Good day, ladies and gentlemen, and welcome to the Garmin Ltd. Third Quarter 2018 Earnings Conference Call. At this time, all participants are on the listen only mode. Later, we'll conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance during the call, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Ms. Teri Seck, Manager of Investor Relations. Teri, you may begin.
Good morning. We would like to welcome you to Garmin Limited's third quarter 2018 earnings call. Please note that the earnings, press release, and related slides are available at Garmin's Investor Relations site on the Internet at www.garmin.com/stock. An archive of the webcast and related transcript will also be available on our website. As a reminder, we adopted the new U.S. GAAP revenue standards in the first quarter of 2018. The prior periods presented here have been restated to reflect adoption of this new standard. This earnings call includes projections and other forward-looking statements regarding Garmin Limited and its business. Any statements regarding our future financial position, revenues, earnings, gross and operating margins, and future dividends, market shares, product introductions, future demand for our products and plans and objectives are forward-looking statements.
The forward-looking events and circumstances discussed in this earnings call may not occur, and actual results could differ materially as a result of risk factors affecting Garmin. Information concerning these risk factors is contained in our Form 10-K filed with the Securities and Exchange Commission. Presenting on behalf of Garmin Limited this morning are Cliff Pemble, President and Chief Executive Officer, and Doug Boessen, Chief Financial Officer and Treasurer. At this time, I would like to turn the call over to Cliff Pemble.
Thank you, Teri, and good morning, everyone. I'd like to begin by mentioning a couple of important milestones we recently celebrated. During the third quarter, we shipped our 200 millionth product, which is a testament to our ability to design, manufacture, and sell unique applications of technology for active lifestyles. Equally as exciting, we started production in our new aviation manufacturing facility located in Olathe, Kansas. This new facility more than doubles our production capacity, allowing us to serve our growing aviation business for many years to come. Moving now to the quarterly results. Earlier today, Garmin reported strong third quarter consolidated revenue of $810 million, up 8% over the prior year. Marine, aviation, fitness, and outdoor collectively increased 16% year-over-year and contributed 80% of total revenues. Gross margin improved to 59.4% compared to the prior year.
Operating income improved to $196 million, up 13% over the prior year. This resulted in GAAP EPS of $0.97 and pro forma EPS of $1 in the quarter. We are pleased with our performance in the first three quarters of 2018. These strong results give us confidence to raise our full year EPS guidance. Doug will discuss our financial results in greater detail in a few minutes. First, I'd like to provide a few brief remarks on the performance of our business segments. Starting with the Marine segment, revenue increased 28% as we saw strong sales continue well into the summer boating season. Approximately half of the growth was organic, while the other half came from acquisitions. Gross and operating margins were 59% and 14%, respectively. We recently announced our GPSMAP 8600 series of chart plotters.
This is the first product line to use our new g3 maps, which combine the best of Garmin and Navionics content. We've been very intentional about investing in our Marine segment. The industry is taking notice. For the fourth consecutive year, we were recognized by the National Marine Electronics Association as Manufacturer of the Year. Panoptix LiveScope won their prestigious technology award. We were also recognized as one of the top 10 most innovative marine companies in 2018 by Soundings Trade Only, which is a B2B news and information provider for the recreational boating industry. It's an honor to be recognized by the marine industry, and we will continue to invest in this segment to maximize its potential. Turning next to Aviation, revenue increased 17%, driven by broad-based growth within the segment.
Gross and operating margins increased to 76% and 35%, respectively, resulting in operating income growth of 49% over the prior year. During the quarter, we completed the acquisition of fltplan.com and have begun integrating these new services into Garmin's existing apps. Also, we recently announced that our ADS-B solution was selected by Gulfstream for the G280 aircraft. Finally, we announced a teaming agreement with Bell to supply avionics for on-demand mobility vehicles. While this project is in its early stages, it's an important first step towards creating a viable urban air transport system. Turning next to the Fitness segment, revenue increased 14%, primarily driven by growth of our wearable products. Gross and operating margins were 54% and 20%, respectively. Operating income grew 12% over the prior year. During the third quarter, we launched the vívosmart 4, a slim, smart activity tracker that includes a Pulse Ox sensor.
