Good day, ladies and gentlemen, and welcome to the second quarter 2016 earnings conference call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. I would now like to introduce your host for today's conference, Teri Seck. Ma'am, you may begin.
Good morning. We would like to welcome you to Garmin Ltd.'s second quarter 2016 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, market shares, product introductions, future demand for our products, 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 Ltd.
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. As announced earlier today, Garmin reported second quarter results highlighted by both revenue and EPS growth. Consolidated revenue increased 5% year-over-year with fitness, outdoor, marine, and aviation collectively growing 20% while contributing 70% of the total revenue in the quarter. Each of our business segments produced strong results, which I will highlight shortly. Gross margin expanded to 57% from 54.2% in the prior year as new products and margin improvement efforts made a clear impact on our business. Operating margin expanded to 24.7% from 21.5% in the prior year, and operating income grew 20% on a consolidated basis. These strong results generated $0.85 of GAAP EPS. Pro forma EPS came in at $0.87, an increase of 21% over the year-ago quarter. Wearable products were a major contributor to our strong second quarter performance.
Over the past year, we have expanded our wearable product portfolio with the goal of offering a wearable device for a wide range of active lifestyles. As part of this effort, we have been pursuing two important objectives. First, we've been expanding the availability of Garmin Elevate wrist heart rate technology across our wearable product lines. Garmin Elevate is now available in multiple models of our running products, in our activity trackers, and in our fēnix series of outdoor adventure watches. Customers have embraced Garmin Elevate, and the feedback we are receiving is very positive. The second important objective is to increase customer engagement by offering applications, widgets, and watch faces through our Connect IQ app store.
Momentum in the app store continues to build as we now offer over 2,000 apps, watch faces, and widgets, and we have surpassed 13 million downloads from the store since its launch early last year. While I'm pleased with the progress we've made so far, there is certainly much more to do. We remain focused on a strong product roadmap and building engagement through Connect IQ and our Garmin Connect community. Looking now at segment highlights. Our fitness segment experienced robust revenue growth of 34% on a year-over-year basis, driven by growth within all product categories. Gross margin came in at 56%, and operating margin was 25%, an expansion of more than 400 basis points over the prior year. This generated operating income growth of 60% in the quarter.
Recent new product launches include the Forerunner 735XT, a lightweight multi-sport running watch, and the vívosmart HR+, which adds GPS capability to our smart activity tracker. As a result of these and many other recent product releases, we estimate that our share of the GPS-enabled smart wearable market in the U.S. has grown from approximately 43% a year ago to approximately 57% today, according to market share data. During the quarter, we also introduced the vívomove, a fashionable analog watch with activity tracking features and a one-year battery life. Looking next at outdoor, which also experienced robust growth, revenue increased 23% year-over-year on strong demand for our outdoor wearables and a full quarter contribution of DeLorme sales. The outdoor segment generated strong gross and operating margins of 64% and 36% respectively, representing an expansion over the prior year. Operating income grew 31% over the year-ago quarter.
One of the many benefits of our business model is the ability to share product platforms, technologies, and components across multiple market segments. Recent examples include the Approach X40, a GPS-based activity tracker with Garmin Elevate wrist heart rate technology, and a built-in database of over 40,000 golf courses providing distance to the front, middle, and back of the green. We also introduced our next-generation dog tracker, the Astro 430, which when paired to a DriveTrack 70 PND, can track up to 20 dogs from a vehicle. The Astro 430 can also pair with a fēnix 3 wearable for convenient tracking and alerts at the wrist. Looking next at Marine, revenue increased 8% over a very strong quarter in the prior year. Gross margin increased to 58% in the quarter, while operating margin expanded to 26%. Operating income grew 19% in the quarter.
