Good day, ladies and gentlemen, and welcome to the Garmin first quarter 2017 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require operator assistance, please press star then the zero key on your telephone keypad. I would now like to introduce your host for today's conference, Teri Seck, Investor Relations. Please go ahead, ma'am.
Good morning. We would like to welcome you to Garmin Ltd.'s first quarter 2017 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. This earnings call includes projections and other forward-looking statements regarding Garmin Ltd. and its business. Any statements regarding our future financial position, revenues, earnings, growth, 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 the 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 Ltd. this morning are Clifton Pemble, President and Chief Executive Officer, and Douglas Boessen, Chief Financial Officer and Treasurer. At this time, I would like to turn the call over to Clifton Pemble.
Thanks, Teri, and good morning, everyone. As announced earlier today, Garmin reported first quarter consolidated revenue of $639 million, up 2% over the prior year. Marine, outdoor, aviation, and fitness collectively increased 12% year-over-year and contributed 75% of total revenues. Gross margin improved to 58.3% as both segment and product mix were favorable. As a result of our increased revenues and gross margins, our operating margin improved to 18.2%, while operating income increased 12%. This resulted in GAAP EPS of $1.26, which includes a significant income tax benefit recognized during the quarter. Pro forma EPS, which excludes this benefit, grew 7% to $0.52 in the quarter. We are pleased with our first quarter results, which delivered growth in revenue, profits and earnings. However, since Q1 represents the lowest seasonal quarter of our financial year, we are maintaining the guidance issued in February.
Doug will discuss our financial results in greater detail in a few minutes, but first, I'd like to provide a few brief remarks on the performance of each business segment. Starting with marine, revenue grew 26% ahead of the overall market, resulting in market share gains. All major product categories performed well. Gross margin improved to 57%, while operating margin improved to 17%, resulting in operating income growth of 76% over the prior year. Marine season is in full swing, and we have seen strong demand for our latest product offerings. We started shipping our new GPSMAP chart plotters early in the season, and the feedback from customers has been very positive. Looking forward, we remain focused on gaining market share through innovations that will clearly differentiate us in the market. Looking next at outdoor, revenue increased 20% on strong demand for outdoor wearables.
The segment continued to generate strong gross margin and operating margin of 63% and 30% respectively, while operating income grew 24% over the prior year. We began shipping the highly anticipated fēnix 5 adventure watch series late in the quarter. Orders have been very strong, and we expect that it will take several weeks to catch up with demand. We also recently hosted our first Connect IQ Developer Summit, bringing together application developers and business partners to participate in hands-on workshops and breakout sessions with our product managers and engineers. At the event, we announced new capabilities for Connect IQ, including the ability for app developers to implement a revenue model. We also announced new integration partners, including SmartThings, which gives us a strong presence in the emerging home automation market.
Turning next to aviation, we reported solid revenue growth of 16%, driven by growth in aftermarket products and led by strong growth related to our ADS-B offerings. Gross and operating margin remained strong at 74% and 31% respectively, resulting in operating income growth of 27% over the prior year. During the quarter, we started shipments of the G1000 NXi, the next generation integrated flight deck featuring wireless connectivity and enhanced safety features. We received European certification for the GTX 345, expanding the addressable market for this popular ADS-B transponder. In addition, we continue to support our OEM partners in the development and certification of new aircraft and helicopter platforms. Much has been said about the challenging market conditions, which remain a factor. However, we continue to believe that market share gains and new platforms provide opportunities for long-term growth.
Looking next at fitness, revenue declined 3%, driven by the rapidly maturing market for basic activity trackers, especially those which lack GPS capability. Despite this challenge, we are very pleased with the performance of advanced wearables with GPS capability, which experienced robust growth during the quarter and nearly offset the steep decline of basic activity trackers. Gross margin increased to 56% as product mix shifted to the higher margin devices. Operating margin increased to 13%, resulting in operating income growth of 11%. During the quarter, we launched the Forerunner 935, which is our most advanced multi-sport watch with new running dynamics features and enhanced performance and recovery monitoring. We also introduced our latest vívosmart 3, an ultra-slim smart activity tracker with wrist-based heart rate and an innovative stress tracking feature.