In addition to providing blood oxygen saturation levels, this device also provides users with advanced sleep monitoring and a new body battery feature that helps individuals understand and manage their energy levels throughout the day. We also added Disney Princess and Marvel Spider-Man bands to our popular vívofit jr. product line, along with new mobile app adventures. Turning next to the Outdoor segment, revenue increased 13% on a year-over-year basis, driven primarily by growth in wearables. Gross and operating margins improved year-over-year to 65% and 38%, respectively, resulting in operating income growth of 16%. We recently announced the integration of Spotify for the fēnix 5 Plus series. Just this morning, the Forerunner 645 Music was added to the list of Spotify-compatible wearables. This gives our customers the ability to download Spotify playlists to the watch via the Spotify app, which is available from the Connect IQ store.
The app is already proving to be very popular with customers. During its first full day of availability, Spotify set a record for the most downloads of a new app from our Connect IQ store. Finally, we recently announced Instinct, a rugged and reliable GPS smartwatch designed to expand the market for outdoor wearables. Looking finally at the auto segment, revenues decreased 16% due to the ongoing decline of the PND market. Gross and operating margins declined year-over-year to 43% and 9%, respectively. Our global market share position in the PND category remains very strong. We recently announced that we've been selected by the Chinese auto group, Geely, to provide camera and driving recorded systems beginning in model year 2020. This award demonstrates the progress we are making as a tier 1 auto supplier. In summary, we are pleased with our results in the first three quarters of 2018.
In light of the strong third quarter results, we are making some adjustments to our guidance. We anticipate our fourth quarter revenue to be relatively flat on a year-over-year basis, with full-year revenue of approximately $3.3 billion and a gross margin of 58.5%. We are raising our full-year operating margin to approximately 22% and lowering our full-year pro forma effective tax rate to approximately 16%, resulting in pro forma earnings per share of approximately $3.45. That concludes my remarks. Next, Doug will walk you through additional details on our financial results. Doug?
Thanks, Cliff. Good morning, everyone. I'd like to begin by reviewing our third quarter financial results, then we do comments on the balance sheet, cash flow statement, and taxes. We posted revenue of $810 million for our third quarter, representing 8% increase year-over-year. Gross margin was 59.4%, a 120 basis point increase from the prior year. Operating expense as a percentage of sales was 35.2%, consistent with the prior year. Operating income was $196 million, a 13% increase year-over-year. Operating margin was 24.2%, a 110 basis point increase from the prior year. Our GAAP EPS was $0.97. Pro forma EPS was $1, a 30% increase from the prior year. Next, look at our third quarter revenue by segment. During the quarter, we achieved 8% consolidated growth, led by double-digit growth in four out of five segments.
This growth was partially offset by decline in our auto segment as a result of continued decline in auto PND business. On a combined basis, marine, aviation, fitness, and outdoor were up 16% compared to prior year quarter. Looking next at third quarter revenue and operating income. On a combined basis, marine, aviation, fitness, and outdoor segments contributed 80% of total revenue third quarter 2018, compared to 74% in the prior quarter. Auto declined from 26%-20%, while every other segment grew. Marine grew from 10%-12%, and fitness grew from 22%-24%. You can see from the charts that illustrate our profit mix by segment. Combined basis, the marine, aviation, fitness, and outdoor segments delivered 92% operating income in the third quarter of 2018, compared to 89% third quarter of 2017.
The aviation and outdoor segments figure year increase in both operating income $ and operating margin. Looking next at operating expenses. Our third quarter operating expenses increased by $21 million, or 8%. Research and development increased $9 million year-over-year due to investments in engineering resources and recent acquisitions. Our advertising expense was down $1 million from the prior quarter. SG&A was up $13 million compared to the prior quarter, increased 60 basis points as a percent of sales. Increase was primarily due to personnel-related expenses, incremental costs associated with recent acquisitions. A few highlights on the balance sheet and cash flow statement. Ended the quarter with cash and marketable securities of approximately $2.5 billion. Account receivable decreased sequentially due to seasonal trends and increased year-over-year on stronger sales. Inventory balance increased on a sequential basis to $557 million to prepare for the seasonally strong fourth quarter.