Our new fish finders have been well-received, and we have grown our share in the inland fishing market. Earlier in the year, we introduced Quickdraw Contours, which enables boaters to create maps of their lakes with all processing and storage taking place right on the device. We recently enhanced Quickdraw by offering a community feature called Quickdraw Community, which is a free cloud-based mapping platform for sharing user-generated HD mapping content. We believe Quickdraw Community will positively impact customer engagement, and will expand the availability of HD mapping content, particularly on smaller fishing lakes. Turning next to Aviation, revenue grew 6% over the prior year, as we experienced growth in both OEM and ADS-B systems. Growth and operating margin remained strong at 74% and 28%, respectively, resulting in a 13% increase in operating income.
During the quarter, the G3000-equipped Piper M600 received type certification, and we are pleased to be the avionics provider for this aircraft. As we continue into the back half of 2016, we will focus on a number of additional certifications, including the aftermarket G5000 system for the Beechjet 400A and the Hawker 400XP. We announced several new products and product enhancements at the Oshkosh Air Show taking place this week. One such announcement is the Flight Stream 510, which is a multi-mode wireless radio system built into a multimedia card, which also includes storage for a variety of flight databases. The Flight Stream 510 is important because it simplifies the task of updating flight databases by leveraging the connectivity of a smartphone or a tablet. Flight Stream 510 also shares flight plans, traffic, weather, and position information with smartphones and tablets running our Garmin Pilot mobile app.
Flight Stream 510 significantly enhances the ability to incorporate consumer devices in the cockpit. Looking finally at the Auto segment, revenues were down 18% in the quarter, primarily due to the ongoing PND market contraction and headwinds caused by revenue deferrals associated with certain auto OEM programs. Gross margin came in at 46%, and operating margin expanded to 16%. We remain strategically focused on new opportunities in the auto OEM market. While we are typically thought of as a navigation and infotainment supplier, we are also leveraging our competencies in other technologies, such as cameras and driver assistance, to expand our ability to serve the market. At the recent 2016 Beijing Auto Show, Peugeot showcased its Model 3008, which includes a factory-installed digital video recorder designed and manufactured by Garmin.
In summary, we are pleased with our performance in the first half of 2016, and we believe we are well positioned for the remainder of the year. With this in mind, we are raising our projected revenue for the year to $2.9 billion, up approximately 3% over 2015. We are projecting gross margin of 55% and operating margin of 19% for the full year. Factoring in an effective tax rate of approximately 19.5%, pro forma earnings per share is expected to be approximately $2.50. Looking at our outlook by segment, we have increased growth expectations for Fitness and Outdoor to 20% for the year. Aviation and Marine are unchanged, while the outlook for Auto has been reduced slightly based on current market trends. That concludes my remarks. Next, Doug will walk you through additional details on our financial results.
Thanks, Cliff. Good morning, everyone. I'd like to begin by reviewing our second quarter results, and move to comments on the balance sheet and cash flow statement. We posted revenue of $812 million for the second quarter, representing a 5% increase year-over-year. Gross margin was 57%, a 290 basis point increase from the prior year, driven primarily by segment and product mix. Operating expense as a % of sales was 32.3%, a 40 basis point decrease from the prior year. Operating income was $201 million, a 20% increase over the prior year. Operating margin was 24.7%, a 320 basis point increase from the prior year. Effective tax rate was 21% in the current quarter, which is comparable to the effective tax rate of 20.6% in the prior year quarter. Our GAAP EPS was $0.85, an 18% growth over the prior quarter. Our pro forma EPS was $0.87, a 21% growth over the prior quarter.
We'll discuss gross margin, operating expenses in more detail later. Next, we look at second quarter revenue by segment. During the second quarter, we had growth in four of our five segments, led by robust double-digit growth in our Fitness and Outdoor segments, single-digit growth in our Marine and Aviation segments. Collectively, these four segments were up 20% compared to the prior year quarter. Looking next at second quarter revenue charts. Auto segment represented 30% of our total second quarter 2016 revenue, compared to 39% second quarter 2015. Fitness grew to 26% of revenue in the current period, compared to 21% in the prior year, while Outdoor grew from 14% to 17%. As you see from the charts that illustrate our profit mix by segment, Outdoor, Fitness, Marine, and Aviation collectively delivered 80% of operating income in the second quarter of 2016.
