Allegion plc (ALLE) Earnings Call Transcript & Summary

Hey, good morning all. This is Deepa Raghavan, senior analyst, electrical industrials. I cover Allegion here at Wells Fargo Securities. Welcome, everyone, to the 2020 Virtual Wells Fargo Industrial Conference. Get started here with Allegion as our first fireside chat host -- fireside chat presenter. Today, we have CEO, Dave Petratis and the IR team of Tom Martineau and Kevin Sawyer. Welcome, Dave, Tom and Kevin to our conference, and thanks for all the adjustments this virtual format has demanded. So appreciate that. Okay. Let me start off with your...

We're glad to be with you, Deepa.

Yes. Thanks for being here.

Let me start off with a big picture question, Dave. Can you talk about Allegion's value-add in the product security business that you play in and your differentiation as the market leader and what kind of helps sustain it?

So there's multiple levers as I look at that value-add that I think are important to reference when we think about Allegion. One would be the investment in [ center creation ] and a concept we call seamless access. When we think about COVID-19, the ability to move through buildings and infrastructure or homes in an unconnected or touchless way, we think, has never shone brighter and this is a trend that's going to affect our industry and Allegion going forward. So the whole concept of seamless access. Number two, the strength of Allegion and its brands, especially in our core markets, our installed base on college campuses, hospitals, government infrastructure leads our industry. We think the performance aspects and quality of those products give us an advantage from an installed base and really being part of that specification of record gives us a recurring revenue base that's important. Third is, Deepa, we talk about our specification capability. We have one of the strongest specification capability in industry and in building projects as you try to upgrade security aspects. The specifications would be able to create the specs, the flow of people, meeting codes and standards gives an advantage that we have built over the last few decades. And then I think one of the strengths that has really shone in 2020 for us is our supply chain. We have performed extremely well. Our system of management, I think, has allowed us to prosper in a very challenging time. And I think that was reflected in our Q1 results. So seamless access of the installed base, the specification capabilities, our supply chain and then our people and systems, I think, are what differentiates Allegion.

Thank you. So some cycle perspective here. Usually in downturns, what kind of sequential business cadence -- which are the ones that go into weakness first and which probably go a little later, like will residential be the first one to be impacted usually in a down cycle, maybe commercial later, institutional typically lagging in taking that to the recovery side? Should we expect residential recovers first? Is this how you think about your businesses?

I think you have to segment the marketplace. And we like to look at commercial, institutional, res, the R&R segments of both commercial, institutional and res as market opportunities. And then you've got to throw in the seamless access, the conversion to IoT-enabled device, [ credentialed ] device. So each one of those segments have different drivers. Let's look at res first, particularly in North America where we're a leader, but res plays a big role globally for Allegion first. As we look at res, driven by consumer confidence winning, those types of things, as we moved into the COVID crisis, we saw some strength in residential. We saw some wins on our side driven by seamless access and our Encode lock capability, Lennar would be an example of that. I think today, we saw -- in today's news, this morning's news, we saw home prices are up. And it's -- in North America, there's a lack of single-family supply. That will help us on both the new build side as well as the repair and replacement side. And so as we go through this with cheap money, the people that are employed are going to be looking for home formation, moving up, I think single-family housing will be a driver. It's not going to be a red-hot part of the market, but we have never recovered from the -- even a decade ago's crisis. So I think the lack of supply will overall be good for Allegion on the res side. As you move into the commercial and institutional, institutional, a very big driver for us. We believe that the projects that are committed, grant's been broken, the permits are there, those are going to continue to roll, and we see that today. Our customers are still demanding. So as we think about the institutional cycle, there's been a little bit of a pause. We think the project work will continue. The question mark becomes, as you move into '21 and '22, I think the market will be solid. I don't see us going off a cliff. Because you have a driver on the institutional side, we still got a lot of aged infrastructure. There'll still be security drivers. Think about K-12 security. So there is -- we still got to figure out the path here, but I'm net positive in terms of that. I think when you move to commercial, that's where we're going to see some challenges. That's not necessarily the sweet spot of our business, but think about malls, hotels, the whole restaurant infrastructure. We might see 24 months for that really to sort itself out, but it's not necessarily the sweet spot of us. That's where I -- we really have to have our eyes wide open and understand.

Got it. That's helpful. Just switching gear to more like the near-term order trend. How do you think second half April exited versus first half? And I ask that in the context of some sites actually reopening here as the U.S. prepares the economy for a phased economic reopening. So we did some checks. Our checks seem to indicate second half was sequentially better. It looks like it's a little too early to talk about sustainability or improvement. But curious what you're seeing within your order trends as you exited April?