During the third quarter of 2018, we generated free cash flow of $234 million, an $81 million increase to the prior quarter. Also during the quarter, we paid dividends of $100 million. During the third quarter of 2018, we put an effective tax rate of 8.5% compared to the effective tax rate of 20.5% in the prior quarter. The decrease in effective tax rate is primarily due to the benefits from U.S. tax reform and increased benefit from U.S. R&D tax credits. We expect our full year 2018 pro forma effective tax rate to be approximately 60%.
This concludes our formal remarks. Miranda, can you please open the line for Q&A?
Thank you. Ladies and gentlemen, if you have a question at this time, please press star one on your touch-tone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the pound key. One moment, please. First question comes from Charlie Anderson from Dougherty & Company. Your line is open.
Thanks for taking my questions. It looks like on the guidance, you guys have kept pretty much everything with the exception of the operating margin a little bit higher. Maybe if you could just add a little color on why you're seeing the better operating margin, despite it looks like mix is going to be fairly similar. As a follow-on question, Cliff, I just would be curious in your thoughts on the geopolitical situation in terms of its impact on your business. Are you seeing anything changing in terms of consumer behavior in Asia? I don't think you want to be a contract manufacturer, but with people scrambling to move outside of China, are there any opportunities for you guys? Thanks.
Yeah. In terms of guidance, basically, each segment that comprises our guidance has a different set of circumstances that we're looking at there. We took each one of those into consideration when we constructed our guidance, and the result came up to essentially relatively flat with last year. With the product mix and the overall trends we're seeing, we felt confidence to upgrade our operating income estimate as well. In terms of geopolitical issues, right now, we don't really see anything that's moving the needle in terms of concerns. The Asia demand still appears to be very strong. I think there's increasing competition in some of the product lines there, particularly in wearables, but we are very competitive with our product line. I would say we probably don't have a vision to become a contract manufacturer given the situation around tariffs.
We actually feel like our capacity is really quite constrained with our own demand right now. We probably don't have the ability to look for other opportunities like that.
Great. Thanks so much.
Yeah. Thanks, Charlie.
Our next question comes from Robert Spingarn from Credit Suisse. Your line is open.
Good morning. Just, Cliff, on that last thing on the op margin guide, you talked about it overall kind of flattish with last year's almost 22. Automotive is clearly coming down a bit this year. Where do you see the strength that's offsetting that? Should we just follow the trends that we've seen for the first nine months? Is there anything different about the fourth quarter?
Well, I think segment mix, as auto comes down, we get improvements from some of the other segments, which are typically higher than auto. There's variables within each segment as well in terms of product mix, for the most part, it's segment mix.
Okay. I was just thinking, yeah, auto's down from last year. Is there one particular segment where you see more momentum in the margin strength out of the other non-auto segments?
Well, we're doing well, as we said, in outdoor. I think our fēnix line continues to be an increasing part of the overall outdoor segment mix. The new fēnix 5 Plus series has a strong margin profile. Also in aviation, obviously, we're doing well there. A large part of benefit there with product warranty, which has been very good, and our products are very reliable in aviation. We're getting some benefit on the margin side with that.
Okay. Just lastly, on marine. Your organic growth is, I guess, solidly in the mid-teens now. I wanted to ask how that compares with the overall marine market. Obviously, you're quite innovative across the product line. How would you say your share movement, your market share movement has been? Is there a way to quantify?
Yeah, I think it's harder to quantify in marine. It's a fairly small industry in the recreational boating category. By our estimates, and I think based on financial estimates that we see from other players that have to be reported publicly, we are taking share. The overall market's probably growing in the 4% range, while we're growing, as you said, kind of in the low to mid-teens organically.
