "",
"content": "Revenue in the linked quarter declined 1%, largely driven by lower noninterest income. Noninterest expense decreased 6% on an adjusted basis, driven by declines in both operating and marketing expenses. Our provision for credit losses was $2.7 billion in the quarter, a decrease of $174 million compared to the prior quarter. The decrease was driven by $57 million lower net reserve build, partially offset by an $83 million increase in net charge-offs."
},
{
"speaker": "",
"content": "Turning to Slide 4, I will cover the allowance in greater detail. We built $91 million in allowance this quarter, bringing the balance to $15.4 billion, an increase of less than 1% from the fourth quarter. The slight increase in allowance balance was driven by modest builds in our Auto and Domestic Card portfolios. Our total portfolio coverage ratio increased 11 basis points to 4.88%. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5."
},
{
"speaker": "",
"content": "Our baseline economic forecast modestly improved this quarter compared to what we assumed last quarter, which generally aligns with consensus. We continue to consider a range of economic outcomes in our reserving process. In our Domestic Card business, the allowance coverage ratio increased by 22 basis points to 7.85%. The increase in coverage was primarily driven by the denominator effect of the runoff of the fourth quarter's seasonal outstandings."
},
{
"speaker": "",
"content": "In our Consumer Banking segment, the allowance increased by $46 million, resulting in a 7 basis point increase to the coverage ratio. The allowance increase was primarily driven by a higher level of originations in the Auto Finance business. And finally, our Commercial Banking allowance decreased by $7 million, primarily driven by portfolio contraction. Coverage ratio increased by 1 basis point to 1.72%."
},
{
"speaker": "",
"content": "Turning to Page 6. I'll now discuss liquidity. Total liquidity reserves in the quarter increased to $127 billion, about $7 billion higher than last quarter. Our cash position ended the quarter at approximately $51 billion, up about $8 billion from the prior quarter. The increase in cash was driven by continued strong deposit growth in our retail banking business and the seasonality of our card balances. Our average liquidity coverage ratio during the first quarter remained strong and well above regulatory minimums at 164%."
},
{
"speaker": "",
"content": "Turning to Page 7, I'll cover our net interest margin. Our first quarter net interest margin was 6.69%, 4 basis points lower than last order and 9 basis points higher than the year ago quarter. The quarter-over-quarter decrease in NIM was largely driven by the impact of having 1 fewer day in the quarter. Modestly higher asset yields were mostly offset by higher funding costs in the quarter."
},
{
"speaker": "",
"content": "Turning to Slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 13.1%, approximately 20 basis points higher than the prior quarter. Strong earnings and lower risk-weighted assets more than offset the impact of CECL phase in dividends and share repurchases. We repurchased approximately $100 million of shares in the first quarter. Our repurchase activity in the quarter was impacted by blackout restrictions and daily purchase volume limitations related to the announcement of the Discover transaction."
},
{
"speaker": "",
"content": "With that, I will turn the call over to Rich. Rich?"
},
{
"speaker": "Richard Fairbank",
"content": "Thanks, Andrew, and good evening, everyone. Slide 10 shows first quarter results in our Credit Card business. Credit Card segment results are largely a function of our Domestic Card results and trends, which are shown on Slide 11. Top line growth trends in the Domestic Card business remained strong in the first quarter. Year-over-year purchase volume growth for the first quarter was 6%."
},
{
"speaker": "",
"content": "Ending loan balances increased $12.9 billion or about 10% year-over-year. Average loans increased 11%, and first quarter revenue was up 12% year-over-year, driven by the growth in purchase volume and loans. The charge-off rate for the quarter was up 190 basis points year-over-year to 5.94%, about 18% above its pre-pandemic level in the first quarter of 2019. The 30-plus delinquency rate at quarter end increased 82 basis points from the prior year to 4.48%."
},
{
"speaker": "",
"content": "On a sequential quarter basis, the charge-off rate was up 59 basis points, and the 30-plus delinquency rate was down 13 basis points. The linked-quarter delinquency and charge-off rate trends were modestly worse than what we would expect from normal seasonality. We believe this is largely driven by lower and later tax refund payments to consumers so far in 2024, relative to what we've historically observed."
},
{
"speaker": "",
"content": "Tax refunds are an important factor in credit seasonality. Each year, they drive an improvement in delinquency payments and recoveries starting in February. Our portfolio trends generally have a more pronounced seasonal pattern than the industry average. Last quarter, our view was that the charge-off rate was settling out about 15% above 2019 levels in the near term. That was based on an extrapolation of our delinquency inventory and flow rates over 3 to 6 months, and that was the horizon of our estimate."
},
{
"speaker": "",
"content": "If the trend of lower tax refunds sustains, it could raise the level of charge-off somewhat in the near term but this does not change our view that credit is settling out modestly above pre pandemic levels in 2018 and 2019. The continuing deceleration in the pace of credit normalization trends sometimes referred to as the improving second derivative supports our view. The pace of year-over-year increases in both the charge-off rate and the delinquency rate have been steadily declining for several quarters and continued to shrink in the first quarter."
},
{
"speaker": "",
"content": "Domestic Card noninterest expense was up 6% compared to the first quarter of 2023, with increases in both operating expense and marketing expense. Total company marketing expense of about $1 billion for the quarter was up 13% year-over-year. Total company marketing drives growth and builds franchise in our Domestic Card and Consumer Banking businesses and builds and leverages the value of our brand. Our choices in Domestic Card are the biggest driver of total company marketing. We continue to see attractive growth opportunities in our Domestic Card business. Our opportunities are enhanced by our technology transformation."