While we continue to see the market for basic activity trackers mature, we also see growth opportunities in advanced wearables with GPS, and we are confident in our product roadmap going forward. Looking finally at the auto segment, revenues were down 19% in the quarter due to the ongoing decline of the PND market and partially offset by growth in our auto OEM product lines. Gross margin was 44%, which is consistent year-over-year, while operating margin declined to 4%. During the quarter, we began shipping our next generation Garmin Drive family of PND devices, which adds wireless connectivity and enhanced driver alerts. We also introduced the Garmin Dash Cam 45 and 55, offering high-quality recording in an ultra-compact form factor. We remain focused on disciplined execution to bring desired innovation to the market and to maximize profitability in this segment. Okay.
Finally, before turning the call over to Doug, I wanted to mention the recognition we recently received from Forbes magazine, ranking us among the top 100 most reputable companies in America. Our employees work very hard to make Garmin the best at everything we do and to operate the business with integrity. It's a special honor for all of us to be recognized in this way. That concludes my remarks. Next, Doug will walk you through additional details of our financial results.
Thanks, Cliff. Good morning, everyone. I begin by reviewing our first quarter financial results, then move to comments on the balance sheet, cash flow statement and taxes. We posted revenue of $639 million for the first quarter, representing a 2% increase year-over-year. Gross margin was 58.3%, a 380-basis point increase from the prior year, driven by the shift towards segments with higher margin as well as product mix within certain segments. Operating expense as a percentage of sales was 40.1%, a 230-basis point increase from the prior year. Operating income was $116 million, a 12% increase year-over-year. Operating margin was 18.2%, a 160-basis point increase from the prior year, as an increase in gross margin with an offset increase in operating expenses. Our GAAP EPS was $1.26, which include the $169 million income tax benefit due to the revaluation of certain Switzerland deferred tax assets.
Our pro forma EPS was $0.52, a 7% increase from the prior year. Next, we'll look at our first quarter revenue by segment. In the first quarter, we achieved 2% consolidated growth, led by double-digit growth in three of our five segments. Collectively, marine, outdoor, aviation, and fitness were up 12% compared to the prior year quarter. Looking next at the first quarter revenue charts. Collectively, the marine, outdoor, aviation, and fitness segments contributed 75% of total revenue in the first quarter of 2017 compared to 69% the prior year quarter. Marine grew from 13% to 16%, while aviation grew from 17% to 19%, and outdoor grew from 16% to 18%. The subsequent charts illustrate our profit mix by segment. Marine, outdoor, aviation, fitness segments collectively delivered 94% of operating income in the first quarter of 2017, compared to 82% first quarter of 2016.
Marine, outdoor, aviation, fitness segments had a year-over-year increase in both operating income dollars and operating margin. Looking next at operating expenses. First quarter operating expenses increased by $20 million or 8%. Research and development increased $14 million year-over-year, or 180 basis points to 19.1% of sales. We continue to invest in innovation, increasing resources focused primarily on aviation, fitness, outdoor, marine, where we see long-term growth opportunities. SG&A was up $6 million compared to the prior year quarter, an increase of 70 basis points as a percent of sales to 16%. Increased spending in SG&A was primarily driven by increased legal-related expenses and information technology costs. Advertising expense was relatively flat compared to the prior year quarter, representing 4.9% of sales. A few highlights on the balance sheet and cash flow statement. We ended the quarter with cash, marketable securities of approximately $2.3 billion.
Accounts receivable had decreased as expected, while sequentially and year-over-year, $391 million. Our inventory balance increased over the prior year sequentially to $533 million as we prepare for the seasonally strong second quarter. In the first quarter of 2017, we generated free cash flow of $95 million, a $21 million decrease to the prior quarter. Also during the quarter, we paid dividends of $96 million and purchased $28 million of company stock with $47 million remaining to purchase through December 2017. In the first quarter of 2017, we reported income tax benefit of $150 million, which includes a $160 million income tax benefit due to revaluation of certain Switzerland deferred tax assets. Excluding the $160 million income tax benefit, first quarter 2017 pro forma effective tax rate was 21.3%, compared to 18.1% the prior quarter.