Fitness operating income as a percentage of total operating income increased from 20% to 27%. Outdoor increased from 22% to 24%. Looking at year-over-year gross margin by segment, all segments posted gross margin rate increase due to shifts in product mix. Total corporate operating margin increased from 21.5% to 24.7% due to gross margin improvement. Looking next at operating expenses. Second quarter operating expense increased by about $10 million, or 4%. Research and development increased $5 million year-over-year, was flat as a % of sales. We continue to invest in innovation and increasing resources focused primarily on Aviation, Fitness, and Outdoor. Our advertising expense decreased $1.5 million from the prior quarter, represented 5.5% of sales, 50 basis point decrease. Additional advertising spend in Fitness was more than offset by decreases in Auto and Marine.
SG&A was up $6 million compared to the prior quarter, increasing 170 basis points as a % of sales to 12.8%. The increase in SG&A was driven primarily by expenses associated with the addition of the DeLorme business and compensation-related costs. A few highlights from the balance sheet, cash flow statement, and taxes. We ended the quarter with cash, marketable securities of about $2.4 billion. Accounts receivable increased both sequentially and year-over-year to $510 million. Our inventory balance decreased sequentially to $508 million as we exit the seasonally strong second quarter, but remains higher year-over-year due to new product offerings. For the second quarter of 2016, we generated free cash flow of $135 million, a $71 million increase over the second quarter of 2015. Also during the quarter, we paid dividends of approximately $97 million.
We purchased about $25 million of company stock, approximately $123 million remaining for purchase through December 2016. As Cliff mentioned, we're updating our tax guidance, now anticipate a full-year tax rate of approximately 19.5%. This concludes our formal remarks. Jamie, could you open the line for Q&A? Thanks.
Ladies and gentlemen, if you'd like to ask a question at this time, please press star and then one on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from Charlie Anderson with Dougherty & Co. Your line is now open.
Yeah, thanks, and thanks for taking my questions and congrats on a great quarter.
Thank you.
I wanted to ask Cliff, it's been interesting, Garmin Elevate's been very helpful for you this year. I wonder how much do you think the rest of the product portfolio can get penetrated with that technology? Also just thinking about as that's helped you this year, and if I think about future versions of these products, there are other biometric sensors you feel like you can add so that this is a sort of a continuous trend for you as opposed to maybe a one or two year phenomena?
Yeah. In terms of penetration of the heart rate technology, we have expanded it broadly across the line, as I mentioned in my remarks. I think we're mostly there. There's probably still a few areas where we believe we can add, and we will do so. I think for the most part, over the past year, we've been able to accomplish what we set out to do. In terms of other sensors, we're certainly working on that as a lot of people say they are. I think the biggest challenge is the next level of sensing technology has to prove that it has utility for the customers, and it has to be technologically feasible. I think we, like everyone else, is searching for that next breakthrough.
A follow-up question from me on gross margin. Very strong in Fitness and Outdoor in the quarter. I think implied in the guidance is that we come down a little bit off that level in the back half of the year. I wonder if you could talk about the puts and takes there.
Yeah, I think the back half will certainly come down in terms of gross margin because of promotional activities and going into the fourth quarter.
Great. Thanks so much.
All right. Thank you.
Thank you. Our next question comes from Ben Bollin with Cleveland Research. Your line is now open.
Good morning. Thanks for taking my questions. A couple items. The first one, looking at the Outdoor and Fitness businesses exiting 2Q, could you tell us your impressions of channel inventory, where it stands with the large number of products that you've launched, how you feel going into 3Q? Also, any impressions or thoughts you have longer term about the growth and operating margin profiles of those businesses. How are you managing them? What's kind of your targets? I have a follow-up.
Okay. Thanks, Ben. In terms of channel inventory, especially with the launch of new products, I think it probably varies by regions and by stores, in general, we feel like the inventory is in a good situation. We feel like our products are selling out well, we don't think that there's any issue with new products stacking up in the channel.
In terms of growth in margins, certainly we've been on a deliberate effort to improve our margins across all of our business segments. I would say that in fitness, as the mix continues to shift towards the activity trackers, that profile will continue to have pressure on it, while in outdoor it's probably somewhat stable at its current levels.