},
{
"speaker": "",
"content": "Our marketing continues to deliver strong new account growth across the domestic Card business. And in the first quarter, Domestic Card marketing also included higher early spend businesses driven by strong new account growth, higher media spend and increased marketing for franchise enhancements like our travel portal, airport lounges and Capital One shopping. We continue to lean into marketing to drive resilient growth and enhance our Domestic Card franchise."
},
{
"speaker": "",
"content": "As always, we're keeping a close eye on competitor actions and potential marketplace risks."
},
{
"speaker": "",
"content": "Slide 12 shows first quarter results for our Consumer Banking business. In the first quarter, Auto originations increased 21% from the prior year quarter, a return to growth after several quarters of year-over-year declines. Consumer Banking ending loans decreased about $3.1 billion or 4% year-over-year, on a linked quarter basis ending loans were essentially flat. We posted another quarter of year-over-year growth in consumer deposits. First quarter ending deposits in the consumer bank were up just under $10 billion or 3% year-over-year."
},
{
"speaker": "",
"content": "Compared to the sequential quarter, ending deposits were up about 2%. Average deposits were up 6% year-over-year and up 1% from the sequential quarter, powered by our modern technology and leading digital capabilities our digital-first national direct banking strategy continues to deliver strong consumer deposit growth. Consumer Banking revenue for the quarter was down about 13% year-over-year, largely driven by lower auto loan balances and higher deposit costs."
},
{
"speaker": "",
"content": "Noninterest expense was down about 3% compared to the first quarter of 2023. Lower operating expenses were partially offset by an increase in marketing to support our national digital bank. The Auto charge-off rate for the quarter was 1.99%, up 46 basis points year-over-year. The 30-plus delinquency rate was 5.28%, up 28 basis points year-over-year. Compared to the linked quarter, the charge-off rate was down 20 basis points, while the 30-plus delinquency rate was down 106 basis points. The linked-quarter charge-off rate improvement modestly underperformed the typical seasonal patterns we've historically observed driven by the tax refund trends I just discussed. Even with the tax refund effects, auto credit performance remains strong."
},
{
"speaker": "",
"content": "Slide 13 shows first quarter results for our Commercial Banking business. Compared to the linked quarter ending loan balances decreased about 1%. Average loans were also down about 1%. The modest declines are largely the result of choices we made in 2023 to tighten credit. Ending deposits were down about 5% from the linked quarter. Average deposits were down about 8%. The declines are largely driven by our continued choices to manage down selected less attractive commercial deposit balances. First quarter revenue was up 2% from the linked quarter. Noninterest expense was up about 6%."
},
{
"speaker": "",
"content": "The Commercial Banking annualized net charge-off rate for the first quarter decreased 40 basis points from the sequential quarter to 0.13%. The Commercial Banking criticized performing loan rate was 8.39% down 42 basis points compared to the linked quarter. The criticized nonperforming loan rate increased 44 basis points to 1.28%. Commercial credit risks continue to be most pronounced in the commercial office portfolio, which is less than 1% of total company loan balances."
},
{
"speaker": "",
"content": "In closing, we continued to deliver strong results in the first quarter. We posted another quarter of top line growth in Domestic Card revenue, purchase volume and loans. Domestic Card credit trends continue to stabilize and Auto credit trends remained stable and in line with normal seasonal patterns. We grew consumer deposits and we added liquidity and maintain capital to further strengthen our already strong and resilient balance sheet. Over the last decade, we've driven significant operating efficiency improvement even as we've invested to transform our technology, and we continue to drive for efficiency improvement over time."
},
{
"speaker": "",
"content": "For the full year 2024, we continue to expect annual operating efficiency ratio net of adjustments to be flat to modestly down compared to 2023. Our expectation includes the partial year impact of the proposed CFPB late fee rule, assuming the rule takes effect in October 2024. The timing of the new rule remains uncertain. If the rule were to take effect at an earlier date, it would be a headwind to the 2024 operating efficiency ratio."
},
{
"speaker": "",
"content": "Of course, the biggest news in the quarter was our announcement that we entered into a definitive agreement to acquire Discover. We've submitted our application for regulatory approval and we're fully mobilized to plan and deliver a successful integration. The combination of Capital One and Discover creates game changing strategic opportunities. The Discover payment position Capital One as a more diversified, vertically integrated global payments platform and adding Capital One's debit spending and a growing portion of Credit Card purchase volume to the Discover network will add significant scale, increasing the network's value to merchants, small businesses and consumers and driving enhanced network growth."
},
{
"speaker": "",
"content": "In the Credit Card business, we're bringing together 2 proven franchises with complementary strategy and a shared focus on the customer. And we can accelerate the growth of our national digital first consumer banking business by adding the Discover's consumer deposit franchise and the vertical integration benefits of the debt network."
},
{
"speaker": "",
"content": "We will be able to leverage and scale the benefits of our 11 years transformation across every business and the network, which will serve as the catalyst for innovation and enhanced capabilities in risk management and compliance underwriting marketing and customer service."