Yeah. Okay. Well, thank you very much.
All right. Thanks, Robert.
Our next question comes from Joe Wittine from Longbow Research. Your line is open.
Thank you. Good morning. First off, in automotive, can you help us understand the scope of the Geely agreement? Are you going to be included in every Geely car in China, or is it kind of an option? If you could address timing of both that agreement as well as a reminder of the BMW China timing. Thanks.
The camera solutions that we're providing to Geely are across most of their models. In China, there is regulation around having camera systems in vehicles, so it is equipment that is required in the vehicle. Timing will be the model year 2020, when the first models start rolling out. We'll start ramping up in later 2019, and that happens to also coincide with the BMW China supply agreement as well.
Cliff, do you anticipate those rolling on are enough that people like us will notice a change in the trajectory of the segment, which has been pretty constant over the last couple of years?
I think definitely that will change the trajectory around auto OEM for sure. We also have additional wins in there that will come online in the 2020 timeframe as well. We anticipate that will be a strong building year for us.
Second, in aviation, in the aftermarket portion, I know there's good things happening on the OEM side, can you update us on what you're seeing in terms of incremental capacity additions? It's been 90 days or so since we last surveyed that channel, curious what you're seeing and hearing. Obviously, I'm just trying to modulate whether we should be expecting much growth in 2019 off of 2018, given those potential capacity constraints.
I don't think we really see anything different in terms of the trends of capacity. We're selectively adding some shops to our list as we see qualified shops out there that can bring on Garmin equipment. In general, it's still fairly linear right now, which is one of the constraints that we face, I think, going forward in aviation. It's really not demand limited, it's capacity limited.
It's fair to say that capacity is a problem in 2019, therefore, some of this demand on the regulation side will spill into 2020, is still your base case?
That's our belief. I think we could reach the low end of the equippage estimates based on today's capacity rates, nobody probably believes at this point that the low end is the most likely case. We think that there's upside potential beyond the 2020 deadline.
Okay. Very helpful. Thank you.
Thank you, Joe.
Our next question comes from Eugenie Anderson from Morgan Stanley. Your line is open.
Thanks very much. This is James Faucette sitting in for Eugenie. I just wanted to dig in a little bit on the December quarter and how you're looking at on a year-over-year. Wondering on the fitness specifically, how much of the year-over-year growth in Q3 was attributable to new launch timing versus what was really existing vívoactive and Forerunner growth? Just trying to look and see how much timing of launches may have had an impact on Q3 and Q4.
Well, I think timing definitely had an impact on Q3. If you look back where we were last year, we had not yet delivered our new product lines into the market, so it was a very easy comp versus Q3 of last year. In terms of what we're looking at for Q4, there's really two dynamics that we see. One is the year-over-year comp with particularly the vívoactive 3, which was a very popular line last year as well as this year. Then the rotation of the product mix within fitness from basic trackers to advanced trackers is another dynamic that's shifting things around within the segment. All that coming together, we feel like our implied guide is basically what it is, fairly flat to slightly down. We feel very good about the product positioning within the segment and where we're at this year.
I think looking forward into the coming year, we'll have a strong product portfolio that we can build on.
Maybe a question for Doug. I'm just wondering on costs associated with the new facility. Are the fixed costs now fully built in to the implied Q4 guidance, or will there continue to be incremental fixed costs that still need to be layered in before we get to the sustained run rate there?
Yes. Basically, we're only partially through our facility build. The current situation is that we have opened, we're running our aviation manufacturing piece. In 2019, we'll be moving over our distribution center. After that's complete, we'll be renovating our existing facilities into office space. There will be continued CapEx spend as well as costs in there. We factored those into the guides we gave you, what the depreciation for Q4, when we get to next year, we'll be factoring in that depreciation expense at that point in time.
That's great. Just from a timing perspective, how long until you get to fully installed and you'll be done building out this new space and facility?
Yeah. It'll probably be, once it's all said and done, like I said, the distribution center, we'll have that moved in 2019. It'll probably be a couple years after that by the time we'll be fully built out on the renovation of the new facility. We're doing it over a period of time, depending on what our needs are.