Okay. Looking at the automobile business on a standalone basis, a little worse year-on-year performance there. Any adjustments to your thoughts longer term? It's kind of been a declining mid-teens type business. Any reason it gets progressively worse from that level?
I think what we saw so far in the first half of 2016 is that the European market has weakened more than what it had been up to that point. I think that's probably the big change in our outlook. Generally, we still feel like it's a good market, we feel like we're doing very well in that market in terms of market share.
Thank you.
Thank you.
Thank you. Our next question comes from Brad Erickson with Pacific Crest Securities. Your line is now open.
Hi. Thanks for taking my questions. First, I guess you mentioned the market share data, and I believe it was the GPS-enabled smartwatches, so that was helpful. In terms of activity trackers, can you kind of provide any market share update for that particular subcategory?
Yeah, Brad, the market share in activity trackers, we believe we're roughly at the 10% level in the U.S. market. Internationally, there's areas of strength and weakness across the whole world, but we're actually doing very well in bigger European countries and also in Asia.
Got it. Then you've obviously come out with a lot of new products here in fitness recently. Can you kind of talk about the second half and how we should be thinking about the cadence of new products on a relative basis to the first half? Thank you.
I think the first half was certainly a big part of what we had planned for the year, but we still have some additional releases that we'll be announcing here in the second half as well.
Thank you. Our next question comes from Tavis McCourt with Raymond James. Your line is now open.
Hey, thanks for taking my question. I've got a few of them. First, for clarification, can you remind us what your previous guidance was for year-over-year decline in the auto segment?
It was minus 15.
Okay, you think the rest of the year will look more similar to what we saw in Q2?
I think roughly similar, yes.
All right. If I look back now, going back six quarters or more, you've had a nice run here in your Asia Pacific business. I'm wondering, is all of that attributable to fitness wearables, or are you seeing some broader strength beyond fitness in that region?
We're doing very well in fitness and outdoor wearables in that region.
Got it. Doug, do you have the impact from net deferred revenue drawdown in the quarter?
Yes. Overall, deferred revenue had a headwind of about $8 million. We anticipate probably full year, probably about an $0.08-$0.10 headwind deferred revenue.
Got it. Cliff, a product question. You mentioned in your prepared script, vívomove, and this was an interesting one, I think because really a departure from the look and feel of Garmin's activity trackers historically. I know it was just very recently launched, but do you have any early indications of sell-through on that device?
I think it is still very early. I think that product appeals to a slightly different kind of customer than our traditional base, so we're waiting to see how it does.
All right. Fair enough. Thanks very much.
All right. Thanks, Tavis.
Thank you. Our next question comes from Jerry Liu with Morgan Stanley. Your line is now open.
Hi. Thank you. Can we talk a little bit about some of the drivers for earnings in the second half of the year? It looks like your gross margin will be better compared to the second half of last year. It looks like the lower year-over-year earnings in the second half this year mostly has to do with higher OpEx, maybe higher advertising. Can you talk about any other drivers, potentially fewer product launches or anything else?
Yeah. As it relates to the gross margin in the back half, you'll see probably some improvement relating to segment mix there primarily. Looking at the gross margins for the full year, we anticipate most of the segments for the full year to be comparable to 2015, except for fitness, which as Cliff previously mentioned, will probably be lower due to higher percentage of activity tracker wellness. We think that's probably going to be fitness gross margins full year, probably in the low 50s. As it relates to expenses, a couple things to think about expense in the back half, the first of which is relating to acquisitions. DeLorme will have full two quarters of expenses related to the DeLorme acquisition, as well as in 2016, this is the year we have a 53rd week.
We have one extra week of expenses in 2016 compared to the previous years. As it relates to advertising, we think advertising probably as a percentage of sales will be comparable year-over-year. There'll probably be some increase in dollars, talking about for full year here, in there, but as a percentage of sales, we think advertising will be relatively comparable to 2015.
