Allegion plc (ALLE) Earnings Call Transcript & Summary

Good afternoon, everybody. This is Joe Ritchie, who runs U.S. Multis for Goldman. Really happy to kind of kick off this afternoon session with Allegion. We have Allegion's CFO, Patrick Shannon, with us today. Patrick, thank you for being with us.

Thank you so much, Joe, for having us on behalf of Allegion. Appreciate it.

Yes. No. For sure. And before I kind of get into questions, just a reminder to the audience, if you have any questions, feel free to shoot me some questions via the web link, or if you prefer to just send me an e-mail, [email protected].

So with that, Patrick, let's just -- I guess, let's just get going. So look, obviously, you guys put up a great quarter a few weeks ago. Just curious like whether there's been kind of like maybe -- it's been about 3 weeks since you reported. Maybe you can give us a little bit of an update on what you're seeing kind of across your regions and across your end markets.

Sure. So as you know, the markets are extremely dynamic today, changing daily. What I would say is that we, I think, have a pretty good process to kind of measure and marry up external market indicators, the types of things that you see as well as our internal market drivers, things that we talk to our customers about, our specification, bid order, quote activity, those type of things to try to get a good long term kind of view on the market. I'd say 3 weeks hasn't really changed anything from when we talked last time. But we will certainly have a much better view at the end of the quarter 2, and we're committed to kind of give everyone a view for the balance of the year and maybe a little bit of longer term kind of perspective as to what we're thinking. But one of the difficulties here, particularly as you think about the nonresidential segment, you've got a long cycle of activity from specification, and then when the building starts, you'll put a bid, quote on activity, then subsequently get an order. And that's a long process. And so within a short time period of what's been happening and the changes in the marketplace, it's hard to kind of pinpoint what the market may or may not be over the next, we'll call it, balance of this year and 12 months after that. We did communicate on the residential side, 3 weeks ago, the point-of-sale information on residential, kind of call it down mid-teens. I'd say that that's fairly consistent. The only additional piece of information I might give would be that, as you would expect, as markets kind of continue to recover here and people go back to work and activity economically starts back up, the -- sequentially, things are improving kind of week-to-week type of thing. But that's to be expected as the economy kind of comes back into force here.

Yes. No. That's helpful. And I appreciate you guys already committing it, to giving us maybe a little bit of a longer term look as we get kind of towards the end of the quarter. I guess as I kind of think about the regions, obviously, Americas is your most important region. And the growth in that business has been really consistently solid for like the last several years. So can you maybe just kind of talk through -- there's been several things that's been driving that, right? Like it's -- the end market has been working for you. You've had a lot of internally driven initiatives in terms of like expanding your channels. There's been the faster growth from electronics -- electronic locks. So maybe you can just kind of start off by just telling us a little bit more about where you're placing your investments in new products and how much opportunity there's left in the channel strategy that's been really good for you guys.

So as you know, we've been putting in our business incremental investments, and they've been really centered in 3 areas. So new product development, the channel and really doing a deeper dive on segmentation of the channels and looking for opportunities where we had underserved market positions and then really trying to accelerate this electronics adoption through demand creation. And so those 3 kind of being the primary areas. I'd say that strategy and opportunity really hasn't changed even in the current situation. Now the level of investment certainly will change. But as we think about new product development, it will continue to be a key strategic focus for us. And it's not just pumping out electronic type of products, but ensuring that we have those products being able to integrate as part of a broader kind of ecosystem, very important to our strategy going forward. The channel development strategy, I'd say we have made a lot of progress. And a lot of the growth that you've seen in our business relative to the broader market, I'd say better because of that, in particular, and we really put a lot of emphasis and focus on trying to get closer to the end customer through programs with our distribution through locksmiths, installers, trying to have a broader product portfolio that competes at multiple price positions and have been fairly successful at that. And I think there's continued opportunities in the marketplace to continue that. You're never really done with that type of work, particularly when I look at areas like multifamily, where historically, we've kind of had an underserved position. It's a good opportunity for us going forward. And as you know, we've got a large installed base where we can kind of continue to push electronic adoption in both the residential and nonresidential segments through either new product development or some of these channel initiatives. So I like the opportunities going forward. It's been a good growth enabler for us and enabled us to outpace the broader market. And I think we've got a good position, and we should be able to continue to do that going forward.

