Harman International Industries Earnings Call Nuggets: Mainstream Vehicles Penetration and Neo Cost Outlook

Harman International Industries (NYSE:HAR) recently reported its third quarter earnings and discussed the following topics in its earnings conference call.

Mainstream Vehicles Penetration

Ryan Brinkman – JPMorgan: There continue to be announcements regarding increased smartphone integration within automobiles particularly as it relates to the iPhone including during this quarter. Now observers have painted this increased integration in a negative light as it relates to Harman although you continue to highlight as an investment positive your work to integrate smartphone to another car. So, for example you mentioned the integration of SIRI technology into the Ferrari FF today. Now in the case of the Ferrari FF customer there probably wouldn’t be much debate even amongst the bearer that this customer is not trying to save a few bucks by just intermediating a need for an embedded product, but is instead looking to enhance the experience of that embedded product. But can you maybe weight into the debate here a little bit when it comes to infotainment penetration in more mainstream vehicles and layout your case as to why if and indeed it is the case that smartphone proliferation is in fact a driver of embedded infotainment system penetration?

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Dinesh C. Paliwal – Chairman, President and CEO: Ryan, you couldn’t be more eloquent and I certainly would like to take part in this debate. I’ve been a very strong advocate over the last four years, five years and without getting any bragging about here I think we turn out to be true so far. We say the future of PND was dark and it has turning out to be true. We say that smartphones will create better awareness and better need, creation inside the car for embedded experience, we are starting to see that. And we also say that five years from today almost all cars rolling out of the production lines will have either some sort of integration of smart devices or embedded infotainment system. My take right now based on lot of discussion I had with the industry champions in Germany and Asia and here in United States is 50% embedded infotainment and 50% would be remaining cars, 50% of them will have some level of smartphone integration. Now let’s define what that is. Smartphone integration can be as simple as having your phone in the car without you touching it whether it’s in your purse or it’s in your foot pocket and you can make hands-free telephone, that’s number one thing. We are already doing it. In fact we are the first one to launch that in BMW and other cars. Second would be your playlist, your address book, you should be able to do that and few other things which will be available. Now let’s remind our listeners, car is expected (of late), which is absolutely for safety reasons will not be (overdone to just about anybody). That way Harman has carved out its niche. We get it, we understand the ecosystem, we understand the safety requirement, we had a record of rolling out system, therefore when you talk about 100 hundred or so live sensors in the car, when you talk about six to eight subsystems in the car, we have that bus which interacts with all the subsystem, we manipulate the live sensitive data. We can do lot of algorithms, we use cloud based information and we do hell of a lot more in real time. So that is an experience. If price was not a prohibitive thing, everybody would like to have embedded infotainment in the car nobody would choose. Now the realty is somewhere in between not everybody can afford it number one, two costs have yet to come down and we’re going to drive that too. We’ve started that with scalable platform, we’ve brought it down by half and we’re going to continue to do that and we’re going to help smartphone companies to do better integration and also share with them the knowledge of what should be the car centric apps and how to write them. We will take a lead. We’re doing with BMW and Audi’s and Chrysler and Toyota. So, I think this is a journey which has just begin and it’s actually win-win for both I’d state that because car phones, I’m a car phone user whether I have a rental car or a friend’s car I like to have basic integration all the time. Yet I don’t want to be dealing with my phone while I’m driving I want to have access to everything whether it’s car diagnostics, whether it’s my peer to peer communication whether it’s a connection to the cloud-based all the content out there. So, my take and my advocacy has been very strong on that we’re at the cusp of major breakout in embedded infotainment journey. We are right now as an industry only 20% penetration and we are looking at 50% or so penetration in the next five years. Imagine the CAGR ahead of us if we do it right embed good technology drive the cost down and be there where customers are not just be in one country and try to save the whole world like some of Japanese players have tried to do we are doing all of those then I think the future is fantastic for us and so is for smartphone that’s my take Ryan. I know I maybe have given a little long answer but I’m very passionate about it and I’ve been watching and learning this space quite a lot.

Ryan Brinkman – JPMorgan: So my last question then is just how would you paint the progress in customer product engineering cost recoveries during the quarter to what extent does this just simply reflect, a certain typical lumpiness there or is it instead maybe indicative of stronger execution via indicatives on your end to better recover those costs?