The 320 basis point year-over-year increase in the pro forma effective tax rate is primarily due to the company's election to align certain Switzerland tax positions with international tax initiatives. We continue to expect our full year 2017 pro forma effective tax rate to be approximately 22%. This concludes our formal remarks. Christy, would you please open the line for Q&A?
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then the number one key on your telephone keypad. Again, if you have a question, please press star one now. Our first question is from the line of Charlie Anderson of Dougherty & Company. Your line is open.
For taking my questions, Cliff, I noticed in outdoor, marine, and aviation, you're sort of well ahead of where you laid out the segment guidance for the year. I wonder if you could kind of talk about how that flows the rest of the year, considering we started at these kind of high levels to begin the year. Then I have a follow-up.
Yeah, I think for outdoor and marine, the first quarter tends to be the lowest quarter, particularly in outdoor and marine is a little higher. Aviation is more sequential. In aviation, we did see some benefit from increased mandate activity, some of which are expiring. Just looking forward, we felt like it's best to maintain where we're at until we have more clarity around second quarter.
Okay. On fēnix 5, I know it's very early right now, I know part of the rationale for that product was to expand the market beyond the current users. I wonder if you have any data back yet on who's buying it. Are they existing Garmin owners? Are you getting new people? Are the demographics changing? Any color on that would be helpful. Thanks.
Yeah, definitely the demographics are changing, particularly around the 5S model, which was designed specifically around the female adventurer audience. The data we're getting back through our online registrations and of course, our cloud platform, Garmin Connect, suggests that we're being very successful with that.
Great. Thanks so much.
Thanks, Charlie.
Thank you. Our next question is from the line of Simona Jankowski of Goldman Sachs. Your line is open.
Hi. Thank you very much. Can you give us a sense for the split within the fitness segment between the basic activity trackers and the advanced wearables?
It's about even.
It's about even. Okay. Then, your inventory days were really high, 183, which I think may be an all-time record. I did hear your comments about preparing for the seasonally strong second quarter, but it still seems like a high level of inventory. Is that because you're seeing stronger than usual demand in the June quarter, or is there something in there that, like activity trackers, that is maybe a result of some of those categories coming a bit short of expectations?
No, I wouldn't say it's due to shortness at all. We are preparing for what has become Q2, has become nearly as big as Q4 in terms of its overall contribution. We do have some new product ramps, such as the fēnix 5, which are driving additional inventory. I think our goal is to have in-stock situations so that we can ship to any customer that wants our products during high season, and we'll continue to manage it pragmatically then throughout the rest of the year.
Thank you very much.
Thanks, Simona.
Thank you. Our next question is from Tavis McCourt of Raymond James. Your line is open.
Hey, guys. Thanks for taking my question, or questions. Just a clarification, Cliff, on the roughly 50/50 split in fitness between basic and GPS enabled, given the ASP differences, is that a unit split or a revenue split?
I think it's a revenue split.
Okay. A couple of other follow-ups on cost structure. Obviously, we've seen a big increase in memory prices the last six months or so. How has that impacted you guys in the first half of this year, or is there an impact that we should expect in the second half of the year related to that? It looks like advertising expense was down year-over-year for the first time in a while. Is that something you would expect to continue, or was that timing related?
Yeah. On the memory prices, definitely there's a tighter market and prices have been going up. We have some longer-term buying arrangements that have allowed us to continue at more favorable pricing during the first part of the year. We do expect to see some impact towards the later half of the year, but we think the impact will be minimal. In terms of ad spending, Q1, we basically have reserved a lot of our activity until Q2. I would expect that to increase sequentially and possibly a little year-over-year as well. Since Q2 is one of the higher quarters, we're going to be promoting our more popular wearables, particularly during the quarter.
Great. I just wanted to make sure I understood correctly your commentary around aviation, given the strong Q1. Was it stronger than you had expected entering the quarter, or did you expect a lot of the aftermarket strength that'll ebb and flow throughout the year?