Got it. No. That all makes a lot of sense, Patrick. And maybe just kind of sticking with the growth that you put up in Q1, pretty impressive growth. In the Americas, you guys called out both resi and nonres being up high single digits. Now you made that comment around resi point-of-sale being down mid-teens, and that's kind of staying consistent. Just -- can you just kind of just talk through what's happening in the resi channel, specifically? I know that the kind of Lennar relationship helped in the first quarter. But maybe talk about how you see kind of resi kind of playing out from here.

I would say being impacted relative to what's going on in the broader economy, we talked about point-of-sale, so you got less foot traffic, big box, retail, and that's kind of what you're seeing there. One of the things that we really put an emphasis on beginning in 2019 is trying to get closer partnerships with the new home build developers, people like Lennar, for example, a key relationship for us that we -- they became part of our business last year. And some of the growth that you saw in Q1 is a result of that. So we didn't have the full year effect of that in Q1 of last year. And so you're seeing the benefits of that. But Lennar is a great example. They're a little bit more forward-thinking, I'd say, in how they think about electronics and the Internet of Things and connectivity of products. And they're really kind of pushing that on the new home build, and that's good for us because it helps accelerate kind of awareness and adoption in electronic locks. And so we look at them as a good long-term partner. Of course, they're also installing our interior mechanical products as well. And we've got an exclusive relationship with them, and we look at them as a great partner going forward.

And I guess mentioning kind of like the point-of-sale, of big-box being off, call it, I don't know, mid-teens. What are you seeing on your online channels? And how big is that business for you guys today? And I'm just thinking this through in terms of lots of people at home right now. It seems like the R&R market, to some degree, has been holding up better than the broader economy. I'm just trying to get a sense for like whether that can kind of help soften the blow of what this downturn looks like for you on that piece of the business.

So that channel has been growing for us, and it's been a good growth enabler with people like Amazon and the like. So we like to distribute through that channel, and we'll continue to do so. I guess I think longer term, it's a good channel and will help to continue to accelerate adoption of electronics, which, as you know, is good for Allegion because it's a higher price point products, similar margin, consequently, more EBIT dollars. And so we like that development in the marketplace. But short term, you have situations where our product set may not be deemed essential from the e-commerce distributor. And so consequently, you have pressure on the top line in short term. But I think longer term, things -- as they come back to more of a normal situation and the consumer is maybe thinking about more renovations in their home, I think that will continue to be a good channel and a good growth opportunity. It's been a good enabler for accelerating the electronics growth in our portfolio, which you know, in Q1, we had double-digit growth in the quarter relative to the prior year. So I would expect that to continue through the e-commerce channel as well.

It's interesting to hear that comment around e-commerce and that your product may not necessarily be deemed essential. Is it your sense that there's been kind of like a shift from an e-commerce perspective to really focus on more essential items like safety, I don't know, janitorial-type supplies? Like what's been your sense on like how they're thinking about their -- I guess, their sell-in and like inventory levels, specifically?

Yes. So it's prioritization. And I think you have -- Amazon in particular was very vocal in terms of what -- how they prioritize and think of some of the things you mentioned, sanitation-type materials, medical, what have you, and just what are they going to stock in the distribution warehouses and what are they going to prioritize from a shipment perspective. I mean I placed a couple of orders on Amazon a couple of weeks ago, and it's a longer delivery time for kind of, we'll call it, the nonessential type of stuff, and I think you're seeing that. But that will work its way through the system. And at some point in the future, I would think that inventory levels will return back to normal levels, and you'll get a spike in activity and those type of things. But it doesn't mean you can't order our products. You can. It just makes -- it may be out of stock or take longer to arrive and those type of things. But it's -- things are going to take a little bit of time before they return to normal.

Got it. And just maybe just closing loop here on the resi side. I mean I know a vast majority of your resi products, which is like roughly, call it, 30% to 35% of the segment, is manufactured in Mexico. In the first quarter, did you see any pull forward in demand given the potential facility shutdowns? And then you also kind of mentioned on the call that you were trying to petition the Mexican government from shutting down. Is there any update on that?

Yes. Sure. So good news, we are now deemed essential, and so we are now producing. The factory is up and running today and actually started early last week. And so fortunately, that was for a short period of time. I think you kind of go back to early to mid-April is when it was closed. So there's no real pull forward into the quarter. But the factory is now up and running, and we're getting back into the normal course of business and fulfilling orders and that type of thing, replenishing inventory during the shutdown. And so that's all good news and being able to service our customers to the extent they need products from us. So that's all up and running now.