Okay, great. Thank you very much, gentlemen.
Thanks, James.
Our next question comes from Ben Bollin from Cleveland Research. Your line is open.
Good morning, everyone. Thanks for taking my question. Cliff, could you talk a little bit about the wearables market overall? What do you think about the organic growth in high-end wearables? How much of your growth would you characterize as expansion of the base versus refresh, trade up? Any thoughts you have on kind of the competitive environment overall? Then a follow-up. Thanks.
Yeah. In terms of organic growth, we still see the smartwatch market as being a growth market, especially as people who have been in basic trackers over the years start to look to trade up and do more. I think there's a lot of awareness around the space right now, so that's helping as well. We're getting some benefit from organic growth, but also as we expand our product line, like we've done with the Instinct, that helps expand our reach to other customers who otherwise may not be ready to go or make that kind of commitment to a fēnix watch for example. In terms of competition, it's definitely getting stronger. There's a lot of competitors out there and some coming into the space from China.
That is a dynamic, especially in the Asian market, but also even other areas as they start to play the market, like what is typically done from those players that play typically on price. That's the way we see things right now.
Okay. Within the aviation business, what are your thoughts when you look through the ADS-B cycle, past even the spillover of demand? Do you have any high-level thoughts? Is this where maybe you start to segue into more targeted commercial aviation opportunities? Any concerns on pull forward of demand potentially sapping consumption in future years? What are your high-level thoughts on what this cycle means once you get through it? Thanks.
I think definitely there'll be some slack to take up once the cycle is complete. I think if there's any good news in the capacity issue, it's that we believe it will be more of a soft landing than what past mandates have been. In terms of segueing to other areas, we definitely have new categories and new opportunities that we're pursuing, and the activity in aviation really is very strong right now in terms of the overall market. We anticipate that there are other opportunities that we can leverage.
Pull forward is certainly a concern in a situation like this, particularly as we see a lot of people updating their cockpits along with ADS-B. We do believe we have a strong product line that should be able to continue those upgrades, especially for people that might have been cautious early on and are now coming forward to maybe complete a panel upgrade after they did some basic work with ADS-B earlier.
Thank you.
Thank you.
Our next question comes from Ron Epstein from Bank of America. Your line is open.
Hey. Yeah. Good morning, guys. What are you seeing, Cliff, in terms of, how can I say, the sell into the aviation channel OE next year? Are you starting to see, I would imagine you would, the pickup in OE demand, particularly in the business jet segment?
Well, I think it's a little early to give specifics. I would say that some of the platforms we're on that have been very strong, like Latitude, we continue to feel very positive about going forward. With the Longitude coming on for Garmin, that will represent an incremental market share gain for us. That should be a growth driver in 2019. In general, the industry, as you know, has had a lot of activity. Barring some kind of an economic shock that might change the calculus of everything, I would say that our view is optimistic for the future.
Okay. Great. Just maybe a couple other points, shifting gears here. When you think about the sell into the channel into the holiday season, how's that going? Particularly when we think about Black Friday, Cyber Monday and all that. Do you guys have any promotions going on? What's your thoughts going into the holiday season?
I think it's just like past years. Definitely, we have a lot of promotional activity that we're planning in terms of both cooperation with our retailers on sales as well as advertising. In terms of just overall activity, I would say it's about where we expect it to be. I think there's really no surprises, and if anything, we're chasing demand and keeping our factories busy. I think right now we feel optimistic about the quarter.
Okay. Maybe just one last financial question. When you think about your balance sheet, do you think you're effectively capitalized? Are you using the balance sheet the best you can? Finally, what are you going to do with all the cash?
Going to cash. No. In looking at that, our primary uses for our cash, one of which is paying reliable dividends. That's very important for us. We did increase our dividend this last year. The second of which is investments back into our business. An example of that is the facility expansion that we did here relates to our aviation manufacturing, our distribution center, as well as building out some existing space for office there. Also acquisitions. Acquisitions we did in the past, DeLorme and Navionics and such. Look at those are really the priorities for our cash on a go-forward basis.