I think, first off, look at our Q1, strong. We had some momentum build under this. I think second, we'll know at the end of Q2, but I'd go back and reference our supply chain, our teams did some extraordinary job -- an extraordinary job globally to stay open and keep our people working safely longer. And Deepa, I want you to just appreciate that 1 or 2 days of booking backlog will help us as we move into the second half. I think third is, Q2 is going to be difficult. We were out depending on where we're at in the world, by government decree, we were out. Today, our Mexican facilities are up and operating. And effectively, globally, we're producing wherever Allegion is at in the world I think that will help us as we build confidence with customers. But again, I'd emphasize, Q2 is going to be tough, but we think we've built some backlog and have got some wins as we moved into the second half that will sustain us.

Got it. So just for clarification, that Mexican plant is now reopened. The one that you mentioned, that decree was extended all the way through May end, but it's kind of early opened?

I want to reemphasize that our 3 Mexican facilities are open, producing and shipping, and our legal teams, human resource teams and operations team did an excellent job. And you heard me say on the call, Deepa, I believe we can keep our employees safer and healthier on the job and just -- I think it's reflective of the work that we began when COVID-19 first came around in early January. There's a value at Allegion, be safe, be healthy, and we executed that. And again, all Mexican plants are open.

That's pretty clear. How has pricing been so far? Generally, it looks like you're thinking about 1% plus top line price realization. Looks like that's what you're thinking over the next 12 to 18 months. Has typically pricing been stable in prior down cycles as well, granted you were under Ingersoll Rand at that time? So curious, any thoughts on pricing now versus prior down cycles? And any context there?

I think if you look at our performance through 2009, '10, '11 on the financial crisis, we drove good price realization during that time. In fact, I think we were very aggressive. We're going to stay disciplined. And I think 1% is a good way to think about it. We announced a price increase at the end of Q1, and that's gone through. Pricing is an important lever of a healthy industry and feel good about it. Tom or Kevin, anything to add there?

Yes. I mean, historically, even during down cycles or during deflationary, inflationary periods, we'll still get that price realization. Times of inflationary periods get -- tend to get a little bit more. So maybe towards the lower end of the range that you're thinking.

All right. Can you talk about your big box exposure right now? And can you kind of make a case or not for any rebound in retail -- in retail stores, just given the significant amount of store closures at this point in time?

So we have a large exposure to big box in North America with our Schlage residential one. I think we've certainly seen a softening in that, and it's driven by reduced hours. I would also say, as Americans have worked from home and the weather has improved, the velocity that I have observed in places like Home Depot, Lowe's, Menards, even local True Values. As I've done my supply checks, these places are pretty busy. And again, I think this will be an area that snaps back relatively quickly. Again, we've got to keep an eye on the replacement market. I think [ cue ] the seamless access drivers, home delivery of groceries, home delivery of meals is accelerating. I think it help up sale of our electronic locks. So I'm cautiously optimistic with the value or the lineup of products that we have and the performance we had in residential in Q1, I think, reflects that.

Got it. So the e-lock's penetration that you're talking about is more from -- it's just from a residential standpoint. That seems to be an area where you think you come out ahead post COVID. You mentioned touchless as well. Those 2 teams post COVID, you come out pretty strong. Anything else to add to that pipeline, where you probably come out ahead post this trend?

I think I would expect us to gain some share in big box because of our supply chain strength. That supply chain for all competitors, heavily Asian based. You've also got Mexican based. I think we ran longer in Mexico and got up quicker. Again, we'll know more as we end the second quarter, but I think its advantage Allegion in terms of just the basic supply chain. I think our electronics, if you go back to my comments in Q1 on electronics Allegion overall grew at 12% in Q1 in electronics, that was heavily influenced by success with the Encode in our electronic locks in the quarter.

Got it. So this is interesting context because a few years ago, I think the question was more, hey, will import brands take some market share? And you just flipped the coin by saying you're better situated. That's good to hear. Is that also...

I -- let me put -- can I put some more color around that? I think the strength of our supply chain, we're 2 weeks faster on the boat with our Mexican supply chain. I mean, take everything else away, I have an advantage versus importers. I think we're going to see that in terms of our overall performance. And I think you saw them early going through that in Q1.

That's fair. So have down cycles been typically where Allegion has seen the most share gains as well? And can you put that -- put your share gains in context ever since you became public, ever since you came out of Ingersoll Rand?

Tom, you were right there at the pulse. You were heading Ingersoll Rand. So share on your commentary there.