Got it. Just one question in terms of the different geographies. It looks like Americas was maybe a little weaker in the second quarter. I know you said EMEA was probably weaker, but maybe just some details on the Americas growth rate. Going forward, would you expect, because of the depreciation in the pound, any need to maybe raise prices there and potentially any demand impact from that? Would any of that be factored into your guidance? Thank you.
Yeah, Jerry, I think in terms of all the factors you mentioned, it's definitely rolled into our guidance. Americas has been a little weaker for two reasons. One is that we are more exposed in this market, the Americas market, to the PND market cycle, that's one dynamic. The second thing is that the activity tracker market in the Americas is more competitive than what we see in the other areas of the world where we're doing comparatively better. Those are two moving pieces there in terms of Americas performance. In terms of specific impact of the pound, we're definitely working that situation, and much like what we did with the euro situation last year, there could be some impact on prices. I think all of this is like threading a needle.
You need to see where you have the ability and the power to raise prices, and also where you do not, and make the appropriate moves.
Got it. Thank you.
Thank you.
As a reminder, ladies and gentlemen, please press star and then one to ask a question. Our next question comes from Will Power with R.W. Baird. Your line is now open.
Great. Thanks. Yeah, maybe just to follow up a bit on the previous question, thinking about the Americas and the competition you're seeing in wearables there. I think one of the market share leaders planning new products here in the second half of the year. Is that a segment that can stabilize year-over-year for you, or should we expect that to actually worsen and be offset by this continued better performance in EMEA and APAC?
Well, I think longer term, we would expect the Americas to grow as well. Again, the near-term dynamics of the PND decline are outweighing the growth we've had in some of the other segments.
Okay. I have a couple financial questions. Just looking at R&D, at least on an absolute dollar basis, at a higher level this quarter, is that the right number to look at moving forward as you move into Q3 and Q4? Were there some things that elevated that this quarter?
Yeah. As I mentioned, R&D will be increasing, primarily because of that DeLorme acquisition, which we'll be adding in there, and also as we add headcount just for new product introduction. We'll see overall from operating expenses as a percentage of sales will be increasing overall full year.
Okay. All right. Just on the buyback, I know you still have some remaining. I wonder if you could just give us a broader thought process on use of cash once you exhaust that. Do you return to a buyback? How do you think about buybacks cash once you get through the current authorization?
Yeah. Basically, our goal is to return about 100% of our free cash flow back to the shareholders between dividends and share purchases. As it looks at share purchases, we looked at a number of things there, one of which, obviously, is our business conditions as well as our market condition there. We'll play that out depending upon how that goes throughout the rest of the year and in the future.
All right. Thank you.
Thank you.
Thank you. Our next question comes from Paul Coster with JPMorgan. Your line is now open.
Thanks. This is Paul Chung, I'm for Paul Coster. Thanks for taking my question. Can you confirm the DeLorme contribution to both margins and top line in 2Q? In which segments can we expect incremental M&A given the large cash balance?
In terms of DeLorme's contribution in margins, we don't break any of that down. I would say in terms of top line, it's attributed to the outdoor segment, it represented less than half of the overall growth that we had in the segment for the quarter. In terms of our outlook for M&A, we don't really comment on our plans, of course, as you can understand. I think our strategy has always been to look for good fits in technology or product lines that would complement our overall portfolio. That's what we've been doing, that's what we continue to do.
Great. Thanks. Then quick housekeeping. The recognition of deferred slowed somewhat. How should we think about the timeline to recognize the full balance? I know you mentioned some incremental was booked this quarter, that seems like a one-off. Thank you.
As it relates to deferred revenue?
Yes.
Basically, in the second quarter, we had $8 million of headwind on deferred revenue. For the full year, we're anticipating a headwind of our EPS of between 8% and 10%. It'll probably be a little bit less than that in the back half.
Thank you. Our next question comes from Simona Jankowski with Goldman Sachs. Your line is now open.
Hi, thank you. First, in terms of gross margins in the quarter, which obviously expanded quite a bit both in fitness and outdoor, could you help us quantify and understand the drivers behind that? I imagine there's some benefit from leverage, other factors like pricing or mix within those segments, that would be helpful.