Yeah, we were pleased. We outperformed our expectations for sure. As I mentioned, there's some mandates, particularly around EMS helicopters, that drove some sales. Plus, we did have very popular aftermarket products that also performed well along with ADS-B.
Great. Thanks very much.
Thanks so much.
Thank you. Our next question is from Joe Wittine of Longbow. Your line is open.
Hi, thanks. In fitness, for the half of the segment that's non-GPS, Cliff, are you able to give some sense of the magnitude of the declines you're seeing in that market for simple devices?
Just to clarify, fitness consists of both the wearable fitness trackers as well as the running watches and then bike. In terms of overall, its contribution, we saw sharply lower revenues in the quarter, and offset by very strong growth in the running products.
Are you able to provide any sort of idea of just the severity of those declines, just to help us level-set our models for 2023?
Yeah, I think we don't break it out by segment, for sure. As we expected when we came into Q1, based on what we saw in the latter half of 2016, activity trackers were down sharply. I think there's probably lots of different reasons for that, and I think there'll be obviously more color around that even as we move through the day. It seems like there's a lot of inventory in the channel, particularly with market leaders, that's being worked through. As that clears and as new products get in, such as our vívosmart 3, we believe that it will moderate as the year goes forward.
With that dichotomy between the low end and the high end, are you making any strategic changes to your development resources for the segment, either pulling back on the low end or reassigning to higher-end devices? Is the strategy to remain every bit as committed to continuing to add features to the below GPS product set?
Yeah. We have a strong roadmap on the basic trackers, as is evidenced by the release of our initial products this year. We have additional products coming. Obviously, we're taking a pragmatic approach to the investment and applying it where we see the most opportunity.
Okay. Finally for me, fēnix 5, the availability remains pretty spotty, including through April. A bunch of big retailers still don't have it. I don't think you're selling on garmin.com just yet. You reference orders are strong. I just want to confirm there's no supply side issues to be aware of. I suppose it's more difficult to manage than prior launches, given the higher number of individual SKUs than previously. Thanks.
Yeah, I think definitely we're pleased with the initial response. It's not just a matter of low supply. We've been delivering in very nice quantities for sure. The orders and the reorders have been very strong. It's going to take some time to work through all of the orders that we have.
Okay, that's helpful. Thanks a lot.
Thanks, Joe.
Thank you. Our next question is from Paul Coster of JPMorgan. Your line is open.
Yeah, thanks for taking my question. As the mix shift goes towards more AMPS devices in the fitness category, what should the impact on gross margins and operating margins in that segment be, please?
Well, it'll definitely mix up because the higher-end devices tend to have a higher gross margin. We would expect it will have an overall positive impact on gross margin percentage and operating margin percentage.
My second question is, you appear to be gaining market share again in marine and possibly in aviation. Can you just talk us through what's giving rise to that, how that's coming about, and can it be sustained?
Well, I think our product lines, particularly in marine, and also I mentioned some strength in aviation too, but our product lines are very strong. We've been keeping them fresh. As a result, we believe that customers are seeing the value and the differentiation that Garmin brings to the market. Keep in mind, these are both very niche segments without a lot of dynamics in terms of the overall channel and the consumer. Consequently, I think obviously there's some limit to what the potential growth trajectory looks like over the long term. Our goal is to be the market share leader, and to continue to be able to grow with the market.
Okay, thank you.
Yeah. Thanks, Paul.
Thank you. Our next question is from Yuji Yamazaki of Morgan Stanley. Your line is open.
Great. Thanks for taking my question. A question on gross margins. Just overall, you saw a good improvement year-over-year in Q1. Just assuming things trend back towards your 56% guidance for the year, are there certain segments that are going to see more volatility than others? Just any color would be helpful there.
I think a lot of it's going to depend, again, on product and segment mix. In Q1, we had the benefit of higher than expected growth in marine and aviation, which mixed the overall consolidated up more. We move into Q2, which is seasonally higher and sequentially higher, we'll see how that mix develops, both in terms of segments and products.
Got it. Just a question on fitness. Is it fair to say that, did you see a pause in shipments ahead of the new product launches in Q1? Are you expecting to make back a lot of that in Q2?