So that's great to hear. And maybe shifting gears then, we've talked a lot about resi at this point, but just provide some thoughts around commercial versus institutional. And how do you think this kind of plays out over the next 12 months?

So great question. Again, we're still kind of trying to figure out where the market goes from here, like you and everyone else. I would say, just kind of you read between the lines type of thing. I would say that the commercial segment may be a little bit slower in the recovery. I think you might see less new construction going forward. But institutional markets, where we have a really strong position, particularly in the K-12, medical area, might not be as heavily impacted, say, as the commercial segment. I do believe, however, and we stated this during the quarterly call, that jobs that are under construction will be completed. They may be deferred a little bit and pushed out, kind of the snowplow effect, but they will be done. I think your question is more along the lines of new construction, new projects, those type of things. And I think it's a wait and see. And again, we're trying to correlate the data like you are, and we'll have a better view of that, I think, within the next 90 days. And hopefully, we'll be able to provide more color on that in the future.

Yes. That's fair. I guess if I think about the project -- go ahead.

All right. Just -- you didn't ask about the residential segment. But from a market perspective, unlike the 2008 crisis, I do believe better situation from an overall perspective, where you've got less homes on the market -- less months' supply. There was a fundamental-ish demand/supply issue relative to the prior cycle, unlike this cycle. And so if you're thinking about recoveries, my sense is the residential markets will recover faster, better positioned than the prior cycle in terms of homes on the market. You've got this whole electronics, adoption and repair, retrofit, renovation type of market. And I think that will help accelerate the residential piece of our business faster than the nonres.

Got it. That makes sense. I guess as you kind of think about just the projects that you already know of, that you're already working through, how do you think about how much visibility you have on the nonres side from like a backlog perspective? I know you referenced you'll have a better view in about 90 days. But I guess my question is, do you have like decent visibility then for 2020? And is this more like a 2021 issue if things don't accelerate?

So there's kind of 2 data points. One might be orders that we have in-house, that we will put on the manufacturing schedule, manufacture and deliver. And that's normally a smaller number, if you will, we -- because it's a highly engineered product, build-to-order type of thing, and we operate on a shorter backlog. We're probably one of the best in the industry in terms of being able to get an order, manufacture and ship within a short time frame, normally, call it, 5 to 10 business days. And the market understands that. And consequently, we carry a lower backlog relative to that. Now the longer-dated items would be at the beginning of the cycle, specifications, and we track that activity. That doesn't necessarily mean there's going to be new construction started. It just means there's an architect working on something. And then you have something where a project, you get a new permit, maybe construction started and you'll put in a bid or quote on activity, and we have visibility to all that. And we look at that information, not only on sequential trends, but year-over-year and those type of things. And so we've got activity relative to that. I'd say in the past 60 days, there's been kind of a dislocation in the market just because when all this came about, people hit the pause button and activity stops, and then it starts to restart. And so you have to kind of take that into consideration. And that, I think, is more around the fundamental of what you're asking is how does that look for the future. And right now, it's just too early to kind of tell.

Okay. Yes. No. That's fair enough. And again, obviously, like the backdrop is pretty unprecedented. And then there's not just the private side, but there's the municipal side as well, and we'll kind of see how things shake out over the next, call it, several weeks and months. One of the things that kind of struck me this quarter, also just on the Americas business, was just how good the margins were. I know you took some actions in 2019. That really kind of helped pay dividends this quarter. Just maybe provide some details around some of the things that you put in place last year to help drive better productivity and whether that kind of continues into the rest of this year.

Yes. So the team, as you mentioned, did a great job on a lot of fronts. And I'll just highlight a couple of the main items. So we did put into place last year a lot of new programs, specific to productivity, we put into -- in new engineers that were dedicated to VA/VE programs to reduce the cost of our production. Those have been paying dividends. We're getting good returns on the capital projects that we're putting in into the factories as well. On the supply side, the traditional negotiating better cost on materials and/or changing our supply base has been very effective as well. We got really good leverage on the incremental volume. I'd say we're doing a better job across the board in all of our factories in the Americas of kind of managing the supply/demand equation more effectively and getting better leverage on our fixed overhead cost structure, and you saw that kind of come through in the quarter. And then we had some benefit from cost containment. We -- obviously, like everyone else, we put the brakes on some discretionary spend. You saw that. We've got some -- a little bit of benefit there. And then deflation on the material input side has been working to our advantage, too. And so this price/cost dynamic, where we kind of continue to have been able to get some favorable price in the marketplace, has obviously more than offset the material input side.