Well, Simona, I think probably the biggest factor I would attribute it to is the refreshing of our product lines and the ability to reset pricing with products with new features and that are more competitive in the market. I think that's the main contributor. We're also very focused on product costs, we're working costs out of the products continually, that's also had an impact on our business.
Thank you. A somewhat similar question in the PND segment. You also refreshed and rebranded that product line earlier in the year. Are you seeing a benefit there from the price increases that you're able to put in? Is there a bit of a change in the trade-off that you're willing to strike in PND between pricing and volume?
Yeah, I think we've definitely seen a benefit in the launch of the new lines. They have great new features that we believe are the best anywhere. In terms of limits, certainly there is a limit in terms of pricing versus volume and our goal has been to maximize profitability.
In other words, are you giving up a little bit of market share there as you try to price higher?
I think we're certainly sensitive to pricing and profit in the segments, I will say. I think in terms of our current approach and the evidence of the market share that's out there could be some slight degradation in market share, but I think the evidence is very slight for that and in general, we feel like our market share is still very strong, both globally and in the U.S.
Just lastly, what was the FX impact in the quarter?
The FX impact in the quarter was about $3 million of headwind, a small amount.
Okay. Thank you.
Thank you.
Thank you. Our next question comes from Ivan Feinseth with Tigress Financial. Your line is now open.
Okay. Seems like we don't hear Ivan.
Mr. Feinseth?
Hello. I'm sorry. Thank you for taking my question. Congratulations on an incredible quarter.
Thank you.
Really putting out some great products.
Thank you so much.
My question is more about your marketing focus and your marketing spend. There are a lot of places where I expect to see Garmin presence, and I do, but there's a lot of places where I would either expect and hope to see the presence, especially in the wearables and even in the action camera, and I still don't see it. What is your overall big picture marketing plan, and do you see also more integration on a lot of your apps with, let's say, healthcare or fitness apps or gym apps and things like that?
Yes. In terms of product placement, certainly there's gives and takes, but we think we're generally represented well at every major retailer, and we also have a very strong presence with the products that you mentioned, particularly in the fitness and the outdoor area in specialty retailers. Generally, we've been working hard on expanding our retail presence. We've been working hard on improving the presentation of our products at retail over the past year, and we think that we've made a lot of progress. In terms of integration of our apps with others, we already do quite a bit of that. For instance, we have integration with MyFitnessPal for nutrition tracking, and we also have integration on the cycling side with Strava as well. We're very open to partnerships, and we've been demonstrating that.
Who do you see as your strongest marketing partner?
Well, I think we're our strongest marketing partner. We're focused on the Garmin brand, and we're focused on partnerships that enhance the Garmin brand.
Okay. Thank you. Congratulations again.
Thank you. Our next question comes from Andrew Spinola with Wells Fargo. Your line is now open.
Cliff, I saw the reference to the ADS-B contribution to the growth in aviation in the quarter. I'm just wondering if you could step back and give us a snapshot of where that opportunity is today. I know it's a multi-year process. Is it still building? Is it going to become a bigger and bigger contributor over the next couple of years for you? Are you still as strongly positioned as you were a year or two ago there?
Yes. In terms of where we're at, it's probably difficult to precisely nail it down, but we think it's somewhere in the 20%-25% equipage that's occurred so far in the market, with the vast majority of the equipage yet to come. I think pilots and aircraft owners are just like everybody else, probably a lot of them will wait until the last minute. We do see a building momentum as time goes on as we lead up to the 2020 deadline. In terms of how we're doing, I think we're doing very well. It's one of those areas where it's difficult to precisely nail down market share, but we believe our share so far in the equipped airplanes is north of 70%.
Doug, how does the ADS-B product line impact the margin profile of aviation? Is it sort of in line or potentially better?
It's in line.
In line. All right. Thank you very much.
Thank you, Andrew.
Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to Teri Seck for closing remarks.
Thank you all for joining this morning. Doug and I will be available for call back. Have a great day.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.