Yes, I could jump in. I guess that was probably the last cyclical downturn that we were able to reference. I don't think any of us were actually part of the specific business unit at that time. But I think from that point, the market decline that's going to happen, we're going to be with it, right? You're going to see the normal market exposure. We were down in that cycle. We would like to think that we actually did better from a competition in general, but that was kind of an aged. What I would look at is from the spin and what we've been able to accomplish. I think over this spin, historically, we posted organic growth rates that are as, if not better, than the competition. We've shown continued performance, execution and not only that on the growth side, but also in terms of the margin, right? We've had good margin and leverage on that volume increase. So I think the -- what we're seeing, especially in Q1, again, just to go back to some of the things Dave said, the manifestation of this electronics convergence that's going on, really helping us in the residential, the investments we've made, both in terms of the product portfolio, but also in the channel, in the nonresidential, was really paying some big dividends. And those types of investments and product developments, I think, have done well for us to allow us to have the strong organic growth.

Yes. Thanks for the comment on...yes?

I would add in a little bit more color here, Deepa. And this is where I think experience matters. You leave some things on the table with an old guy like me, but this is my sixth or seventh downturn. And as I've gone through the dotcom blowups, the financial crisis that we went through 2008, 2009, and now this pandemic, I think in all the chaos, you have to believe there's opportunities to grow. There's opportunities to differentiate yourself versus competitors. And I believe as we go through this over the next 4 to 6 quarters, the experience at Allegion and the system and management that we built is going to allow us to gain share and see opportunities in seamless access. And I always look at the glass as half full. I believe our system of management, our product sets, the vision around seamless access and our supply chain is going to reward Allegion and shareholders as we go through this. It's also the ability to get cost out. If you look at our Q1, we were already well down the path of restructuring actions in Asia and Europe. It's just -- you've got to face the reality of your current state when you're in the construction-related markets, this is how brands like Von Duprin, Schlage, LCN stand for decades or really over a century of success. And I'm confident we'll be stronger as we roll through this.

Just tagging on that margin comment, both Tom and you may, Dave, 2 parts to this question. How do we think about COVID-19 impacting your 2019 Investor Day target over the medium term? I don't want to focus on the 4 to 6 revenue CAGR, but more on the 50 to 100 bps margin expansion target annually that you had. Does this impact anyway? And also, as you talk about it, can you talk about your European and Asian businesses? And generally, how the lower margin structure can be improved or not and plays into this medium term targets?

Yes. So let me take that one, Deepa. Specifically to start kind of around how we -- let me start with the European, Asia businesses. So typically, as -- I think everybody knows, this is kind of an industry dynamic. The Americas tends to do a little bit more profitable from a business, more homogeneous, gives better leverage. I think you see that we drive it to an exceptional level, I think, in terms of the performance. But in the other more nonhomogeneous markets where you tend to have more country by country, specific offerings, brand beachheads, as you will, going through that typically have a little more of a difficult challenge. In both cases, we've been saying and you know that we're under scale. I think if you think about the larger population, some of the larger competitors out there, it's an opportunity for us as we think about the market dynamics, the future, how that might play out. But we'll -- we continue to think that we can be profitable in those regions. We'll continue to improve. We'll take the actions that Dave mentioned in terms of the rightsizing and the restructuring to make that -- the right decisions. I think over time, the restructuring was just to reiterate, done prepandemic, right? So I think we got ahead of that, or we were getting ahead of that early on to get the right size, take the cost structure out, reformat, to ensure that we're more competitive on an ongoing basis. So I think that puts us in a good place, at least as we go forward in terms of the region. As we think about the kind of the long-term strategy and where we were at, this is going to -- especially on the margins, this is going to impact the business for sure. Q2 is going to be a tough quarter for us. It's just as it is for anybody. The dynamics, the speed, the recovery that's very challenging in terms of -- it's very specific to the jurisdiction, the state, the municipality, the [ taxes ] states are doing, right? So it's going to be a slower evolution before it comes back. We feel it. We would reiterate, though, that from the long-term thesis and the investment thesis, think about last year, Q1, we were well within the guidance, and we were probably building momentum as we tried to get into, especially with the Americas strength. So the fundamentals of the business, right, would demonstrate the performance. We have done that over time and being able to adapt. We've got the electronics growth migration working for us. We talk a lot about the fact that we leverage very well on the business. So if we do get the organic growth, we have margin expansion opportunity. All that drives our EPS growth. That was the fundamental thesis that we had at the Investor Day. And then -- and not to discount it, but the capital allocation and deployment strategy for us is the key element, right? Strong cash flow generation from our business has historically been done. This stays true, whether you're in a down market or an up market. So we'll continue to lever that as we go forward, and that will give us the ability to think about the capital deployment opportunities as well.