},
{
"speaker": "",
"content": "Pulling way up, the acquisition of Discover is a singular opportunity. It will create Consumer Banking and global payments platform with unique capability, modern technology, powerful brands and a franchise of more than 100 million customers. It delivers compelling financial results and it offers the potential to create significant value for merchants and customers, and an unparalleled strategic and economic upside over the long term."
},
{
"speaker": "",
"content": "And now we'll be happy to answer your questions. Jeff?"
},
{
"speaker": "Jeff Norris",
"content": "Thank you, Rich. We'll now start Q&A session there. [Operator Instructions]"
},
{
"speaker": "",
"content": "Josh, please start the Q&A session."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Ryan Nash with Goldman Sachs."
},
{
"speaker": "Ryan Nash",
"content": "So Rich, maybe just start off on credit. It sounds like you're running a little bit ahead of what you had outlined in the last quarter. But when you put aside the time the tax refund, maybe just talk about what you're seeing from the consumer? And do you think we've now reached the inflection where we can more closely follow seasonal patterns? And once the noise settles, do you think we're kind of back at that 15% level that you had outlined?"
},
{
"speaker": "Richard Fairbank",
"content": "Thank you, Ryan. Look, I think that the story continues to be one of -- well, in terms of -- there's sort of the consumer itself. Let's just talk about the consumer for a second and then let's talk about Capital One's credit performance but just the health of the consumer. I think the U.S. consumer remains a source of strength in the economy. The labor market remains strikingly resilient. Rising incomes have kept consumer debt servicing burdens relatively low by historical standards. And when we look at our customers, we see that they have higher bank balances than before the pandemic, and this is true across income levels."
},
{
"speaker": "",
"content": "On the other hand, of course, inflation shrank real incomes for almost 2 years. And in this high interest rate environment, the cost of new borrowing has gone up in every major asset class. And I think at the margin, these effects stretch some consumers financially. So -- but on the whole, I'd say consumers are in reasonably good shape relative -- pretty strong shape relative to historical benchmarks. So in terms of Capital One's performance, we continue to see a settling out. We consider -- we believe that for Capital One, I can't speak for all card issuers but we definitely have seen what we think is sort of a landing."
},
{
"speaker": "",
"content": "And our -- so we feel very good about where the credit is. The point that I wanted to make about the tax refunds, let's just pull up for a second on that. The tax refunds are something that nobody knows for sure exactly what's behind seasonality but I think it's a -- we believe, a very important driver of seasonality. It's a bigger effect for us than other players because I think cash refunds just play a little bit bigger role in -- collectively across our customer base."
},
{
"speaker": "",
"content": "So the tax refunds in the very near-term effect credit performance, Ryan, what you're referring to the 15% guidance that we gave, that was not an annual guidance number that was saying, if we just extrapolate in the very near window of just what we see in terms of delinquencies and delinquency roll rates. That's where we would see charge-offs, and charge-offs tend to be higher in the first half of the year. So what we're doing is giving a window to the higher part of charge-offs for the year, and we were saying they were settling out looked like around 15% above 2019 levels."
},
{
"speaker": "",
"content": "Part of that -- and so basically, what I'm saying is that includes our assumptions about what happens with tax refund and the seasonality effect. As we can see in the government data, tax refunds are lower and later than by historical patterns. And so that affects our near-term credit performance. And actually, we often talk about, well, isn't the 6-month window basically once charge-offs start bubbling and going through the roll rate buckets we can pretty much see where charge-offs are going. Tax refunds actually affect the payment rates in every bucket."
},
{
"speaker": "",
"content": "So our point was in the very near term, it actually leads to a bit of a higher charge-off rate than we had guided to over that near window. But that doesn't change our view that credit has settled out but the 15% was not a guidance for the year. We haven't really given credit guidance for the year. What we're really saying is we have seen credit settle out but we wanted to just flag that both in the Credit Card business and in our Auto business while credit continues to be very strong, and you've seen things like really improving delinquencies, we just wanted to point out that in the very near term, relative to what we have seen in terms of historical seasonality and kind of confirmed by what we watch as the patterns of tax refunds, there is -- it's coming in lower and later. And we just wanted to flag that effect because it affects the very near-term numbers that we cited earlier."
},
{
"speaker": "Ryan Nash",
"content": "Got it. Maybe as my quick follow-up for Andrew. I guess, given Rich's answer, what does that mean for the trajectory of the allowance? It seems like we've heard a handful of other issuers talk about us being at the peak or maybe even coming down and potentially being below where it ended the prior year. Can you maybe just talk about what you think this means for Capital One, given your credit expectations?"
},
{
"speaker": "Andrew Young",
"content": "Yes. Sure, Ryan. I'd like to say from my perspective that there's a simple answer but there's not. And then there's a host of things that are going to drive allowance from here, not the least of which is growth, but just focusing on coverage and assuming that's what others are pointing to. The first thing I'd highlight and I said in my talking points that fourth quarter had seasonal balances, they quickly pay off in the first quarter and therefore, have negligible coverage, which we see every year."
},
{
"speaker": "",
"content": "So the coverage ratio this quarter up a bit from last quarter is really a result of that dynamic. But if you look at coverage ratio now, it's largely in line with the preceding quarters, I mean, the biggest driver as we look ahead, are the projected loss rates. And as we've been saying for a number of quarters, delinquencies are the best leading indicator of that. And so every quarter, we're going to look out over the next 12 months and then the reversion from there. And we're going to take into account a range of outcomes and uncertainties. And so you've seen over the last few quarters, keeping the coverage ratio flat. I will note, though, even in a period where projected losses in future quarters are lower than today and might indicate a release otherwise, you could very well see a coverage ratio that remains flat or only modestly declined as we incorporate the uncertainty of that future projection into the allowance."