Okay. Great. Thank you very much.
Thanks, Ron.
Ladies and gentlemen, if you have a question at this time, please press star one on your touch-tone telephone. One moment, please. Our next question comes from Paul Coster from JP Morgan. Your line is open.
Hi. Thanks. This is Paul Cheng on for Coster. Thanks for taking my question. Just on your operating margins, they're usually seasonally weaker in through Q, but it came in pretty strong. I know aviation was a big contributor, but anything else you want to point out?
Well, as you said, segment mix is a big factor. I think it's difficult to look year-over-year just at the number and draw a conclusion. You really have to look at how the pieces are moving within the segments.
Okay. That would mean that your view on kind of seasonality in fiscal year 2019 is unknown at the moment based on product mix?
Well, I think seasonality is yet a different consideration. Each segment has their own seasonality, and I think as the segments are growing and moving around each other, that will impact, obviously, the overall combined margin of the business.
Okay. Next question's on auto. How should we think about longer-term sustainable operating margins? Have we kind of hit trough levels, or is there some kind of opportunity to cut OpEx in this segment? Judging by your new win in China, it looks like you're still investing a bit.
I think we're investing in the tier 1 side of auto OEM, and we're also investing in keeping our consumer products fresh. We're investing in a third area, which is creating niche applications of PND technology for other types of vehicles and navigation out there. There's targeted things that we're doing. Some ability to scale our expenses, but I think as the business transitions, especially if we get larger revenue contributions from OEM, the margin profile will obviously follow the mix of the segment and will tend to be in the kind of range that we're seeing now.
Quick modeling question. What should we model for tax rate for 2019? Thank you.
Yeah. It relates to 2019. We'll give that to guidance in February when we give all of 2019 guidance. I should mention that in 2018, we did see some favorable benefits that probably will not recur into 2019, one of which was the R&D tax credit. When we were doing the tax return for 2017, we identified some additional benefits. We rolled through some of those impacted from catch up basically in 2017 to 2018. I'll give you a little bit of color on that, but we'll give you a better idea on 2019 effective tax rate when we give all the guidance in February.
Appreciate it. Thank you very much.
Thank you.
Our next question comes from William Power from Baird. Your line is open.
Just a couple of additional questions. Continued strong growth in APAC, I guess that's been kind of a running theme. I know fēnix has been a big driver of that. Is that still the principal driver of the growth there, or are you seeing uptake of new products that are potentially helping that? Given, Cliff, some of the commentary on increasing competition out of China, do you think you can continue to grow that region double digits?
In terms of driving growth in APAC, definitely fēnix is one part of that. Each country and each market is probably different. We've also been able to grow with some of our other categories, such as golf and dive watches, as an example. In terms of China, that's definitely a new factor that's going to put some dynamics into the market. We believe that we have a strong product lineup and plans around our product line that will help us be competitive there. At this moment, again, it's probably the normal course of competitiveness that we see.
Okay. All right. Just coming back to fitness, I know you called out wearables as, I think, the key driver. Is there any way to get any further granularity with respect to trackers versus smartwatches, Forerunner, what the kind of the key pieces of the growth were in the quarter?
I think a lot of the growth was driven around the advanced wearable category, which is really our GPS-enabled vívo line of products. We also saw growth in what we call the basic tracker category, which we have a more unique product lineup there compared to the rest of the market, but that our unique product offerings have helped us to grow that category as well. In terms of what we call the pure running market, we are kind of at the end of a product life cycle there. I think going forward, as we introduce new products, we'll see upticks. We were relatively flat in terms of the quarter on running.
Great. Okay. Thank you.
All right. Thank you.
I'm showing no further questions at this time. I would now like to turn the call back over to Teri Seck for closing remarks.
Thanks, everyone, and have a great day. Doug and I will be available for calls the rest of the day. Thank you. Bye.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may disconnect and have a wonderful day.