Yes. And just on that point, right? So you got like about 160 basis points of price on the quarter. How does that kind of -- in this kind of backdrop, like can you sustain that? Can you sustain like that type of pricing? Or should we be thinking about something lower? You mentioned your input costs are also going down, right? So I'm just wondering like whether distributors are pushing back at all at this point on the pricing side.

I haven't seen much of that. Just as a reminder, well-disciplined industry. And you kind of go back to some of the characteristics of the industry in terms of complexity, highly engineered product, those type of things. Make it, I'd say, easier to get some price improvement year-over-year. Now your question about does it continue, does it get better, worse, et cetera. Remember, last year, we put in a higher price increase to offset what at the beginning of 2019 was a higher inflationary environment. And so you're seeing the benefits of that, kind of the carryforward of those movements that were put in place last year carry forward into Q1. So you're not going to have the uplift associated with that. Now we did go out with the price increase at the beginning of Q2 this year. And we would hope that we can kind of continue to get some pricing improvement, but it's not going to be to the extent that we saw the back half of last year and Q1 of this year. But there'll still be some incremental year-over-year, and it will help buoy margins as material costs have kind of stayed, I'd say, flat from a commodity cost perspective. And so that's still working to our benefit here in terms of year-over-year margin.

Yes. That makes sense. And I guess just maybe just parsing out the pricing comments too, like how much of that was a function of what you were putting through, with the second quarter comment, is that more of like a residential comment? Or is that more of like a what you're expecting into your projects-type comment?

It's more on the nonresidential side. And the resi side, very difficult, as you know, to get any incremental price year-over-year, particularly through the majority of the channel we sell through, big box or e-commerce. And so you really have to drive the productivity side of the equation to drive margin improvement, which we've been doing. But there's always some opportunities to maybe better manage the discount structure, those type of thing -- rebates, returns, things that deteriorate price, I think we've got a good handle on, and we continue to manage those well. And we'll do our best to try and minimize those going forward.

Got it. Fair enough. Maybe switching gears. We spent a lot of time on the Americas, but just switching gears to the -- to some of your international businesses and specifically the cost actions that you announced this quarter. So how should we think about the $20 million to $25 million in cost actions? How much of that is targeting EMEA? And can you just maybe just talk us through some of the things that you're doing and what you would expect from a payback perspective?

Yes. So that number quoted is mostly the cost of the programs, right? And as you -- and that was disclosed as an international program, cost reduction in both Europe and Asia. As you would expect, given that Europe is a bigger segment than Asia and more costly, too, when you do these types of programs, the lion's share, majority, would be Europe-centric. And it's really -- I would characterize it as something we were looking at going into the year to simplify the organization, really try to push the decision-making back down closer to the customer, more specific there, and just giving us opportunities for improvement, really relooking at some of the areas where we compete, whether it be market-centric, product-centric, what can we do to simplify things. And so those are kind of the nature of the cost reduction activities on both a Europe and Asia perspective. As you know, entering 2020, markets were softening, weakening. This COVID-19 really accelerated that. And we had some wood to chop. And so that was the result of kind of those actions initiated at the end of Q1.

Okay. Great. And I guess just in terms of executing those actions and the plans in Europe, like is it any more difficult to get at some of these costs because of the shutdown, because of the physical distancing that's going on?

Yes, it is. I mean it's -- you want to be -- to the extent there's employees involved in the situation, you want to be respectful and handle it the right way and those type of things. And it's very difficult to do in this virtual world. But needless to say, we're trying to work through that. It's more challenging, I'd say. It maybe takes a little bit longer to kind of execute on some of those things. But we're working through it the best we can, and we'll kind of continue to plow forward.

Got it. And then just to remind us just from the EMEA business, like how should we be thinking about your exposure on a country-by-country level? And then like which countries are you seeing your activity normalize faster or slower in the region?

So you should think of our predominant business being Germany, Italy, France, U.K., kind of in that order, I would say. And if you kind of read the headlines, Germany coming back to work sooner, rather. I think they got a handle on the situation faster as a broader economy. Italy, obviously, a little bit slower. It's -- each country has its own unique twist to it in terms of how the local government is handling it. All of our factories, by the way, are up and running now. When we talked on our earnings call, Italy, at the time, was still closed. But they're up and running. Lower volumes, as you would expect, but nonetheless, shipping product to customers and whatnot. So it's just dependent upon each country, but things are starting to recover. Again, more visibility, I'd say, 90 days from now. And we just kind of continue to monitor what's going on in the marketplace like you guys on a day-to-day basis.