},
{
"speaker": "",
"content": "And so eventually, the projected losses will -- when they're lower will flow through the allowance and bring the coverage ratio down as those uncertainties become more certain. And under that scenario, you would see a decline. But at this point, like I'm not going to be in the forecasting business of when that actually is going to take into account because, like I said, we really need to take the factor of uncertainty as we look ahead every quarter that we go through the reserving process."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Mihir Bhatia with Bank of America."
},
{
"speaker": "Mihir Bhatia",
"content": "Rich, if I could switch for a second to the Discover acquisition. There's been a lot of talk around deal approval, particularly focusing around potential antitrust issues within the Card business. And I was wondering if you could share your thoughts and perspective on that issue if you've heard anything from regulators but also just to hear how you are thinking about that issue?"
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Thank you, Mihir. So we have filed our merger applications with both the Fed and the OCC and we are engaged with the -- sorry, with the DOJ as they, of course, play a key role in advising the Fed and the OCC on competition questions. We believe our applications make a very compelling case for approval. We believe strongly that this merger will increase competition among banks and credit card issuers and payment networks, and provide significant benefits for consumers, merchants and the communities that we serve. While some have raised concerns about competition, we believe that the facts in favor of the deal will be compelling."
},
{
"speaker": "",
"content": "On the network side, let's remember that we're not currently in that business. If the deal is approved, we will still have 4 networks just like we do today but we will be adding new customers and scale to the smallest by far of the 4 networks and be able to leverage our technology talent and marketing capabilities to greatly enhance Discovery's competitive viability. Their market share was 6% a decade ago and sits at just 4% today. The significant investments that we are planning will provide substantial benefits for consumers and merchants as we've outlined in our regulatory applications."
},
{
"speaker": "",
"content": "On the Credit Card side, the regulators have found every time they've studied it that the credit card market is highly competitive and not at all concentrated. In fact, it's less concentrated today than it was 10 years ago. Consumers can choose from over 4,000 issuers, all able to offer products with similar capabilities. Imagine this, a card issued by a small credit union can be used every place that a card issued by a bank like Capital One can be used, anywhere in the world, that kind of level playing field doesn't exist in any other industry and certainly not in airlines or grocery stores or many of the others. There's a reason that we ask folks what's in your wallet. We compete not only with these 4,000 other issuers to gain your business in the first place but also with every other card you likely already own. Put another way, we have to compete every day for every single transaction because our customers can simply choose at any moment to use another card. And if they don't like the card they have, they can stop using it entirely or close the account or switch to another card with another bank, large or small, in minutes."
},
{
"speaker": "",
"content": "We also believe that the facts will show that there are no barriers to entry in the credit card business as thousands of current issuers and the new ones are forming all the time demonstrate. New and incumbent fintechs backed by significant VC funding are able to leverage the infrastructure of sort of credit card as a service players like Marqeta to achieve instant scale and high growth."
},
{
"speaker": "",
"content": "Also, any existing bank can choose where in the credit spectrum they play simply by changing their credit policy. Let's also remember that consumers can choose to use another form of payment entirely, cash, debit or buy now pay later, which has exploded onto the marketplace. New fintechs are entering the payments in small-dollar credit space every day all looking to take market share from traditional credit card players like Capital One. We faced this competition for years and we'll continue to face it in the future. It's powerful evidence of a healthy and fiercely competitive marketplace. But we have been successful by focusing on the needs of our customers and offering credit card and retail banking products with the most straightforward terms and fewest fees in the industry. We're the only major bank where all of our deposit products come with no fees, no minimums and no overdraft fees."
},
{
"speaker": "",
"content": "So pulling way up, we believe the facts will show that this transaction is both pro-competitive and pro-consumer, bringing our best-in-class products and services to a broader set of consumers and small businesses and greatly enhancing opportunities and benefits for merchants. In the end, that is what we believe the regulators will use their very vigorous process to evaluate."
},
{
"speaker": "Mihir Bhatia",
"content": "Got it. That is helpful. Just turning back to the health of the consumer for a second for my follow-up. If you could just talk a little bit about the environment for card acquisitions, you did mention, I think, that the growth you see good growth opportunities in the card business. So wondering if you can expand on that. Maybe talk about just some of the puts and takes as you consider where to make those investments? Are there parts of the market where you're being more cautious given the environment?"
},
{
"speaker": "Richard Fairbank",
"content": "Mihir, we are leaning in pretty much across the board in the card business, powered by a healthy consumer and the traction that we're getting in our business, we are really all parts of the card business are seeing very nice account originations, seeing good traction on the purchase volume side. And -- so it's very much a positive time for leaning in, as you see reflected in our marketing, as you see reflected in some of the growth numbers, and as I see in numbers behind the numbers that you see, just a lot of traction. And just -- let's just savor for a second, some of the things that are powering that are 2 things that I would flag is: one, the continued investment that we are making to win at the top of the market. And I think that not only affects our success at the top of the market but I really believe there's a lifting of all boats from those investments and that traction there."