Yeah, we really didn't pre-announce any of the products in Q1. We were basically ready to ship when we announced the products. We didn't see any market impact from announcements that impacted the quarter. That said, with the new products, we've seen excitement around those, and we're encouraged by the follow-through in the market on those new products.
Great. Thanks so much.
Thanks, Yuji.
Thank you. Our next question is from Ben Bollin of Cleveland Research. Your line is open.
Good morning, everyone. Thanks for taking my question.
Morning.
I wanted to start on the aviation business. Could you talk a little bit about what you're seeing in the OEM category on the business jet side? Any expectations you have for how that develops through the year, if visibility does improve, and your market share impressions, and then I have a follow-up.
On the OEM side of aviation, I would say it's business as usual from what we've been reporting for a while now. The overall OEM side of the business, as has been widely reported by many players, has been kind of lethargic in terms of the market. We're doing, I would say, okay, but we move along with the ups and downs of our OEM partners. We do have the benefit of some newer platforms that we're still comping against from last year. That's an incremental benefit, but in general, OEM continues to be somewhat sluggish.
A broader question, when you look at the wearables category as a whole, how do you view the impact of what Apple has done with Watch? Last night they said the units for their Apple Watch grew nearly 100% year-over-year. I'm curious if you think it's having any impact on your outdoor and fitness business, and then a last housekeeping item maybe for Doug. Could you talk about the FX impact to operating profit in the quarter before including the FX hedges? Thank you.
Ben, in terms of impact from the Apple Watch, we are also seeing steep growth in our advanced wearable category. It doesn't seem to us that there's an impact from the Apple Watch. We've said before that we believe the customer base for the Apple Watch versus our devices are slightly different. Consequently, I think we're seeing strong performance and even some pull-through from their success as people see the opportunity for improved health and for pursuing active lifestyles, and they probably recognize then that Garmin offers strong products for those pursuits. Regarding the FX impact in Q1, there was a revenue headwind about $6 million. Not a significant amount of impact in the quarter.
Thank you.
Thank you.
Thank you. Our next question is from Brad Erickson of Pacific Crest Securities. Your line is open.
Hi, guys. Thanks for taking the question. First, can you just lay out how much Q1 outdoor benefited from the fēnix 5 channel fill, or I guess how much it added to the overall outdoor growth rate in the quarter?
We don't break it out by product categories, but we were pleased with what we were able to deliver in Q1.
Got it. I guess a higher level question on fitness. Given the maturity in basic trackers you're calling out, is that a business Garmin really wants to be in longer term? We've always known that pricing and margins would inevitably compress in that segment, but with calling out maturity, seems like it's a headwind worth addressing now from a strategic standpoint. Any comment there?
Yeah, I would say it's still a very large market. It's still a market that is adjacent to our interest in the overall active lifestyles, it's an area that we still have a lot of interest in.
Got it. Thanks.
Thanks, Brad.
Thank you. Our next question is from Richard Valera of Needham & Company. Your line is open.
Thank you. Cliff, just wanted to try to clarify your comments about the basic trackers being, I think you said 50% of the wearables in fitness, but that would exclude the cycling products, is that correct?
That's correct.
It's less than 50% of the total fitness category revenue, right?
Yes.
Would you be willing to give any sense of how big the cycling piece is?
No, sorry, we don't break it out more than that.
Fair enough. Just on the marine category, obviously still a very strong growth there. I would guess you got some year-over-year benefit from the partial quarter contribution of DeLorme in the first quarter of 2016. Would you be willing to give any sense of how much of a year-over-year benefit you might have gotten from that sort of partial quarter DeLorme impact in the first quarter of 2017?
Yeah. DeLorme is actually recognized in the outdoor segment. The majority of our growth in outdoor was driven by wearables, with less than half of that really coming from DeLorme.
Got it. Okay. Thank you.
All right. Thank you.
Thank you. That concludes our Q&A session for today. I'd like to turn the call back over to Teri Seck for any further remarks.
Thanks, everyone. Doug and I will be available for callbacks today. Have a great day. Bye.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a great day.