Dinesh C. Paliwal – Chairman, President and CEO: Ryan, you might have heard Herbert and I on the roadshow as well as in the calls that the business, the Company being hired that was running a very different business model that we expensed, $60 million, $70 million even $100 million on a large complex custom development that’s made for unit prices to recover our cost. That’s not acceptable to us, certainly not. So we tried to change the culture. You don’t change the existing fund, that’s what you can definitely do for the new contracts or do some sort of an added agreement with your customers that hay guys, I’m not going to wait for me to recover for the lifecycle. You got to start saying me on a regular basis and that culture is starting to get hold. We got recovery a quarter before, we got good recovery now and what I continue to expect recovery to come in every quarter. And by the way, this is combined with change orders. We are getting lot of change orders. The change order business as we all know is highly profitable and you don’t have to wait for five years to get the color. You do a change order you get paid. So combined with the recovery of fast engineering we have incurred, we are recovering now plus we are doing change orders. This will allow us to also face lumpiness of volatility away. But we are not there yet Ryan. I want to caution us. We are pushing, we are winning, but this is a culture change, externally as well as internally. But I think you can count on one thing I come from a culture where I always got engineering work done before and get paid before in my former Company and that’s where we’re going.

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Neo Cost Outlook

David Lim – Wells Fargo: So I have a question on neo cost in your third quarter. Can you sort of quantify that and will we see a tailwind in F Q4 as well?

Herbert K. Parker – EVP and CFO: This is Herbert, I’ll take that question. The neo cost what we had last year, as you know we spoke last year and indicated that neo would not be an issue this year. But what we had for the Lifestyle Division was $3.5 million in the third quarter of 2012.

Dinesh C. Paliwal – Chairman, President and CEO: If we put things in perspective David, last year we had a gross impact of $78 million of neo and that was $24 million, which means we did hell of a good job in terms of offsetting or charging it back to our customers. So, out of that $24 million net, we also promise you all and investor community that you’re not going to hear neo discussion in ’13 and you are not going to hear until you ask. You’re asking – it’s actually minimal impact. The market has come down, the prices of neo has come down and our engineering and R&D team have done a good job in finding substitute and designing the products so that they are more efficient with the user scale. So, I think it’s a non-issue for us…

David Lim – Wells Fargo: So then, I guess the question that I have is, next quarter will we see a degree of a tailwind given that neo prices have come down on a year-over-year basis. Will we realize in the next quarter?

Dinesh C. Paliwal – Chairman, President and CEO: We’re not going to call out this particular item, because we’re not going to see exponential change from this quarter to next quarter. Prices have come down, but they are still pretty high compared to what they were three years ago. You know they shot up like 1100%. So, they have come down they are still 500% high. So, either we have designed it out or we have efficient design or we have done pricing agreement with our customers that impact it too. So, we don’t allow this affect that. So, I would not say that Q4 would have any significance relate to neo, David if I may.

David Lim – Wells Fargo: And then just to clarify a point you said 50% embedded infotainment and 50% on smartphone integration, those are two unique products. Did I understand you correctly on that?

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Dinesh C. Paliwal – Chairman, President and CEO: They are two unique, yet there is a lot of sort of grey area in between, because you walk in a phone with any smart device you are going to be actually using some feature functionality from that bad infotainment if you want to have really tight integration of smartphones in the car. If you have nothing in your car than you will be restricted to some integration capability. So they are unique yet, there will be some cooperation like I gave you an example of (terry), but there will be few more like that. But yes they are too independent and the way I see it most of the people will both, they will have embedded and they will have a smartphone of some degree. Mind it we should also remind ourselves that smartphones every nine months, embedded system you are putting in we are designing it for the life of the car and our challenge is to keep the software current and hardware should be so modular that you can drop out a chipset very easily at the dealership. You can do that if you are going to rely on a smartphone for your complete connectivity in the car and mind it I heard someone was asking me earlier that somebody in China, a European automaker has designed a cradle for iPhone 5. I say well thank you that’s good thing, but you know what you are not going to be selling car just for iPhone 5. You are going to be selling it for five, six, eight different smart devices. So we have to be careful that we are designing car together with automakers for seven, nine, 10 years not for nine months.

David Lim – Wells Fargo: So I just want to clarify. So the Infotainment a grade you see a ceiling on that at 50%. I am assuming that the content on Infotainment, embedded infotainment is definitely higher in the smartphone integration, but would you term that as correct.

Dinesh C. Paliwal – Chairman, President and CEO: Absolutely correct, absolutely. It’s an exponential difference without a doubt.

A Closer Look: Harman International Industries Earnings Cheat Sheet>>