},
{
"speaker": "",
"content": "Also we continue to just have a lot of success powered by our technology transformation, including not only the customer experience and some of the product capabilities that we're able to offer but really impacts on the whole way that we run the business and very notably on the credit and marketing side of the business, the ability to create mass customized offerings and real-time solutions just enables us to have more traction on the growth side."
},
{
"speaker": "",
"content": "Also, I just want to say that we also are pleased to see things picking up in the Auto business and also we continue to have a lot of traction on our national bank."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Rick Shane with JPMorgan."
},
{
"speaker": "Richard Shane",
"content": "Rich, I want to make sure I fully understand what you're describing in terms of credit. The framework is that charge-off rates will be about 15% higher than '18, '19 levels in the near term. But now with tax refunds, it might be a little bit higher than that, that over time, it will converge back towards slightly above '18, '19 levels. When I look at the delinquencies. And 1 of the things we've observed is that role from delinquency to charge-off is actually higher than it has been pretty much at any time in recent history. Does that suggest that delinquencies actually need to get back below '18, '19 levels to achieve that level of charge-off performance?"
},
{
"speaker": "Richard Fairbank",
"content": "So Rick, there's a lot. First of all, let me clarify some of the things that you were saying weren't exactly I think as we intended to state them. So let me just -- so we talked about -- so yes, we talked about credit. We're saying credit settling out. We said in the very near term, where charge-offs are tend to be higher in the first half of the year. In the near term, based on extrapolation from delinquency buckets and roll rates we would expect them to settle out at 15% higher than pre-pandemic. That was a near-term forecast. That was not an annual forecast. And then you -- just to clarify your comments that, and over time, it will converge back to slightly above 2018 and 2019. I just want to say those are your words, not ours. We have not given guidance on full year charge-offs. We tend not generally to give guidance on full year charge-offs. But we very much like to give you the feel of how things are going."
},
{
"speaker": "",
"content": "So we are very much see credit settling out. You can see that the trends that continue on the second derivative of delinquencies, and that's a very positive thing. The -- there's another factor that affects charge-offs, which is recoveries. And the recoveries have been -- we've been saying for quite some time, recoveries are lower than usual because of the very low charge-offs we saw over the past 3 years. So that all else equal, pushes up net losses relative to pre-pandemic levels. And that impacts probably larger and more prolonged for us than for some of our competitors because we tend to have higher recovery rates than the industry probably as a result of our business mix and our strategy, and we tend to work most of our recoveries in-house rather than selling debt. So we see a longer tail of recoveries from past charge-offs than most do."
},
{
"speaker": "",
"content": "So by the way, the recoveries, we had talked about recoveries. There probably sort of been at their bottom in terms of that brown out and over time probably heading in a more positive direction. But that also impacts the relationship between charge-offs, prepandemic and where they are today. So pulling way up, we don't have guidance for credit for the year. We continue to be very happy about charge-offs the way after years of -- after a long period of normalization, that charge-offs are settling out. We've given -- we just wanted to flag that the seasonality, let's just comment -- let's just pause for a second on the seasonality. It still remains to be seen whether the tax refunds are just lower end of story or whether they're later The key thing right now is they are lower cumulatively than they have been -- than they were pre-pandemic for this period of time. And what will take a look at is how it plays out from here to see how much was just later and how much was lower."
},
{
"speaker": "",
"content": "But what we're saying is, to the extent that it's lower than that impacts in the very near term the charge-off numbers that we had talked about before. But it doesn't change our view about Credit settling out. It doesn't change our view about very positively about the Consumer, about Credit performance, but it's just something we wanted to flag across both the Credit Card and Auto business."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from John Pancari with Evercore ISI."
},
{
"speaker": "John Pancari",
"content": "I guess back to the Discover combination, any update to your thoughts around the timing of the deal close? I know the Fed, the OCC just extended the comment period. And I know you put out there, you expect late '24, early '25. So any change in terms of your expectation around the timing of the close or any of the key financial metrics that you set out?"
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Thanks, John. So let me comment on the Federal Reserve and the OCC extending the comment period. It's standard practice for the Federal Reserve to extend the comment period on bank mergers. We expected the extension and we don't take any signaling on our deal from the Fed's decision here. So with respect to the overall timing, the Fed and the OCC typically take several months to work through bank merger applications in consultation with the DOJ on competition questions and they engage frequently with our team along the way. And of course, that process is underway. And we continue to have the same views about the timing of all of this that we did at the time of the announcement."
},
{
"speaker": "John Pancari",
"content": "Okay. Okay. Great. And then separately, just regarding the -- your expectation on the CET1 front for a pro forma CET1 ratio of about just shy of 14%. Any change to that expectation? And any change to your thoughts around buyback activity in the near term? Could you remain active on that front?"
},
{
"speaker": "Andrew Young",
"content": "Yes, John, with respect to the deal, I'll just say, as we talked about when we announced it, we, at the time, used a blend of consensus estimates of where we would have the CET1 at the time of close. There's a number of variables that are going to move between now and in legal day 1, not just the stand-alone performance of each of our companies but balance sheet marks, some of which are driven by credit and stock price. And so I'm not going to be in the business of sort of recasting every time a little number moves. But I will say our valuation of the deal considered a wide range of outcomes. And so we remain just as excited today about the financial and strategic benefits of the transaction as we did when we announced the deal."