Okay. What -- just talking about capital deployment, what's your current M&A appetite? Do you envision any large deals, maybe not fiscal '20 or more so fiscal 2021 at all here?

I would characterize the capital deployment on the M&A front as in a more relationship building, I don't see anything moving significantly in the next 6 months. But again, it's the time to build relationships, partnerships, and if the opportunities that come through that really drives seamless access and that vision of electronics, we have the financial strength to do what Allegion needs to do. But it's going to be quiet on the Allegion front here for the foreseeable future in terms of M&A.

Got it. Can you talk a little bit about your liquidity position, just given the down cycle. And just curious if you've run any stress tested scenarios and how you're thinking about balance sheet preservation if things get worse from here?

Yes, absolutely. We feel like we're in a really good place. The balance sheet is solid. We entered the year at a very good place on -- our covenants well below any thresholds. Our leverage ratio is at a record low, I think, since the spin. We don't have any near-term debt maturities. So it's not a driver for us to have to be in the market. We have an untapped $500 million credit facility. We went ahead and put the share repurchase programs on hold for now, right? And we'll continue to monitor how we're driving the cash deployment and cash generation, think about CapEx spend as well as other elements for the cash. So we would say it's just pretty solid. The -- I think I forgot about the second part of that question. I guess, it was more around....

Stress testing and generally how you're thinking if things get worse.

Oh, the stress testing. Yes. Thanks, Deepa. Yes. So I would say, we typically -- we do that. And actually, you could see even part of our Irish filings that a going concern model and assessment is the requirement as part of the plc filings. We've done that. We've looked at it. Again, given that we started the year with a very solid cash basis, we project good cash generation. Again, as I mentioned before, whether it's down or upturns, we'll convert the cash. We'll monitor the working capital appropriately. And on -- the capital structure's in a solid place, so I don't see any concerns at the moment for the ongoing business.

I would say, too, Allegion, if you benchmark key cap generation ratios, we perform extremely well. And our cash generation in Q1 as well as Q4, but particularly at Q1 was one of our better quarters. I'd -- like a couple of things, we did a good job of generating cash. We also had some nice finished goods inventory that has helped us navigate the shutdowns that we had to incur and we've never been in a better financial situation in terms of cash, liquidity and I think the ability to face whatever comes ahead.

That's fair. I think in Q1, you noted some working capital benefits. Can you talk through how sustainable they are, if at all? And generally, how your free cash flow sets up in this down cycle?

Yes. I mean, in general, we'd like to think cash conversion for us is typically a focus for internally. We drive that as part of the overall cash flow thesis. I would just reiterate that working capital as a percent of revenue for us is actually very modest. It's not a big working capital-intensive business, right? So as we go through this, we'll still monitor and track that, measure the receivables against any expected. We're not seeing any short-term impacts at the moment. We'll monitor that as we go through Q2. Inventory, naturally, you'd expect to come down a little bit, but -- as we adjust for any volume declines. But again, we want to make sure that we're appropriate and mindful of coming out of the recovery. And then, of course, on the payables, right now we'll just -- we'll match that and be prudent. So working capital is, for us, again, it's probably a lower materiality threshold, and it's the overall cash conversion that we'll stay focused on and again, we feel strong about that.

We're coming to close. So I'll end with the final question, Dave and Tom. What are your top 3 macro metrics that you're watching for here to see how the recovery could play out in the next few months?

So one that is key in my mind is permits. It's really the green light to break grant. That's both on non -- and non-resi activities. I think second, we need to keep an eye on state and local budgets, the health of those. There's clearly going to be pressure on state budgets that drives a lot of institutional spending. There actually could be some opportunities within that, but -- and remember, bond issues, typically when a local school district issues bonds for K-12, community colleges, that money is going towards that and so we'll continue to keep an eye on that. I think the ABI is another key indicator. We saw that drop in March and April. I tend to believe that will come back relatively quickly, but it's something that we've got to watch. And the third one, that might surprise you, Deepa, infection rates. We've got to be mindful that there's 7 billion plus on the planet and only a small percentage have been infected. How we navigate that, how we navigate that through the fall, the arrival of the vaccine, it's a pretty important macro indicator to I think how this is going to go forward over the next 12 to 18 months.

That's pretty helpful. Thank you so much for your participation today. That brings us to the end of our fireside chat here. Thanks so much, guys.

Thank you, Deepa.