Yes. No. Now that makes sense. Maybe just kind of closing loop here on the cost actions, right? So it sounds to me like the payback is probably going to be more than a year, just given what you're doing and the regions that you're doing them in. Decrementals are pretty high in EMEA this past quarter. I mean should we kind of expect similar decrementals then for the rest of the year? Or should they get progressively better as we kind of -- as the year goes on?

So hard to say. And the reason I'd say that is because, well, a couple of things. One is we're -- our factories are probably less utilized than, say, in Americas. And so any volume reductions really kind of penalize the region, particularly in Europe. And we addressed that to some extent, recently, for example, with the closure of Turkey and moving that to Poland, and we still have some inefficiencies we're working through. But I'd say the decrementals are more pronounced internationally, just given the kind of our footprint from a facility perspective, the scale, we don't quite have the scale we would like and enjoy. So any further reductions in demand on top line would further exacerbate the situation in terms of deleverage. And so I would say short term, it's going to be under pressure. As we progress throughout the year, we will start seeing some of these cost reductions we talked about, and that will help mitigate and offset those type of things. And we're taking the appropriate actions across the board globally on discretionary spend and hiring freeze and all these type of things to help mitigate the cost and better marry our cost profile with revenue top line. So all those things are being enacted. And -- but Europe will, nonetheless, have a heavier decremental margin basis of the volume and demand.

Got it. And then maybe just -- we've got a couple of minutes left here. Just maybe just touching on the balance sheet and cash flow. I think just on cash flow specifically, you guys called out not a lot of opportunity on the working capital side. I'm just curious, just as you're kind of thinking about the year, are you still thinking that you guys can achieve, let's say, 100% free cash flow conversion on net income? Or how should we be kind of thinking about like the decline in cash flow will be similar to like the potential decline in net income?

Yes. So historically, we've been able to manage a really good conversion, north of 100% on average of available cash flow to net earnings. That will continue. We'll kind of continue to manage that. We did a great job of making really good progress in working capital. In Q1, really good improvement in velocity of turnover in receivables and inventory. So my point on the working capital previously was we operate about 5% to 6% working capital as a percentage of revenue. So not a huge opportunity for us, additional cash, if you will, to kind of wring out of the system. But we'll continue to work it and get more efficient. But I would expect the conversion still to be at kind of like, we'll call it, the 100% to net earnings going forward.

Great. And I guess just last question. I know you guys suspended the buyback this quarter. Just under what scenario do you think you kind of reinstate the buyback? And then also along the same lines, how are you thinking about M&A? Is this an opportunity to be opportunistic? Or is kind of like the spigot kind of shut off at this point just because of the backdrop?

Yes, real quick. So you're getting at the capital deployment. So again, 3 pieces to the strategy. Organic investments, which we talked about, we'll continue to do that and hopefully position us stronger as we come out of this than before. M&A situation, I would characterize as, short term, probably not any activity. It'd be very difficult to value a business. I'd say we'd be more on the opportunistic side in looking at things. It will be interesting to see, when the fog lifts, how it impacts our industry, if it will trigger any further consolidation with some of these, I'd call, mid-capital type companies, and we'll just kind of keep an eye out on those, continue the dialogues there. On the shareholder distribution, as you know, we stepped up the dividend, I'd say, fairly nicely. That remains intact. We continue to do that. We have opportunity going forward to continue to do that looking into 2021 and going forward. The deferral on the share repurchase program was more of a, hey, let's put a pause on that activity. Our balance sheet is extremely strong today. We're better positioned today than we were at the time of spin. Our debt-to-EBITDA, 1.7x. And so really good shape. Good, strong cash position. We have a $500 million undrawn facility today that we could tap into if needed. I don't see a need to, but we could. And as you know, we generate a lot of cash in the back half of the year that we can put to use by going back to the market through share repurchase. And so historically, we've said, "Hey, we want to put our capital to use for our shareholders." That principle has not changed. And the key takeaway here is we have a lot of optionality and flexibility to do those things given our strong balance sheet position and the cash flow that we generate and enjoy, and we can put that to work by really going back to the market and being in the market on share repurchase going forward.

Now it makes a lot of sense. Guys, really appreciate your time today, Patrick, thanks for joining us, and have a great rest of your week.

Okay. Thanks a lot, Joe. I appreciate it.