},
{
"speaker": "",
"content": "With respect to our stand-alone repurchases, Capital Ones, I'll note that the agreement with Discover does not prohibit us from buying shares. I noted in my prepared remarks, we were blacked out for a period leading up to the deal. And afterwards, the SEC has safe harbor rules that limit the daily average amount of purchases we can do for a period of time after the announcement. So as a result of those limitations, Q1 had a pace that was less than what we've done in recent quarters. I will also just note that there's also blackout restrictions on repurchases during the proxy vote period. But again, outside of those blackouts, we're not prohibited, and we're able to continue repurchasing shares."
},
{
"speaker": "Jeff Norris",
"content": "Next question please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Moshe Orenbuch with TD Cowen."
},
{
"speaker": "Moshe Orenbuch",
"content": "Rich, putting aside the tax refund thing, I mean, yours -- we're sitting here looking you've still got what has been a somewhat persistently high inflation environment and the potential for increases in unemployment, given the nature of your portfolio, you've got kind of a lower end consumer and higher-end consumer. How do you think about that, those factors in terms of thinking about what type of charge-off level you're going to reach over some period of time, not a particular point in time, but over some point in the next year or 2, like where you think about that -- they driving a higher level of charge-off expectations? Or how should we think about that?"
},
{
"speaker": "Richard Fairbank",
"content": "Moshe, so our -- I think what you're partly getting at is because we have -- part of our portfolio is subprime consumers, how do we feel about how they're performing and sort of in the context of an environment of higher inflation and so on. Let me just comment a little bit about the subprime consumer. In the global financial crisis, we observed that credit metrics in subprime moved earlier in both directions, subprime -- we saw that, but then we saw sort of everything move proportionately, in fact, subprime moved frankly, somewhat less proportionately than prime as a multiple, but obviously, all portfolios worsened quite a bit during the global financial crisis in the pandemic, subprime credit improved more and more quickly than prime but it also began to normalize more quickly, too. And of course, that's in the context of lower income consumers seeing disproportionate benefits of government aid and then unwinding that over time."
},
{
"speaker": "",
"content": "And subprime is, of course, not synonymous with lower income, although they are somewhat correlated. So on the other hand, so if we look at how they have been doing, the income growth from -- for say, lower-income consumers has been consistently higher over the past several years. And we have seen really quite -- other than the tax refund effect, which does show up more in our lower end part of our customer base than the higher credit end. Really, we have seen the subprime performance be very strong. It just worsened faster. And then on a proportional basis, everything caught up with it. But it frankly always seems to be a first mover, and it settled out, frankly, a little bit earlier than -- started settling out a little bit earlier than the rest of our portfolio."
},
{
"speaker": "",
"content": "So based on current performance, we feel very good across the credit spectrum. We also -- it certainly catches our attention when we see the inflation specter sort of become greater lately. So we have a real eye on that. As you know, we continue to look at the marketplace and trim around the edges and so on. But the net impression that I would leave you is we continue to feel very good about really the full spectrum of our customers, we continue to lean into the growth opportunities. We have, for some time, just been doing some trimming around the edges and just being a little tighter on the credit lines and things like that credit line increases. But the impression that I want to leave with you is that we are still pretty feel good about this marketplace and the growth opportunities there."
},
{
"speaker": "Moshe Orenbuch",
"content": "Got it. And maybe just as a follow-up question. You alluded to or Andrew alluded to the fact that you expect that late fee -- you can still kind of achieve your objectives from a efficiency ratio even with the late fee coming into effect. But could you talk a little bit about your thoughts about any mitigating efforts that you're planning or in the process of doing? Or is it something that you're going to try and use from a competitive standpoint to take share? How do you think about it?"
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Thanks, Moshe. So let's just pull up and reflect on the fact that the CFPB's rule on late fees is scheduled to take effect on May 14. We are prepared to implement the rule on this time line, if necessary, but ongoing litigation efforts continue to create uncertainty on the ultimate outcome and the timing of the rule. As we've said before, when the rule is implemented, there will be significant impact to our P&L. We expect that this impact will gradually resolve itself within a couple of years from the implementation of our mitigating actions. These mitigating actions include changes to our policies, products and investment choices. Some of these mitigating actions have already been implemented and are underway. We are planning on additional actions once we learn more about where the litigation settles out. Ultimately, these mitigating actions will play through different line items in the P&L and will mitigate the impact of the late fee rule on our P&L within a couple of years of their implementation."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Don Fandetti with Wells Fargo."
},
{
"speaker": "Donald Fandetti",
"content": "Yes. Rich, can you provide your latest thoughts on auto lending? I know a lot of focus has been around cards, but -- and used car prices have been a little bit lighter recently as well as the tax issue. Maybe talk a bit about a potential pivot there."
},
{
"speaker": "Richard Fairbank",
"content": "Yes. So we're feeling very good about the Auto business. So let's just pull way up. Auto industry margins have recovered somewhat over the past few quarters. Our origination volumes in Q1 were up 20% on a year-over-year basis and a quarter-over-quarter basis, and we're pleased with that growth. Now there are still headwinds to the auto business. Affordability remains a concern due to the combined effects of high interest rates and still high car prices. And even as car prices have normalized significantly from their peaks, they haven't yet reached a new equilibrium."
},
{
"speaker": "",
"content": "So we anticipated the risks in this business, tightening up credit back in 2022, I think, several quarters before some of our competitors. As a result, the performance of recent originations from '22 and '23 has been really strong and frankly, even better than our pre-pandemic originations. And vintage over vintage, that risk remains stable. And as margins have recovered a bit, we're seeing an opportunity to lean back in. So our years of investments in industry-leading technology and credit infrastructure have allowed us to remain nimble and enabled us to make targeted adjustments to our origination strategies where we see opportunities for growth or emerging risks."
},
{
"speaker": "",
"content": "So looking ahead, we remain confident in the business that we're booking and bullish about the opportunities for growth. So we continue to set pricing in terms that we're comfortable with and feel good about the opportunities that we see in the market. And after talking for really a couple of years about sort of dialing back. I think this is sort of a period where it's moving more into a leaning into it situation for Capital One. And we're, I think, very benefited by the choices that we made over the last couple of years and seeing very strong performance in our vintages."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Sanjay Sakhrani with KBW."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Rich, I think your point on tax refund is clearly a very valid one. Interestingly, though, to your point on the second derivative, that's improved quite nicely even into March. And I think when I look at the tax refund stats now from the IRS, it seems like you've seen a catch-up in refunds and it seems like the average refund numbers have kind of come in line with last year, if not slightly higher. So I think those are improving, too. Is there a lag effect there? So like should we see that more pronounced if that's the case in April and May? How has been in the past?"
},
{
"speaker": "Richard Fairbank",
"content": "Yes. So I can see that you're a student of tax refunds. Just think of all the areas of expertise that you've developed over the years trying to really get your head around this credit card business, things that neither you nor I thought we would really have to learn. Let me make a couple of comments here. So a key question is what are we benchmarking things too. So relative to -- if we talk about relative to last year, the things were even lagging relative to last year, and they've actually crossed over very, very recently crossed over the curve from last year, which I think you're referring to. But then last year really was somewhat of an outlier relative to pre-pandemic."
},
{
"speaker": "",
"content": "Now one might ask, well, why didn't we just used last year as the seasonality benchmark? Last year itself was an odd year. And from a credit point of view with all the normalization. It was hard to read things through the noise. As we watch the patterns this year, we're going to really end up comparing by the time it's done, how this year compares to last year and whether collectively this year and last year represent sort of a new seasonality that we have to modify relative to the past. I think it's premature on that. And relative to reading seasonality, it's really hard to look at last year's credit metrics just because there was so much normalization."
},
{
"speaker": "",
"content": "So we've had an eye on this. We have tended to stick with our seasonality benchmarks, which are developed over a number of years. And I think when this is -- when we're done with this period, we'll sit back and look at it and say, did we learn something about the business that where seasonality might be less magnified in a business like ours than it was before. I think it is too early to tell. But to your other point, even relative to last year, it has very recently crossed over in terms of tax refunds. And yes, to your point, these are things that themselves then have lag effects because people have to get the refunds then they have to make payments. So this is why very much we are flagging a phenomenon that is sort of in the middle of happening. And the key thing will be by the time it's done was the cumulative tax refund effect. And we're just kind of sharing with you as we go along."
},
{
"speaker": "",
"content": "And the reason I'm particularly leaning into this particular one is because last time we made a very near-term sort of extrapolation just from our windows of delinquency buckets about where the -- given that in a year, the high part of the year is in the first half of the year, we were just kind of saying in that high part of the year, where things were sort of settling out. And I wanted to give that a little bit -- we're not revising the number but just to say if the seasonality patterns are probably driven by the tax refund effect if it doesn't catch up to historical patterns, then in the very near term, the numbers will be higher than that in this very -- this window we're talking about higher than the 15% number that I said."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Understood. Understood. The second derivative looked good nonetheless for March."
},
{
"speaker": "Richard Fairbank",
"content": "Right. So look, can I just -- I want to just seize that point. The second derivative continues to be strong. In fact, when you look at sort of all the card players, you can see the strength of Capital One's second derivative. There's another topic, so you didn't know when you were studying all that calculus that this would be at the heart of what you do. But -- so there's lots of good to pull from this. I just wanted to just clarify the tax refund effect, which I think has a little bit more impact on Capital One than certain other players and to point out that we actually think we see that effect in both of our consumer businesses."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Great. Just one follow-up for Andrew. Just on the capital return question earlier. Can we step up the run rate relative to some of the last quarters as we look ahead? I know there's been a lot of volatility on some of the regulatory proposals on capital. But as we look ahead, I know there's no limitations but can we see a step up in the level of capital return relative to the past few quarters as we look ahead, given your capital levels today?"
},
{
"speaker": "Andrew Young",
"content": "Well, there's 2 parts to that, Sanjay. The first is, given the transaction, we are in the process of submitting a new capital plan. So that's just a procedural piece. So once that new capital plan is approved, then we have unlimited capacity relative to the SCB in this intervening period, the amount that we repurchase is constrained to what we've requested."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Bill Carcache with Wolfe Research."
},
{
"speaker": "Bill Carcache",
"content": "Rich and Andrew, following up on your comments on Auto, how much of an advantage is your excess capital position? Are you seeing competitors who are capital constrained and perhaps can't take advantage of the attractive market conditions to the same degree? And then I'll just ask my follow-up now. As Capital One continues to grow, could you speak to your category 2 preparedness?"
},
{
"speaker": "Andrew Young",
"content": "Yes, I'll start, Bill, with the -- Rich, do you want to do the..."
},
{
"speaker": "Richard Fairbank",
"content": "Competitive dynamics in auto. Here my observation about the auto business is that it's still a very competitive marketplace. But when we see our opportunities to grow, we tend to zig a little bit while others zag. And so we sort of pulled back for a little while and others leaned in. And my point is really now I think we're leaning in and others are pulling back a little bit more. I hadn't really sort of analyzed it in terms of really capital choices really as much as just the very natural rhythms of the marketplace and some of the advantages that Capital One has by virtue of our choices that we made over the last couple of years. But we'll have to think about that. But I just think this is just very much sort of as you've seen numerous times in the past where there's a little bit of an inflection point for Capital One at a time that's a little different and occasionally in a different direction than the inflection points of others."
},
{
"speaker": "Andrew Young",
"content": "And then, Bill, with respect to category 2. Well, first, let me just note, we're going to be below the $700 billion threshold at closing and the trigger is really a 4-quarter average beyond that. So I just wanted to mention the specifics of what is going to trigger it. But within category 2 to category 3, there's really 3 big distinctions. The first one is losing the tailoring benefit for LCR and NSFR, and you can see based on the ratios that we hold there and our conservatism around liquidity. We feel very well prepared. The other 2, which are the inclusion of AOCI in regulatory capital and the DTA threshold going from 25 to 10. Those are both already included at least in what was proposed for the Basel III end game rules. We all know that those proposals are being debated and refined. But ultimately, we're looking at those 2 implications as part of the proposal anyway."
},
{
"speaker": "",
"content": "And so we don't really see a big difference in the long-term implications, at least as we sit today, again, the proposal may take a different form. But from a planning perspective, those were 2 things that we already had our eye on. And so we ultimately feel well prepared all of the implications of either category 2 or the Basel III end game proposals if they were to go in as currently constructed."
},
{
"speaker": "Jeff Norris",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "And our final question comes from Jeff Adelson with Morgan Stanley."
},
{
"speaker": "Jeffrey Adelson",
"content": "Rich, I just wanted to circle back on your comment about how you continue to kind of trim around the edges. I think last quarter, you were suggesting that the trimming was sort of abating after a number of years of trimming. But given your comments today about how you're continuing to lean in, how the U.S. consumer remains a strength of source, how are you thinking about potentially opening up the credit box a little bit more from here? And relatedly, does the pending deal with Discover factor into how you're thinking about allocating capital at all into more growth at this point?"
},
{
"speaker": "Richard Fairbank",
"content": "Thanks, Jeff. We -- the trimming around the edges is, of course, what we do all the time and reactively to not only what we observe in the marketplace but what we think may be coming in the marketplace. We are very much sort of in the same place we were three months ago when we've been talking about this. In other words, the trimming around the edges and the dialing back was a little bit more pronounced in the quarters during the big credit normalization than it has been as we see things settling out. And the drivers of that continue to be -- probably -- in addition to what I said about the consumer, very much also the -- observing our credit performance, not only just the overall portfolio performance but very much the performance of our originations."
},
{
"speaker": "",
"content": "And strikingly, our originations continue to come out generally on top of each other quarter after quarter. Obviously, that's lagged data that we're viewing but we're -- we've been struck by how long it's been and how consistently it's been that our originations have been generally on top of each other. And a lot of that comes from the trimming around the edges that we have been doing even as there's been some underlying a little bit sort of worsening of overall consumer credit metrics. So we're in a very similar place to where we were. We feel good about our credit performance and origination performance. We are leaning in across the credit spectrum."
},
{
"speaker": "",
"content": "With respect to the Discover deal, it's not really altering our origination strategy that's very much continuing as it was before. Obviously, we're very excited about the Discover deal. But I think that with respect to our own strategy it's really pretty much the same as it was before."
},
{
"speaker": "Jeffrey Adelson",
"content": "And I also wanted to just ask really quickly about the small business car strategy. I know you recently just launched that new Venture X business card recently. It seems like a really unique value proposition with the charge card component. Can you just talk a little bit more about the opportunity to drive growth there and maybe how that's going so far? Any early reason to the type of customers you're getting?"
},
{
"speaker": "Richard Fairbank",
"content": "Okay. Yes, Jeff. So we launched the Venture X business card, broadly in the third quarter of last year, and we're pleased with the market response and the customer engagement so far. So Venture X business, much like our Spark cash plus card was developed to help business owners run and invest in their business with no preset spending limit, great travel benefits and elevated earn everywhere. And it's a great example of our business is leveraging each other's innovations because we've taken many of the industry-leading travel features of our consumer Venture X product and combine them with the business-grade capabilities of our small business offerings, including the flexible spending capacity that is designed for larger businesses."
},
{
"speaker": "",
"content": "So we have been investing in our small business card program, and more broadly, to win at the top of the market for years. And this launch stands on the shoulders of all of that investment, it stands on the shoulders of our technology transformation and is another example in the continuing drive of Capital One to win at the top of the market across consumers and small business. So I appreciate the question and we certainly are excited by our continuing progress."
},
{
"speaker": "Jeff Norris",
"content": "Thanks, Rich and Andrew. Thanks, everybody, for joining us this evening and for your continuing interest in Capital One. Have a great evening."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] |
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